Employee or Independent Contractor?

by Melanie Askew, CPA, Consulting Manager

Posted on January 22, 2020

How do you know if someone working for your organization is an employee or an independent contractor?  As individuals may perform duties for your organization as either independent contractors or employees, it is crucial to make the correct classification from the start.  The classification not only determines what benefits the individual is eligible to receive, but also what rules must be enforced regarding hours worked, payments to be made, and amounts to be withheld for tax purposes.

An employee is an individual who performs services for the employer who is subject to employer control regarding what will be done and how it will be done. A contractor is an individual who performs services for an organization or other individuals but they are in control of the result of the work. This can be easy to determine in most cases, however when it is not there is an option to use something called an Economic Realities Test. The Department of Labor released a new interpretation in 2015 which is covered in FACT Sheet 13, which can be found here. The Economic Realities test is one way an organization can determine whether a worker is economically dependent on the employer or is actually in business for his or her self.

There are several factors to be considered when making this determination. These factors can be grouped into Behavioral Control, Financial Control or the Type of Relationship.

Behavioral Control:  

1) The extent to which the services rendered are an integral part of the principal’s business

2) The nature and degree of control by the principal

3) The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor

Financial Control:

4) The amount of the alleged contractor’s investment in facilities and equipment

5) The alleged contractor’s opportunities for profit and loss

Type of Relationship:

6) The permanency of the relationship

7) The degree of independent business organization and operation

An organization can use these as a guide to assist in determining the status of a worker. To determine behavioral control, it is important to consider whether the organization determines the how, what and when something will be done. In situations where the worker is an employee, the organization provides extensive instruction, training, and also tells the worker where to purchase materials and supplies. An independent contractor is generally instructed on what should be done but with less extensive instruction. In essence, they are told what should be done but not how to do it. 

In determining financial control, factors that generally lead to a worker being considered an employee include the worker having minimal out-of-pocket expenses, and they are usually reimbursed for incurred expenses. An independent contractor usually has a more significant investment. They are not reimbursed for expenses and they realize a profit or incur a loss. Generally they set their own prices. 

In looking at the relationship of the parties, an employee generally receives employee benefits such as a pension, insurance or vacation pay. Additionally they are generally a more permanent relationship or longer term. An independent contractor would not receive any additional benefits, and normally there is a written contract that specifies terms of the agreement and responsibility of each party. Additionally they are generally only contracted for a project or a set period of time.

Your organization must weigh all of these factors when determining whether a worker is an employee or an independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. In addition, factors that are relevant in one situation may not be in another.

The keys are to look at the entire relationship, considering the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination. We can see how this works in a couple of examples.

Situation A –

The organization is a small special education school district that is looking for someone who specializes in speech and language development and assistance. The District provides a room for the students to come to therapy sessions and have a set school schedule of 8:00 am to 11:00. The District’s program is to provide speech-related services to the highest risk students at least three times per week throughout the entire school year. Beyond the set classroom hours, the District expects the therapist to determine and document what services are needed for each student and how these will be provided. 

The speech therapist is certified and has 10 years of experience in the field. They provide all the needed items used to assist children learning how to make specific sounds, including video or recording equipment, mirrors etc. They have previously had a business license as a sole proprietor and normally charge a rate of $30/ hour for their services; however they are willing to provide services to the District at a discounted rate of $20 per hour as long as they are contracted for a 10-month period.

Situation B –

The organization is a large school district that is looking for someone to come in to provide specialized services to high need students for 3 hours per day, 5 days a week starting in January and extending through to the end of the school year. The district will be providing all supplies and a room in which to work. The district will pay up to $20 per hour and are providing access to training and on the job training for the therapist. Additionally, district staff will directly supervise the therapist at all times. Although the therapist is issued a five-month contract, the expectation is that it will be an ongoing employment arrangement beyond that. 

The speech therapist is not certified and has 6 months of experience in their field. They are not licensed as a business and have no set rate. They are willing to work for $15 per hour as long as they are also provided access to health benefits.

Situation A is likely to be considered an independent contractor. In reviewing the seven factors above, the services provided would be considered an integral part of the organization’s business. However, they are not exerting a great deal of control over the services provided beyond reasonable expectations for it to be done during normal operating hours and requiring documentation of the work performed. Additionally, although a location is provided, they are not providing any of the direct equipment, which would cause the burden of that to fall on the therapist. Although this is a longer-term relationship, there is no expectation of permanency. Additionally, the therapist has a history of operating as their own business and is the party setting the pay rates, which allows them control over their own potential profit or loss opportunities.

Situation B is likely to be considered an employee/employer relationship, even though this example position is not integral to the operation of the organization. The District also is dictating in more detail what is to be done and how it will be done by providing training and direct supervision at all times, resulting in an exertion of behavioral control. The burden of cost remains primarily on the District, as they are providing all necessary equipment. The paid rate is also set by the District and, if the District pays the lower rate and provides items generally considered as employment benefits, this would even more clearly indicate treatment of the individual as an employee. Although there is only a five-month contract, the intent to have ongoing employment after that point indicates this is a more permanent type of relationship.

These examples illustrate how each case needs to be reviewed carefully and that an organization cannot just rely on one or two items to make a determination.  In both examples, the District should pay close attention to the wording of a written contract. A written contract may show the intention of both the organization and the worker. This may be especially significant in situations where it is difficult, if not impossible, to determine status based on other facts.

In addition, in any situation where the relationship is not clear, the organization should reach out to their attorney or the U.S. Department of Labor for guidance.