Dear Rita in HR: I am executive director of a very small nonprofit. Recently, I had to fire an employee for the first time. In retrospect, I probably made a bad hiring decision, but it was a real nightmare to go through. I would like to just hire independent contractors from now on. As I understand it, with contractors I just pay them a flat amount every month and at the end of the year they get a 1099 instead of a W-2. Sounds like a great solution to me! Are you going to rain on my parade?
Signed,
Found the Magic Wand
Dear Magic Wand: Get out your umbrella, my friend. Payroll and other taxes can account for up to 30 percent of an employee's cost, so I understand how hiring an independent contractor instead of an employee can sound like a good solution for nonprofits on a tight budget. Unfortunately, the federal government and many states are cracking down on that practice, called "worker misclassification," and with good reason. Some employers have abused the independent contractor classification as a way to avoid paying minimum wage and payroll taxes or to duck requirements for meal and rest breaks. In 2010, the Massachusetts Attorney General settled a case with FedEx Ground alleging misclassification of its drivers as independent contractors. That settlement was worth $3.5 million. New York has a special task force devoted just to pursuing misclassification issues. California imposes stiff fines on employers for misclassification, above and beyond the other penalties that otherwise exist.
Don't think that your nonprofit will be immune because of your small size or 501(c)3 status. I have seen several nonprofits get caught in the misclassification trap after they terminated the "contract" and the worker subsequently filed for unemployment benefits, for which contractors are not normally eligible. Increased cooperation between governmental agencies means that information gets shared between all the different government entities that get a piece of those payroll taxes. So while it may start with an unemployment claim, it can lead to a full-scale audit of your organization by state and federal tax authorities.
So what is the legal definition of an independent contractor so you can avoid the misclassification trap? Ah, if only it were that simple. You see, different tests are used to determine whether a worker is properly classified depending on the agency reviewing the classification. The IRS has its own rules, but state workers' compensation, unemployment and labor boards also have their own regulations for classifying workers as independent contractors or employees.
Whether a worker is properly classified as an independent contractor or an employee is not something that an employer can just decide to do one way or another. The classification depends on the nature of the relationship. In general, your relationship with an independent contractor is going to be more like one you have with a separate business that is providing a service or product for a set price with little direction in how the work gets done. Not surprisingly, the more "independent" the worker, the more likely they are to be appropriately classified as a contractor.
The following chart explains the types of tests typically used by governmental agencies to determine whether someone is an independent contractor or an employee:
Type of Test
Common-law
Economic Realities
Hybrid
Description
Degree of control and degree of independence in three categories: 1) behavioral control; 2) financial control; and 3) the type of relationship. The origin of this test is in the twenty-factor IRS test (see links at the end of the article).
Often used where there may be multiple employers, this test focuses on whether the individual worker is economically dependent on the business.
The broadest test will look at both the economic realities and the common-law factors, particularly the right to control the "means and manner" of how the work is performed.
Agencies and Laws That Use This Test
Federal Insurance Contributions Act
Federal
Unemployment Tax Act
Income tax withholding
Employee Retirement and
Income Security Act
National Labor Relations Act
Immigration Reform and Control Act
Title VII of the Civil Rights Act
Age Discrimination in Employment Act
Americans with Disabilities Act
Fair Labor Standards Act
Family and Medical Leave Act (likely to apply)
Title VII of the Civil Rights Act
Age Discrimination in Employment Act
Americans with Disabilities Act
Courts in different areas of the country have applied the tests differently, and as you can see from the chart, some laws have been analyzed using more than one test. Now that we've gotten through the legal jargon, let's look at the problem from a more practical perspective.
Best Practices for Classifying Workers
Although every situation will be a little different, there are some common characteristics of a contractor relationship. For example, a contractor will typically:
You should also avoid treating the contractor like an employee. For example, independent contractors should not receive the types of benefits that employees often receive, such as paid time off or health insurance. While employees may require job training, independent contractors should come to the job already having the necessary skills and training. Contractors should not be using your nonprofit's business cards, and if you give them an email address, consider using the word "contractor" in the address or specifying that the individual is a contractor in their signature line. Mike McVay, Accountant 850-725-5696
Signed,
Found the Magic Wand
Dear Magic Wand: Get out your umbrella, my friend. Payroll and other taxes can account for up to 30 percent of an employee's cost, so I understand how hiring an independent contractor instead of an employee can sound like a good solution for nonprofits on a tight budget. Unfortunately, the federal government and many states are cracking down on that practice, called "worker misclassification," and with good reason. Some employers have abused the independent contractor classification as a way to avoid paying minimum wage and payroll taxes or to duck requirements for meal and rest breaks. In 2010, the Massachusetts Attorney General settled a case with FedEx Ground alleging misclassification of its drivers as independent contractors. That settlement was worth $3.5 million. New York has a special task force devoted just to pursuing misclassification issues. California imposes stiff fines on employers for misclassification, above and beyond the other penalties that otherwise exist.
Don't think that your nonprofit will be immune because of your small size or 501(c)3 status. I have seen several nonprofits get caught in the misclassification trap after they terminated the "contract" and the worker subsequently filed for unemployment benefits, for which contractors are not normally eligible. Increased cooperation between governmental agencies means that information gets shared between all the different government entities that get a piece of those payroll taxes. So while it may start with an unemployment claim, it can lead to a full-scale audit of your organization by state and federal tax authorities.
So what is the legal definition of an independent contractor so you can avoid the misclassification trap? Ah, if only it were that simple. You see, different tests are used to determine whether a worker is properly classified depending on the agency reviewing the classification. The IRS has its own rules, but state workers' compensation, unemployment and labor boards also have their own regulations for classifying workers as independent contractors or employees.
Whether a worker is properly classified as an independent contractor or an employee is not something that an employer can just decide to do one way or another. The classification depends on the nature of the relationship. In general, your relationship with an independent contractor is going to be more like one you have with a separate business that is providing a service or product for a set price with little direction in how the work gets done. Not surprisingly, the more "independent" the worker, the more likely they are to be appropriately classified as a contractor.
The following chart explains the types of tests typically used by governmental agencies to determine whether someone is an independent contractor or an employee:
Type of Test
Common-law
Economic Realities
Hybrid
Description
Degree of control and degree of independence in three categories: 1) behavioral control; 2) financial control; and 3) the type of relationship. The origin of this test is in the twenty-factor IRS test (see links at the end of the article).
Often used where there may be multiple employers, this test focuses on whether the individual worker is economically dependent on the business.
The broadest test will look at both the economic realities and the common-law factors, particularly the right to control the "means and manner" of how the work is performed.
Agencies and Laws That Use This Test
Federal Insurance Contributions Act
Federal
Unemployment Tax Act
Income tax withholding
Employee Retirement and
Income Security Act
National Labor Relations Act
Immigration Reform and Control Act
Title VII of the Civil Rights Act
Age Discrimination in Employment Act
Americans with Disabilities Act
Fair Labor Standards Act
Family and Medical Leave Act (likely to apply)
Title VII of the Civil Rights Act
Age Discrimination in Employment Act
Americans with Disabilities Act
Courts in different areas of the country have applied the tests differently, and as you can see from the chart, some laws have been analyzed using more than one test. Now that we've gotten through the legal jargon, let's look at the problem from a more practical perspective.
Best Practices for Classifying Workers
Although every situation will be a little different, there are some common characteristics of a contractor relationship. For example, a contractor will typically:
- Have a significant degree of control over how the work is performed (minimal direction by the employer)
- Provide their own equipment for the work
- Have multiple clients
- Set their own hours
- May hire and fire their own workers
- Operate as a "business" including a bank account separate from their personal account, have a federal tax ID number, and their own insurance.
You should also avoid treating the contractor like an employee. For example, independent contractors should not receive the types of benefits that employees often receive, such as paid time off or health insurance. While employees may require job training, independent contractors should come to the job already having the necessary skills and training. Contractors should not be using your nonprofit's business cards, and if you give them an email address, consider using the word "contractor" in the address or specifying that the individual is a contractor in their signature line. Mike McVay, Accountant 850-725-5696
