Quirky Question # 169: Independent Contractor or Employee?


Our company is located in Washington. To limit costs, we turned to use independent contractors in order to avoid paying benefits, limit overhead, and increase flexibility. But when can someone we hired as an “independent contractor” and for whom we expressly retained no “right to control” nonetheless be deemed an employee, exposing the company to unplanned risks under Federal and some state laws?


In some circumstances there may be advantages for businesses to hire independent contractors rather than employees, including avoidance of taxes under the Federal Insurance Contributions Act (“FICA”) and Federal Unemployment Tax Act (“FUTA”), ADEA and ADA compliance, contributions to pension plans, unemployment insurance, health insurance, employee “headcount,” and workers’ compensation insurance. It may reduce expenses associated with employees by relieving the employer of the duty to comply with certain record keeping statutes.

Given the complexity of determining employment status in any particular case, and the potential risk of retroactive liability, employers should consult with legal counsel before assuming that an individual will qualify as an independent contractor for all purposes. If an audit by the U.S. Internal Revenue Service (“IRS”) discovers that an employer has misclassified workers, not only may the employer be required to pay the back taxes that should have been withheld from the employee’s wages, but a penalty may be charged as well. Employees also challenge independent contractor status under stock-based retirement and compensation plans, as illustrated by the multi-million dollar settlement in Vizcaino v. Microsoft Corp., 184 F.3d 1070 (9th Cir. 1999), cert. denied, 528 U.S. 1105 (2000). As preventive analysis and planning will help avoid costly liability, it is important to resolve at the outset the issue of whether an individual’s services for the employer will be considered those of an employee or independent contractor.

Different criteria exist to determine whether an individual is an employee or independent contractor. Some agencies, for example, employ the “common law” test, while others use an “economic realities” test. Thus, it is important to note that a worker might be an independent contractor under one test, but an employee under another. Rev. Ruling 87-41, 1987-1, Cum. Bull. 296, 298-99; 26 C.F.R. § 31.3121(d)-1(c); see, e.g., Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318 (1992) (adopting common law test in ERISA context).

Under the common law test, the principal criterion considered is whether, and to what extent, the employer has the right to control the manner and means by which the work is performed. The IRS uses a 21-factor test, which is an outgrowth of the common law test that focuses on: (1) behavior control, (2) financial control, and (3) type of relationship. Internal Revenue Service, Employer’s Supplemental Tax Guide, Publication 15-A, p. 6 (2009) at http://www.irs.gov/pub/irs-pdf/p15a.pdf; see also, NLRB v. Friendly Cab, 512 F.3d 1090 (9th Cir. 2008) (taxi drivers were “employees” not “independent contractors,” where employer exerted considerable control over means and manner of drivers’ performance, and did not provide them with opportunity to pursue entrepreneurial opportunities).

(a) Behavioral Control:  Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of instructions the business gives the worker and training that the business gives to the worker.

The following are examples of business instructions:

• when and where to do the work;
• what tools or equipment to use;
• which workers to hire or get to assist with the work;
• where to purchase supplies and services;
• what work must be performed by a specific individual; and
• what order or sequence to follow.

The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.

The training an employer provides to a worker may also be indicative of employee or independent contractor relationship. An employee may be trained by an employer to perform services in a particular manner. Independent contractors ordinarily use their own methods.

(b) Financial Control: In determining whether a worker is an employee or an independent contractor, courts look to whether the company has a right to control the business aspects of the worker’s job. The following factors weigh into this determination:

The extent to which the worker has unreimbursed business expenses: Independent contractors are more likely to have unreimbursed expenses than are employees. While employees may also incur unreimbursed expenses in connection with the services they perform for the company, it is the extent of these expenses that is significant. Fixed ongoing costs that are incurred regardless of whether work is currently being performed weigh strongly in favor of an independent contractor determination.

The extent of the worker’s investment: An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.

The extent to which the worker makes his or her services available to the relevant market: An independent contractor is generally free to seek out business opportunities beyond the company for which it is performing work. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

How company pays the worker: An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors on an hourly basis.
The extent to which the worker can realize a profit or loss: An independent contractor can make a profit or loss. The company incurs the profit or loss if the worker is an employee.

(c) Type of Relationship: Courts also look to the type of relationship between the company and the worker in determining whether a worker is an employee or an independent contractor. Facts that show the parties’ type of relationship include the following:

Written contracts: Written contracts describing the relationship of the parties may be evidence that the parties intended to create an employee or independent contractor relationship.

Benefits: If the company provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay, it is likely that the relationship is employer-employee.

The permanency of the relationship: If a company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.

The extent to which services performed by the worker are a key aspect of company’s regular business: If a worker provides services that are a key aspect of a company’s regular business activity, it is more likely that the company will have the right to direct and control the worker’s activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

While the above factors are generally considered by courts in determining an independent contractor or employer-employee relationship, other criteria may be controlling under specific laws. For purposes of the Fair Labor Standards Act (“FLSA”), which governs the payment of minimum wages and overtime, the following criteria are controlling:

• the degree of control that the employer exercises over the manner in which the work is performed;
• opportunities for profit or loss;
• the worker’s investment in the business;
• the permanency of the relationship; and
• the skill required to perform the job.

Under the FLSA, the focal point is whether the worker is “economically dependent on the business to which he renders service” or is, in fact, in business for himself. Dole v. Snell, 875 F.2d 802, 805 (10th Cir. 1989). Given the complexity of determining employment status in any particular case, and the potential risk of retroactive liability, employers should consult with legal counsel before assuming that an individual will qualify as an independent contractor for all purposes.

Generally, none of these factors standing alone will determine the status of the employment relationship. Each situation will be determined on its own facts. As a general proposition, the most important factor is whether the individual is subject to the will and control of the employer as to the tasks the individual performs.

To distinguish between employees and independent contractors for the purposes of the FLSA, courts apply the “economic realities” test. This test seeks to determine the extent to which a worker is economically dependent upon the particular business with which he or she is connected. Those who are sufficiently dependent are considered “employees” covered by the provisions of the FLSA. Those who are sufficiently independent to be considered self-employed are “independent contractors” and thus not covered. Halferty v. Pulse Drug Co., Inc., 821 F.2d 261, opinion modified, 826 F.2d 2 (5th Cir. 1987).

The Washington State Court of Appeals held on December 20, 2010, that a worker is an “employee” for purposes of wage and hour law not under the common law “right to control” test, but rather on the more employee-favorable “economic realities” test. Anfinson v. FedEx was brought by two route drivers who argued that their class of worker was not an “independent contractor,” but rather an “employee” for purposes of Washington’s Minimum Wage Act (WMWA), and as a result entitled to overtime compensation for all hours worked over 40 in a work week.

After a four week trial on the classification, the jury was instructed to use a “right to control” test and found in favor of the Company. The Court of Appeals reversed, holding that instead an “economic realities” test should have been applied. The Court believed that under that test, no single factor is determinative, but that depending on the “circumstances of the whole activity” and ultimately, “whether as a matter of economic reality, the individual is dependent on the business to which he renders service.” In other words, even a worker over whom the Company did not retain the right to control could be deemed an “employee” if the economic reality of the relationship bound the worker to the business.

The Court also found instructive the factors established by the Department of Labor & Industries: (1) the degree of control that the business has over the worker; (2) the worker’s opportunity for profit or loss depending on managerial skill; (3) the worker’s investment in equipment or material; (4) the degree of skill required; (5) the degree of permanence of the working relationship; and (6) the degree to which the worker’s services are an integral part of the business.

As a result of this decision, many more individuals currently considered “contractors” will be classified under Washington State law as “employees” and entitled to minimum wages, overtime, breaks, and meal periods. Employers should review each of their independent contractors to determine whether they pass the more-stringent “economic realities” test under WMWA, and consult legal counsel.

(See also, Forcing Employees to Litigate in One State, Quirky Question # 153.)

Dorsey & Whitney

Dorsey is a business law firm, applying a business perspective to clients' needs. We make it our first priority to know the context in which you do business - your market, your competitors, your industry.

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