Avoid Underpaying Independent Contractors

From having a dream you wanted to bring to fruition to being your own boss, every business owner has their own reasons for starting their business. However, most business owners have one reason in common: the desire to make money. One way businesses make money is by saving money where they can. From finding lower-priced materials to make a product to negotiating cheaper rent on an office building or warehouse, there are many options for saving money. However, one way you should not try to save money is by underpaying independent contractors. Specifically, employers should not try to save money by classifying an employee as an independent contractor. If you have questions regarding worker classification or need assistance ensuring your workers are appropriately classified, an experienced Arizona business attorney with Harrison Law, PLLC may be able to clarify matters. Call (480) 320-2310 to discuss worker classification and ensure your records are in order.

Independent Contractors vs. Employees

There is often confusion regarding the difference between independent contractors and employees. Both can be remote or on-site when they work, work full- or part-time, and work on various types of projects. They also have similar performance expectations and have a degree of professional responsibility in terms of meeting deadlines and the quality of their work. Given these similarities, it is understandable that there might be some uncertainty about how to classify a worker. However, the differences between employees and independent contractors are significant and it is these differences that make it so critical to ensure that workers are appropriately classified.

Elements That Qualify as an Employee

Employees work under the explicit direction and control of their employer, being told when, where, and how to work. Their employer typically provides the tools and equipment needed to perform their job duties. Employees are eligible for employer-provided benefits such as health insurance or retirement plans, have taxes withheld from their paychecks, and are paid a salary or hourly wage. Employees are provided with certain protections such as minimum wage and overtime pay through the Fair Labor Standards Act.

While these are generally true of employees, it is important to note that just because a worker does not meet one of these elements does not mean they are not an employee. For example, many construction workers provide their own tools on the job site. A worker is considered an employee if they are economically dependent upon the employer. Generally, most of these elements exist when the worker is an employee, but the lack of one or more of these elements does not definitively mean the worker is not an employee.

Elements That Qualify as an Independent Contractor

Independent contractors are given some direction, such as being told what to work on, parameters around the work such as templates or other criteria that must be met, but are generally not under the control and direction of the business they are working for. Independent contractors set their own work schedule and work methods and they work where they choose. They must pay their own taxes and do not receive benefits. They are typically paid per project, task, or contract, and invoice the business for the work they have done. They do not get the protections of various employment laws.

Perhaps one of the most distinctive differences between employees and independent contractors is that independent contractors have an opportunity to make a profit or suffer a loss based on their performance. While employees get paid a set pay, independent contractors only make money when they can find clients. If they do not provide high-quality work, they will find it difficult to find clients and will lose money. However, if they provide high-quality work, finding clients will be easier for them. They can take on as many clients as they can handle, allowing them to increase their profit accordingly.

Why Correct Classification Matters

Businesses are not required to provide benefits to their employees, and whether an employer holds out taxes or a worker pays them, the taxes still get paid. Some business owners may wonder why it matters how a worker is classified, given those facts. While it may seem like those are the only two important differences that matter, other differences matter as well. Additionally, it is not just a matter of whether benefits are required or taxes are paid. There are federal and state laws that require proper classification and offer different protections based on whether the worker is an employee or an independent contractor. Improperly classifying a worker can have significant consequences for an employer.

Financial Penalties

Employers can face a variety of financial penalties for misclassifying workers. Back wages, overtime pay, unpaid taxes, interest, penalties, and state unemployment taxes are just a few of the potential financial penalties a business may face. For example, the Internal Revenue Service (IRS) may charge a $50 fine for each unfiled W-2, plus a percentage of the wages that should have been paid, the full amount of Social Security and Medicare that the employer should have paid plus 40%, interest on these amounts, and a failure-to-pay penalty. Employers should note that these penalties are per violation, and can range from $5,000 to $25,000 or more per violation. The IRS does offer Form SS-8 for determining how a worker should be classified. Employers can fill out the form and submit it to the IRS for an official decision.

Criminal Penalties

In cases where the employer is found to have engaged in fraud or intentionally misclassified employees as independent contractors, they may also face criminal penalties. These penalties can include up to one year in jail and fines of $1,000 or more per employee. Additionally, class-action lawsuits may be filed, resulting in punitive damages, compensation and legal costs.

Reputational Damage

Misclassifying employees as independent contractors can also cause reputational damage to the business. This can reduce the business’s employee retention, causing them to not only lose employees, but spend more money on recruiting and training new hires to fill the empty roles. Additionally, if an employer does this too often, word may spread beyond employment circles and customers may begin to hear about it. This can cause customers to question the business’s ethics and decide to take their business elsewhere.

Lawsuits From Affected Parties

In addition to potential financial and criminal penalties, businesses can also face lawsuits from the affected individuals. Workers who were misclassified as independent contractors can file a lawsuit themselves, or the Department of Labor (DOL) can file a lawsuit on their behalf. The DOL can also stop the shipment of goods produced under these violations, costing the business additional money in unsold products.

What Is Economic Dependence?

There are many factors considered in determining whether a worker is an employee or independent contractor, but ultimately, the questions come down to one: is the worker economically dependent on the potential employer? What does economic dependence mean, though? In this context, economic dependence is not the amount of income the worker earns or whether they have other income sources. Instead, it is whether the worker relies on the employer for income or is in business for themselves.

An employee is economically dependent on their employer for work. They have a sense of permanency with their employer, and do not generally seek other work to increase their income. If their employer stops providing them with work and income, they do not have a backup source. In other words, they count on their employer for their income. Independent contractors are in business for themselves and not economically dependent on a single business for their work and income, even if the independent contractor opts to work with one business at a time.

Six Factors Considered in Determining Economic Dependence

Per 29 cfr part 795, there are six economic reality factors considered when determining whether a worker is economically dependent upon the potential employer. As of March 11, 2024, these factors are weighed relatively equally, with the courts looking at the totality of the circumstances, or all the factors of the situation. Prior to that, some factors were weighed more heavily than others. If you are uncertain how to consider these factors and determine your workers’ classifications, a business attorney with Harrison Law, PLLC may be able to work with you to determine the appropriate classifications for your workers and if necessary, take action to correct any misclassifications.

Opportunity for Profit or Loss

This factor considers the worker’s opportunities for profit or loss based on their managerial skills. Do their skills, including initiative, judgment, or business acumen, affect their economic failure or success in the performance of their work? The worker must have the opportunity to either make a profit or suffer a loss to be considered an independent contractor. In determining this, some of the questions that are considered include:

• Can the worker decide or sufficiently negotiate the pay or charge for the work they provide?
• Can the worker choose to accept or decline jobs, or decide the order in which to do the jobs, or determine what time to do the jobs?
• Does the worker hire others, rent space, or purchase materials to perform their work?
• Does the worker engage in advertising, marketing, or other efforts to secure more work or expand their business?

The answers to all of these questions does not have to be yes, but in general, they will be if the worker is an independent contractor. Additionally, some decisions that impact pay do not indicate the worker is an independent contractor. For example, working more hours or taking on additional jobs when the worker is paid a fixed rate per job or per hour is not exercising managerial skills and thus, not an indication that the worker is an independent contractors.

Investments By Worker and Potential Employer

Independent contractors make independent business investments, but employees only make investments to cover job-related costs and do not contribute to business growth. When an worker makes investments that help them reach new markets, reduce business costs, or expand their business, they are likely an independent contractor, even if their investments are made on a much smaller scale than that of the potential employer. However, if the worker’s investments are limited to job-related expenses only, such as tools, labor, or costs their employer has imposed on them, they are likely an employee.

In other words, is the worker investing in a way that helps them do more than just the work they do for the potential employer or are they only investing the bare minimum that allows them to do the work for the potential employer? If they are investing in a way that helps them do more than just the work for the potential employer, they are investing in business growth and that makes them an independent contractor.

Degree of Permanence of Work Relationship

Independent contractors understand that the work they do is typically not permanent. Their work relationships are generally of definite duration, non-exclusive (allowing the worker to work for multiple businesses, including those within the same industry), project-based, or otherwise sporadic due to working for multiple entities. In some cases, independent contractors take seasonal or temporary work, but that does not necessarily guarantee the worker is an independent contractor.

However, employees take a job with a sense of permanence. This does not necessarily mean that an employee takes a job intending to work there until retirement or death, but instead the work is of indefinite duration or continuous, and often requires exclusivity to the employer. For example, many employees work set schedules that do not change and would make it difficult for them to take on additional work from another employer. Additionally, many employers stipulate that their employees cannot work for a competitor while working for them.

Nature and Degree of Control

The potential employer’s control over the worker, including reserved control (control the employer retains, even if they do not exercise it frequently or at all), can indicate whether the worker is an independent contractor or an employee. This control can include whether the potential employer controls the worker’s work schedule, supervises how the worker performs the work, or puts explicit restrictions on the worker’s ability to work for other employers. If the potential employer controls prices or rates services or the marketing for products or services provided by the worker, this may also indicate the worker is an employee. If the worker retains more control over these aspects of the work relationship, they may be an independent contractor.

Whether the Work Is Integral to the Business

This factor does not focus on whether the worker is integral to the business, but whether the work they perform is. If the work they perform is considered critical to the business, this tends to indicate the worker is an employee. If the work is not critical, the assumption tends to be that they are an independent contractor. However, as with all factors, there are exceptions and it may be possible for an independent contractor to do integral work and an employee to do work that is not integral at all. This factor must be considered along with all the other factors to determine whether workers are employees or independent contractors.

Skill and Initiative

Often, if a worker does not use any specialized skills or relies on the potential employer to train them in specialized skills for the job, the worker is likely to be an employee. When the worker has specialized skills that they use to perform the work and those skills also contribute to a business-like initiative, they are likely an independent contractor. However, specialized skills alone are not indicative of the worker’s classification, as both independent contractors and employees may have specialized skills. Again, it is critical to consider this with the other factors to come to a conclusion.

How an Arizona Business Attorney May Assist You

You may think an independent contractor will save your business money. You may not think you are underpaying them. If you have misclassified a worker as an independent contractor, you may very well be underpaying them and ultimately, risk costing your business a lot more money than the correct classification as an employee would. Independent contractors have their place, and your business may be one of those places, but making sure that you have properly classified them is critical. A knowledgeable Arizona business attorney with Harrison Law, PLLC may be able to review your worker records, including job descriptions, pay rates, contracts, and other factors, to ensure you have correctly classified all your workers. If you have discovered a misclassification or been contacted by the DOL or a worker about a misclassification, we may also be able to assist you with correcting the error and negotiating any penalties associated with it. Call (480) 320-2310 to schedule a consultation and learn more about worker classifications.