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Independent Contractor or Employee

This article addresses whether an employer should designate a new hire as an Independent Contractor or Employee.

People commonly use the term “employee” to describe all workers who perform services for a business. Both state and federal law, however, distinguish different types of workers. The main distinction is between workers who are “employees” and those who are “independent contractors.”

The employee-independent contractor distinction is an important one. Businesses, for example, generally must withhold money for federal income tax, Social Security, and Medicare from wages paid to an “employee.” Those same withholdings, however, are not required for independent contractors. The employee-independent contractor distinction also affects things like whether a business must pay its workers minimum wage and overtime under the Fair Labor Standards Act (29 U.S.C. § 201 et seq.) and Arizona Minimum Wage Act (A.R.S.§ 23-362 et. seq). Employees, for example, are entitled to minimum wage and overtime, while independent contractors are not.

Whether a worker is considered an independent contractor or employee depends on the nature of the work relationship that exists between the worker and the business. Simply labeling a worker an “employee” or an “independent contractor” does not govern. It is the substance of the underlying relationship that matters.

Courts have developed case law around how to determine the substance of the underlying relationship. The employee-independent contractor determination depends on the entirety of the circumstances. See Rutherford Food Corp. v. McComb, 331 U.S. 722, 730 (1947). Under social legislation like the FLSA, the ultimate question is whether, as a matter of economic reality, the worker is dependent on the business for which she works. Donovan v. Sureway Cleaners, 656 F.2d 1368 (9th Cir. 1981) (citing Bartels v. Birmingham, 332 U.S. 126, 130 (1947)). The Ninth Circuit, in Real v. Driscoll Strawberry Associates, Inc., 603 F.2d 748, 754 (9th Cir. 1979), laid out a multi-factor test for answering the “economic reality” question:

“(1) The degree of the alleged employer’s right to control the manner in which the work is to be performed; (2) the alleged employee’s opportunity for profit or loss depending upon his managerial skill; (3) the alleged employee’s investment in equipment or materials required for his task, or his employment of helpers; (4) whether the service rendered requires a special skill; (5) the degree of permanence of the working relationship; (6) whether the service rendered is an integral part of the alleged employer’s business.” Id. at 754

The same common law factors as those set forth in Real are used to distinguish between employees and independent contractors for tax and withholding purposes. The IRS has issued its own guidance on how to make the determination and sums up the common law factors by dividing them into three categories: (1) behavioral control (essentially asks whether the business has retained the right to tell the worker how to perform the task for which she was hired), (2) financial control (essentially asks whether the business has retained the right to control the business aspects of the worker’s job), and (3) the type of relationship of the parties. See IRS Publication 15-A (2013).

Businesses who misclassify workers can be subject to significant liability stemming from, among other things, unpaid back wages and overtime, various tax and employee benefits obligations, fines, penalties and even litigation costs.

Before you engage a worker as an independent contractor, make sure they are, in fact, an independent contractor. The law firm of Harlow, Spanier & Heckele, PLLC can help.

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