Businesses often seek a "bright line" test for whether someone with whom they have contracted for services should be classified as an "Independent Contractor" or as an "Employee". The answer has important consequences including but not limited to the applicability of employment laws and other laws and regulations, tax withholding and tax matching requirements, and rights upon termination. This discussion is limited to a review of relevant statutory and case law, including but not limited to regulations adopted by the Internal Revenue Service, United States Department of Labor, Texas Workforce Commission and related agencies. The author is an attorney licensed only in Texas without regard to the facts and circumstances of any particular situation. Thus, this discussion is of a general nature, not intended to serve as legal advice, and it does not address the laws of any particular state other than Texas.

Before delving into various "tests" let us clarify for the record that there is no single test for determining an individual's status as employee vs independent contractor. In fact, the IRS readily admits that "no single fact provides the answer" which requires that one evaluate various factors that tend to show employee status versus those factors that tend to show an independent contractor relationship..[1]

In addition to the absence of a single, determinative factor, it is also important to note that the Internal Revenue Service does not have exclusive jurisdiction over the issue of "employee" status and some individuals may qualify as statutory employees meaning that taxes must be withheld and paid by the employer (i.e. such individuals are considered "employees" for tax purposes, despite being defined as independent contractors under normal common law rules.[2]

Moreover, in addition to the IRS and common law principles, other agencies and statutory schemes impact the definition of employee status, including but not limited to the Equal Employment Opportunity Commission ("EEOC"), the Department of Labor ("DOL"), various state unemployment offices such as the Texas Workforce Commission ("TWC") or the California Employment Development Department ("EDD").

Defining an individual as an "independent contractor" and not an "employee" within one set of rules/regulations does not necessarily protect an employer from a different set of rules/regulations defining that same individual as an "employee" subject to the applicable employee protections/requirements. The converse is generally not true. In fact, the author is not aware of a single instance in which an employer elected to treat an individual as an employee, including the payment of all applicable payroll related taxes, benefits, etc., yet a different set of governmental agency regulations dictated "independent contractor" status. In fact, Texas law creates a presumption of employment and places the burden for proving otherwise on the employer.[3]

Regarding the various tests, most advisers start with the IRS' definitions due to the significant penalties for misclassifying an individual as an "independent contractor" as opposed to IRS rules defining such individual as an "employee." Even the IRS has different tests.[4] Historically the IRS utilized the "Twenty Factor" test which is described below, but due to pressure from Congress to simplify and refine the Twenty Factor test, the IRS has recently organized such factors into three main groups or categories of factors, described as Behavioral Control, Financial Control and Type of Relationship ("Three Category Test")[5] as follows:

1. Behavioral Control:
   Behavioral Control factors show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker, keeping in mind that the "right" to control the work is central to this inquiry, not whether the business actually exercises such right on a regular basis. Behavioral Control includes such issues as how, when or where to work, what tools or equipment to use, policies and procedures for performing the work (as opposed to a pure end product analysis), what assistants to hire and or report, and any training. In fact, if the business provides training about required procedures and methods, the IRS is likely to view this as an employment relationship.
2. Financial Control:
   Financial Control factors focus on the right to direct or control the business or financial part of the work. More specifically, does the individual have an opportunity to realize a loss as well as a profit, which suggests an independent contractor status; whereas, a relationship limited to profits only tends to suggest an employment relationship. Unreimbursed business expenses tend to suggest an independent contractor status; whereas, full reimbursement for business expenses suggests an employment relationship. Though not dispositive, a significant investment by an individual suggests an independent contractor status; whereas, no investment tends to suggest an employment relationship.
   
   Finally, and of considerable importance: how does the business pay the worker. Payment via a regular wage, whether it is hourly, weekly, etc. tends to suggest an employment relationship; whereas, a flat fee for the job is generally considered an independent contractor, though some professions such as the legal profession commonly pay by the hour without necessarily transforming such workers into employees.
3. Relationship of the Parties:
   A written contract may be of assistance, but, again, it is not dispositive of the issue. Employee type benefits such as insurance, pension plan, vacation pay or sick pay suggest an employment relationship. The converse is not particularly significant, since many employers provide few if any benefits. The permanency of the relationship is also significant. More specifically, a relationship with the expectation of permanence, subject to early termination by either side "at will" suggests and employee status; whereas, a specific duration such as 90 days, or even more significantly, tied to completion of a particular project or matter, tends to suggest independent contractor status. Additionally, the more that the services performed by the worker a key aspect of the regular business of the company, the more likely it is that such worker will be considered an employee.

As noted above, the IRS has recently categorized and reorganized the Twenty Factor Test into the allegedly simpler Three Category Test described above. It is axiomatic that most IRS' "simplifications" fail to achieve their stated goals. Thus, many practitioners (and perhaps courts) continue to consider the Twenty Factor Test as having some relevance to the thinking behind the more recent Three Category Test. Thus, the 20 factors[6] are very briefly described below (which largely duplicate the Three Category Test noted above):

1. Instructions: If the employer as the "right" to give instructions as to when, where, and how the work is to be performed, such person is ordinarily an employee.[7]
2. Training: Training a worker suggests employee status.[8]
3. Integration: Integration of the worker's services in to the primary business operations of the business generally shows that such worker is subject to direction and control, and, hence, employee status.[9]
4. Services Rendered Personally. If the services must be rendered personally, rather than subcontracting or assigning such services to others, this suggests control and employee status.[10]
5. Hiring, Supervising and Paying Assistants. The hiring, supervising and paying of assistants by or at the direction of the worker's supervisor tends to suggest employee status.[11]
6. Continuing Relationship. A continuing relationship indicates employer-employee relationship.[12]
7. Set Hours of Work. The establishment of set hours of work by the person for whom the services are performed suggests employee status.[13]
8. Full Time Required. Full time status suggests control and employment status; whereas independent contractors are free to work when and for whom he or she chooses.[14]
9. Working on Employer's Premises. Working on the business premises suggests control and, hence, employee status; whereas, freedom to do the work elsewhere suggests a lack of control. But the importance of this factor depends on the nature of the service involved and whether an employer would generally require an employee to perform such service on premises. Control is alternatively indicated by having the right to compel the worker to travel to a designated route, canvass a specific territory within a certain time, or to work at a specific place as required.[15]
10. Order or Sequence Set. Requiring a worker to perform services in a certain order or sequence shows control and, hence, employee status; though again, simply having the right to do so, albeit perhaps an unexercised right, tends to show control and employee status.[16]
11. Oral or Written Reports. A requirement that a worker submit regular or written reports suggests control and employee status.[17]
12. Payment by the Hour, Week, Month. Payment by the hour, week, or month generally points to an employer-employee relationship; whereas payment by the job or on a straight commission generally indicates that the worker is an independent contractor.[18]
13. Payment of Business and/or Traveling Expenses. Payment of business and/or travel expenses suggest that the worker is an employee. Moreover, assuming the obligation to pay such expenses, but only subject to the right to regulate and control such expenses further suggests employee status. Predetermined, especially where the employer retains the right to regulate and direct the worker¿s business activities.[19]
14. Furnishing of Tools. The fact that the person or persons for whom the services are performed furnished significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship.[20]
15. Significant Investment. If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer-employee relationship.[21]
16. Realization of Profit or Loss. A worker who can realize a profit or suffer a loss as a result of the worker¿s services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee.[22]
17. Working for More Than One Firm at a Time. If a worker performs more than de minimls services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor.[23]
18. Making Service Available to General Public. The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.[24]
19. Right to Discharge. The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right in an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer¿s instructions. An independent contractor, on the other hand, cannot be fired so as long as the independent contractor produces a result that meets the contract specifications.[25]
20. Right to Terminate. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship.[26]

As also noted above, other governmental agencies impact the definition of "employee" versus "independent contractor" depending on the issues and venue. For example, the Federal Fair Labor Standards Act ("FLSA") -- enforced by the Department of Labor ("DOL") -- employs the "Economic Reality Test" which focuses on the purpose of the FLSA to protect workers. This test looks not only to control, but also to dependence by the worker on the employer, as a significant factor in extending employee status to such a relationship.

This Economic Reality Test has been adopted in related legislative areas, meaning that this more inclusive test applies in areas such as discrimination, minimum wages and overtime, retirement benefits, family and medical leave, and is often useful in the areas of unemployment insurance and workers' compensation insurance issues. The DOL explained the FLSA Economic Reality Test with the observation that "an employee, as distinguished from a person who is engaged in a business of his own [an independent contractor], is one who, as a matter of economic reality follows the usual path of an employee and is dependent on the business which he serves."[27] The opinion letter listed six factors closely associated with the Economic Reality Test:

1. A limited amount of the worker's investment in facilities and equipment;
2. The nature and degree of supervision retained or exercised by the company;
3. The worker's opportunities for profit and loss (meaning beyond a mere wage as real participate in profits or, especially, the opportunity to actually lose money);
4. The small degree of worker's independent initiative, judgment, and foresight in open market competition with others required for the success of the operation;
5. A high degree of permanency of the work relationship; and
6. The broad extent to which the services are an integral part of the company's business.[28]

Somewhat similarly, in California prior to the Borello[29] decision, California courts generally focused on "control"[30]. The Borello Court found the business growers to be employers even though they did not have authority over the work details, since they retained "all necessary control" over their operations.[31] The Borello court identified the following additional factors:

1. Whether the person performing services is engaged in an occupation or business distinct from that of the principal;
2. Whether or not the work is part of the regular business of the principal;
3. Whether the principal or the worker supplies the instrumentalities, tools and the place for the person doing the work;
4. Whether the alleged employee invested in required equipment or materials;
5. The skill required in the particular occupation;
6. The kind of occupation, with reference to whether, in the locality, the work isusually done under the direction of the principal or by a specialist without supervision;
7. Whether the alleged employee has the opportunity for profit or loss depending on his skills (management and work);
8. Length of time for which the services are to be performed;
9. Degree of performance of the working relationship;
10. Method of payment, whether by time or by the job;
11. The intent of the parties as it relates to whether they believe they are creating an employer-employee relationship.[32]

For a slightly different perspective, the Texas Workers' Compensation Act[33] defines an "employee" as "each person in the service of another under a contract of hire, whether express or implied, or oral or written. For TWC purposes, and employee includes "an employee employed in the usual course and scope of the employer's business who is directed by the employer temporarily to perform services outside the usual course and scope of the employer's business; and (2) a person, other than an independent contractor (or employee of an independent contractor), engaged in construction, remodeling, or repair work for the employer at the premises of the employer; and a "trainee" under the Texans Work Program. The term "employee" does not include master or seaman of an interstate vessel; or a person whose employment is not in the usual course and scope of the employer's business. From this last point, the TWC would appear to make an employee who is permanently not involved in the normal business of the employer a non-employee. While this is a "factor" under the various IRS rules, course and scope is not determinative under the IRS. One possible rationale for the TWC's focus on course and scope relates to the purpose of the TWC which is to create classes of employee services whose rate as a percentage of the payroll accurately reflects the risks imposed and generates an adequate fund to pay for employee' injuries on a class by class basis. Allowing employees to permanently engage in non-normal business operations of the employer tends to defeat this objective of matching revenue with risk. Thus, it is difficult to apply the TWC limitation of employee status for any purpose other than TWC insurance premiums and entitlement to benefits.

The common-law rules are somewhat different, though again all of the rules seem to overlap and repeat the various tests from slightly different perspectives. "Under the common-law rules, anyone who performs services for you is your employee if you have the right to control what will be done and how it will be done."[34] The key is not whether the business provides the worker with freedom of action; it is whether the business has the right to control the essential aspect of the worker's performance.[35]

The common law control factors are generally considered to include the following points:

1. The extent of control which it is agreed that the employer may exercise over the details of the work;
2. Whether or not the worker is engaged in a distinct business or occupation;
3. The kind of occupation and normal conditions in the geographic area of working under employer direction or as a specialist without supervision;
4. The skill required;
5. Whether the employer or worker supplies the tools and workplace;
6. The expected duration of the relationship;
7. The method of payment, whether by the time worked or by the job;
8. Whether or not the work is part of the regular business of the employer;
9. Whether or not the parties believe they are creating an employer-employee relationship; and
10. Whether or not the worker does business with others.[36]

All of the factors and tests described above must be evaluated in relation to the purpose for which the various tests and/or factors have been created. More importantly, the concepts of "Statutory Employee" and "NonStatutory Employee" must be considered. These terms mean and refer to the concept that certain workers are "deemed" to be employees by the IRS despite not necessarily falling within the definition of "employee" under any of the relevant IRS or common-law tests; and other workers are "deemed" by the IRS to be "independent contractors" (i.e. not employees) despite the possibility that they would otherwise be defined as employees through application of the various tests as to status. More specifically:

Statutory Employees: If workers are independent contractors under the common law rules, such workers may nevertheless be treated as employees by statute ("statutory employees") for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes, below:

1. A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
2. A full-time insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
3. An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
4. A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer's business operation. The work performed for you must be the salesperson's principal business activity. See Salesperson in section 2.

Social Security and Medicare taxes: Withhold social security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:

1. The service contract states or implies that substantially all the services are to be performed personally by the [worker];
2. The [workers] do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities);
3. The services are performed on a continuing basis for the same payer.

Statutory NonEmployees: There are two categories of statutory nonemployees: direct sellers and licensed real estate agents. They are treated as self-employed for allfederal tax purposes, including income and employment taxes, if:

1. Substantially all payments for their services as direct sellers or real estate agents[37] are directly related to sales or other output, rather than to the number of hours worked; and
2. Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.

Conclusion

The distinction between "Independent Contractor" and "Employee" status remains elusive, and there is no single bright line test. As a general proposition, the safest route is to error in favor of employee status, though the overhead burden and legal rights associated with employee status sometimes motivate businesses to pursue the "Independent Contractor" type relationship whenever possible. The author is an attorney licensed only in Texas and this article is of a general nature without regard to the facts and circumstances of any particular situation. Thus, this discussion is not intended to serve as legal advice, and it does not address the laws of any particular state other than Texas.

 

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Endnotes

[1] Internal Revenue Service, Independent Contractor or Employee¿,IRS Publication 1779 (Rev. 1-2005), at http://www.irs.gov/pub/irs-pdf/p1779.pdf; accord, Rev.Rul.87-41, 1987-1 C.B. 296 (stating that the factors are designed only as guides and cannot necessarily be applied across the board and not according to any mathematical formula, because the importance of each factor will vary based on the job and other facts).

 

[2] Internal Revenue Service, Employer¿s Supplemental Tax Guide, IRS Publication 15-A, (January 2005), http://www.irs.gov/pub/irs-pdf/p-15a_05.pdf.

[3] texas workforce commission, especially for texas employers § 1 (2006 ed.), http://www.twc.state.tx.us/news/efte/ics_contract_labor.html (2006).

[4] Internal Revenue Service, supra note 1; Internal Revenue Service, supra note 2 at 6-8.

[5] Internal Revenue Service, Employer¿s Supplemental Tax Guide, IRS Publication 15-A, (2004 Ed.).

[6] Rev. Rul. 87-41, 1987-1 C.B. 296; See also I.R.C. § 3121(defining what an ¿employee¿ means).

[7] Rev. Rul. 68-598, 1968-2 C.B. 464; Rev. Rul. 66-381, 1966-2 C.B. 449.

[8] See Rev. Rul. 70-630, 1970-2 C.B. 229.

[9] See United States v. Silk, 331 U.S. 704, 714-716 (1947).

[10] See Rev. Rul. 55-695, 1955-2 C.B. 410.

[11] Rev. Rul. 55-593, 1955-2 C.B. 610.

[12] United States v. Silk, 331 U.S. 704, 716 (1947).

[13] See Rev.Rul. 73-591, 1973-2 C.B. 337.

[14] See Rev.Rul. 56-694, 1956-2 C.B. 694.

[15] See id.

[16] See id.

[17] See Rev.Rul. 70-309, 1970-1 C.B. 199; see also Rev.Rul.68-248, 1968-1 C.B. 431.

[18] See Rev.Rul. 74-389, 1974-2 C.B. 330.

[19] See Rev. Rul. 55-144, 1955-1 C.B. 483.

[20] See Rev. Rul. 71-524, 1971-2 C.B. 346.

[21] See id.

[22] See Rev. Rul. 70-309, 1970-1 C.B. 199.

[23] See Rev. Rul. 70-572, 1970-2 C.B. 221.

[24] See Rev. Rul. 56-660, 1956-2 C.B. 693.

[25] See Rev. Rul. 75-41, 1975-1 C.B. 323.

[26] See Rev. Rul. 70-309, 1970-1 C.B. 199.

[27] Wage & Hour Opinion Letter, DOL, No.832, June 25, 1968

[28] Id.

[29] S.G. Borello & Sons, Inc. v. Dep¿t of Indus. Relations, 769 P.2d 399, 399 (Cal. 1989).

[30] Tieberg v. Unemployment Ins. Appeals Bd,, 2 Cal.3d 943, 946 (Cal. 1970).

[31] S.G. Borello & Sons, Inc. 769 P.2d 399 at 400-401.

[32] S.G. Borello & Sons, Inc., 769 P.2d 399 at 404.

[33]Tex. Lab. Code Ann. § 401.012 (2006).

[34] Internal Revenue Service, supra note 2 at 4.

[35] Id.

[36] Id. at 6.

[37] This includes appraisers if they earn their income based on sales or other output.