Sheakley Updates

Independent Contractors: Correctly Classifying 1099s

Ella Baker
Independent Contractors: Correctly Classifying 1099s
Reading time 13 Mins
Published on Aug 6

Tips to help you avoid misclassification

The Bureau of Labor Statistics reports that more than 10.3 million workers throughout the United States, or seven percent of the total workforce, are classified by businesses as independent contractors. With independent contractors representing such a large portion of the workforce, it is, perhaps, unsurprising that the Department of Labor estimates that up to 30 percent of these individuals have been misclassified by the businesses for whom they perform work. Federal and state agencies often have separate or overlapping criteria for worker classifications, which can result in employers misclassifying workers. Worker classification is critical in relation to issues of benefits eligibility, workers’ compensation coverage, unemployment tax liability, wage and hour laws, and other matters. Misclassification of independent contractors can result in serious issues for business owners. Here are some helpful tips to help you avoid worker misclassification.

Who is an independent contractor

A simplified definition of an independent contractor is someone who provides services that are unrelated to the employer’s primary business and who offers these services to the general public. An employee is someone for whom you, as an employer, control what work is to be performed, when the work is performed and where the work is performed.

For the purposes of the Internal Revenue Service (IRS), business owners must ensure that they correctly determine whether a worker should be classified as an independent contractor or an employee. “Correctly” can be seen as a subjective term and business owners should be careful to consider all aspects of the worker-business relationship, especially how relevant regulatory agencies define that relationship.

Why companies use independent contractors

Whether you choose to work with an independent contractor because you need to complete a short-term project or for ongoing expertise outside your company’s normal scope, independent contractors are a popular choice for small and mid-size businesses who are looking to keep payroll costs low and reduce overhead. Since independent contractors aren’t regular employees, businesses only pay them when they’ve performed work. Perhaps more importantly, from a cost savings standpoint, business owners don’t have to withhold or match payroll taxes from independent contractor payments and the costs of these workers doesn’t contribute to workers’ compensation premiums, since independent contractors are not covered by an employer’s workers’ compensation plan.

Due to the differences in the employer’s responsibility toward independent contractors, the proper classification of workers is extremely important. In Ohio, different agencies are responsible for separate aspects of the employment law, and those agencies use different rules and tests to determine an employee’s status or classification. Due to guidelines from the IRS and state agencies in classifying employment status, the penalties and fines imposed for improper classifications can be substantial.

Characteristics of an independent contractor

While the exact criteria used to determine whether a worker is an independent contractor is typically decided on a case by case basis by the different agencies that govern the relationship, there are some common characteristics typically shared by independent contractors. These include:

• Worker is regularly engaged in business besides that of the employer and is available to the general public to perform such services.
• Worker possesses special skill or trade not common to the general public.
• Worker is engaged by the employer to perform services not ordinarily a regular business activity of the employer.
• Worker supplies his own tools and materials and hires and controls his own helpers.
• Worker has a contract for completing a specific job and is paid a lump sum, without deduction of withholding and social security taxes, rather than by an hourly rate.
• Worker controls the hours worked, the selection of materials, and the quality of performance.

These factors, and other considerations, are often used by employers in the determination of a worker’s status. However, employers should be strongly cautious of ensuring that they consider other elements that help to determine worker status, especially those set forth by government agencies.

IRS and independent contractors

Since the potential penalties and costs associated with worker classification are so high, the IRS stresses that it is critical for employers to correctly determine the classification of workers. Failure to do so can result in serious consequences for employers, including being held liable for unpaid employment taxes. The IRS provides guidelines and assistance to help employers determine worker classification.

The initial guidance given by the IRS is the Common Law Rules. These rules allow businesses to provide evidence of their degree of control and independence over the worker and is divided into three categories:

  • Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  • Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  • Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

The facts gathered from these three categories should help a business to determine the classification of a worker. While there is no magic number of factors that determines whether a person is an employee or independent contractor, these guidelines, together with a well-rounded view of the entire employer-worker relationship, provide a pathway to correctly classifying workers.

For businesses that are still unclear on worker classification after reviewing the three categories of evidence, the IRS offers employers and workers the opportunity to file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The Form SS-8 allows the IRS to review the facts and circumstances of employment and make an official determination of worker classification.

FLSA and independent contractors

The Fair Labor Standards Act (FLSA) has its own test for determining the classification of workers than the IRS. For FLSA purposes, Ohio courts follow the Sixth Circuit Court of Appeals six-factor “economic reality” test to determine the classification of independent contractors whenever disputes arise. This test considers the following:

• The permanency of the relationship between the parties
• The degree of skill required for rendering the services
• The worker’s investment in equipment or materials for the task
• The worker’s opportunity for profit or loss, depending on his or her skill
• The degree of the alleged employer’s right to control the manner in which the work is performed
• Whether the service rendered is an integral part of the alleged employer’s business

The FLSA test is more likely to find a worker is an employee than any other test employed by the federal government, so employers should pay careful attention to this test when assigning classification to workers.

Workers’ compensation insurance and independent contractors

In Ohio, independent contractors are not covered under the business’ workers’ compensation insurance. Employers must be careful, however, to ensure that persons performing work for them are truly independent contractors before relying upon this exception. Generally, the question of whether someone is an independent contractor involves a case-by-case determination focusing on which party had the right to direct and control the work.

The Ohio Bureau of Workers’ Compensation (BWC) has its own 20-factor Independent Contractor/Employee Questionnaire that it employs to determine worker classification. While the questionnaire is modeled on the IRS’ own 20-factor test, there are certain provisions that differ slightly from the federal version.

The BWC outlines the factors for the test as follows:

  • The person is required to comply with instructions from the other contracting party regarding the manner or method of performing services;
  • The person is required by the other contracting party to have particular training;
  • The person’s services are integrated into the regular functioning of the other contracting party;
  • The person is required to perform the work personally;
  • The person is hired, supervised, or paid by the other contracting party;
  • A continuing relationship exists between the person and the other contracting party that contemplates continuing or recurring work even if the work is not full time;
  • The person’s hours of work are established by the other contracting party;
  • The person is required to devote full time to the business of the other contracting party;
  • The person is required to perform the work on the premises of the other contracting party;
  • The person is required to follow the order of work set by the other contracting party;
  • The person is required to make oral or written reports of progress to the other contracting party;
  • The person is paid for services on a regular basis such as hourly, weekly, or monthly;
  • The person’s expenses are paid for by the other contracting party;
  • The person’s tools and materials are furnished by the other contracting party;
  • The person is provided with the facilities used to perform services;
  • The person does not realize a profit or suffer a loss as a result of the services provided;
  • The person is not performing services for a number of employers at the same time;
  • The person does not make the same services available to the general public;
  • The other contracting party has a right to discharge the person;
  • The person has the right to end the relationship with the other contracting party without incurring liability pursuant to an employment contract or agreement.”

Since the BWC is designed to protect injured workers, properly classifying workers for workers’ compensation purposes is extremely important. While the Independent Contractor/Employee Questionnaire is required after a worksite injury, it is advisable to seek the guidance of the BWC prior to any injuries to determine accurate worker designation.

Unemployment insurance and independent contractors

The Ohio Department of Job and Family Services (ODJFS) Office of Unemployment Insurance Operations has its own criteria for worker designation. Since the services of an independent contractor are excluded from covered employment, meaning these workers are ineligible for unemployment benefits, it is vital that the relationship between the worker and company be properly classified.

To be considered excluded employment, the employer must be able to establish that the worker is free from direction or control over the services being performed for the company. This right to control, whether exercised or not, is the most important determining factor in the relationship. The 20-question test that ODJFS uses to determine the employer-worker relationship includes:

  1. The manner or method by which instructions are given to any individual(s) performing services?
  2. What training is required for individual(s) performing services?
  3. How are the services provided integrated into the regular functions of the employer?
  4. By whom does the business require that services be provided?
  5. Who hires, supervises and/or pays the individual(s) performing services?
  6. What type of relationship exists between the business and the individual(s) performing services which contemplates continuing or recurring work, even if not full time?
  7. Who sets the time (hours) during which the individual(s) services are to be performed?
  8. How much time does the business require the individual(s) performing services to devote to the business?
  9. Where does the business require that work be performed?
  10. Who sets the order of work the individual(s) follow while performing services for the business?
  11. What type of reports, oral or written, does the business require the individual(s) performing services to submit?
  12. How are the individual(s) performing services paid?
  13. Who pays expenses for the individual(s) performing services?
  14. Who furnishes the tools and materials used by the individual(s) performing services?
  15. What investment do the individual(s) performing services have in the facilities used to perform the services?
  16. What is the profit or loss to the individual(s) performing services as a result of the performance of such services?
  17. Do the individual(s) performing services also perform similar services for other businesses? If yes, for whom?
  18. How do the individual(s) performing services make their services available to the general public?
  19. Does the business have the right to discharge the individual(s) performing services? If, yes, in what manner?
  20. Do the individual(s) performing services each have the right to end the relationship with the business, without incurring liability pursuant to an employment contract or agreement? If yes, how?

Even in the face of a contract that designates the independent contractor relationship, the principle feature in determining the exact nature of the relationship rests on the employer’s right to exercise direction and control under the Common Law Rules.

It’s all about control

As seen throughout the tests applied by various federal and state rules governing worker designation, the single most important factor in worker classification is the degree of control and direction the employer is able to exercise over the individual worker.

In Ohio, the principal test devised by the Ohio Supreme court for determining the legal status of the employment relationship originated in Gillum v. Indus. Comm., which stated:

Whether one is an independent contractor or in service depends on the facts of each case. The principal test applied to determine the character of the arrangement is that, if the employer reserves the right to control the manner or means of doing the work, the relation created is that of master and servant, while if the manner or means of doing the work or job is left to one who is responsible to the employer only for the result, an independent contractor arrangement is thereby created.

In laymen’s terms, this means that the amount of control a business is able to exercise over a worker is the most important element to consider in determining a workers’ designation.

Sheakley and employee classification

Determining the status of your workers can be a confusing and difficult task that can be costly if errors occur. Don’t put your company’s financial future at stake by leaving employee designation up to gut feeling or in the hands of unqualified individuals. Sheakley’s HR and PEO professionals can provide you with the assistance you need to ensure that your workers are properly classified and that you remain compliant with federal and state employment laws.

Schedule your free consultation with Sheakley’s HR professionals today. You can also learn more about how Sheakley’s Human Resources Outsourcing Solutions can help you grow your business. Stay up-to-date on all things Sheakley by subscribing to our blog and following us on social media. Join in the discussion by commenting below.

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