Employers should be mindful, however, that whether an individual working for your business qualifies as an employee or an independent contractor is not a clear as one might think. This is because the definitions and tests used to determine employment status vary among different agencies and various laws that govern the workplace. For example, the standard for determining an individual’s employment status under Georgia’s unemployment law differs from the standard used by the Internal Revenue Service (IRS). The definitions and tests used to determine employment status also vary among the National Labor Relations Act, the Civil Rights Act, the Fair Labor Standards Act, and the Employment Retirement Income Security Act. To complicate matters, the cases are factually intensive and the criteria used are somewhat subjective. Moreover, the courts and administrative agencies are not always consistent in their rulings, which makes it difficult for a company to know with certainty if it has properly classified its workers.
It is critical that employers properly classify their workers because misclassifying workers as independent contractors can be a costly mistake. If a worker is misclassified, the IRS, the Georgia Department of Labor, or the U.S. Department of Labor can bring an action to establish a business owner’s liability for certain unpaid employment benefits, including federal income tax withholdings, matching FICA payroll taxes, Social Security and Medicare taxes, workers’ compensation insurance, minimum wages and overtime wages, and unemployment insurance. Interest on the unpaid taxes and penalties can also be assessed against businesses.
The consequences of misclassification can be rather significant. In a landmark case, Microsoft agreed to settle an action for approximately $97 million over its alleged misclassification of employees as independent contractors. Federal Express has been embroiled in class action litigation for the past several years over its classification of drivers as independent contractors. In December 2007, United States tax authorities reported that Federal Express owed more than $319 million dollars in back taxes and penalties as a result of an IRS finding that Federal Express improperly classified 15,000 of its workers as independent contractors. Federal express is not alone. Companies of all sizes and in various industries have had legal challenges over their classification of workers.
Given the costly ramifications of misclassification, Georgia business owners should have an understanding of the standards that apply before classifying workers as independent contractors.
Georgia Employment Security Law
Georgia’s Employment Security Law, O.C.G.A. 34-8-1 et seq., requires business owners with employees to pay unemployment insurance contributions for those employees. In contrast, where an individual does not have employment status as defined by the Employment Security Law, the business owner is not liable for such contributions.
The test for determining whether the services performed by an individual qualify as employment, or are exempt, is set forth in Code Section 34-8-35(f). The Georgia legislature amended this Code Section last year to recognize situations in which the IRS has already determined that an individual is not an employee, presumably to avoid inconsistent determinations between the Department of Labor and the IRS. The amended state law, however, does not provide a clear test for determining whether an individual’s services qualify as employment and, therefore, whether the business owner is liable for unemployment insurance contributions.
Before July 1, 2007, under Georgia law, the test for whether an individual who was paid wages was exempt from employee status consisted of the three following factors: (1) the individual has been and will continue to be free from control or direction over the performance of such services, both under the individual’s contract of service and in fact; (2) such service is either outside the usual course of the business for which such service is performed, or such service is performed outside of all the places of business of the enterprise for which such service is performed; and (3) the individual is customarily engaged in an independently established trade, occupation, profession, or business. This three-factor test is often termed the “ABC test” and has been adopted by many states across the United States.
The amended Code Section, effective July 1, 2007, provides for two alternative methods for establishing that an individual is exempt from employee status. In the first option, an individual does not qualify as an employee if factors (1) and (3) above can be established. This means that an individual does not qualify as an employee if “[s]uch individual has been and will continue to be free from control or direction over the performance of such services, both under the individual’s contract of service and in fact; and [s]uch individual is customarily engaged in an independently established trade, occupation, profession, or business.” Under the second option, an individual will not be considered an employee under Georgia law if “[s]uch individual and the services performed for wages are the subject of an SS-8 determination by the Internal Revenue Service, which decided against employee status.”
Oftentimes, business owners do not seek an SS-8 determination from the IRS before the Georgia Department of Labor investigates an individual’s status and reaches its own conclusion that an individual was an employee. At that point, the business owner must be able to establish both prongs of the state law test in order to avoid liability for unpaid unemployment insurance contributions.
Whether the first prong of the test-that the individual was free from direction and control-can be established turns on a number of factors. Among the factors considered are whether the individual supplies his or her own equipment, whether the individual is free to set his or her own work hours, and whether the individual is free to come and go as he or she pleases. A signed “Independent Contractor Agreement” certainly supports the argument that an individual is not an employee. No single factor, however, is determinative.
The second prong of the test-whether the individual is engaged in an independently established trade, occupation, profession, or business-is particularly confusing and can lead to unpredictability for business owners. Even if the business owner can establish the first prong of the test, the business owner must be able to establish that the individual is engaged in some other trade, occupation, profession or business. For example, the Supreme Court of Georgia found that this prong was satisfied where the workers were free to sell competitor’s products under their contracts with the fashion show director. The Court of Appeals similarly held that this prong was satisfied where the individuals were allowed to represent competitors and also held other full time occupations.
This element of the test suggests that business owners must take some affirmative steps to insure that the independent contractors working for them, in fact, hold themselves out in occupations outside of their independent contractor relationship. This may include making it a condition of the independent contractor agreement that the contractor work in a separate occupation and providing in the contract that the contractor has the freedom to provide the same services for competitors.
IRS 3-Part Test
For purposes of determining whether a worker is an employee for purposes of federal employment taxes, the IRS test is no less unpredictable and factually dependent than the state law test. The IRS uses a 3-factor test to determine whether an individual is an employee or an independent contractor, considering the following categories of facts:
- 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?
5 Tips for Proper Classification
Below are five tips to help you avoid misclassification:
- Gain an understanding of the federal and state guidelines. As we have described above, there are federal and state guidelines with which you should be familiar. The more you understand these guidelines, the better you can structure your workers’ relationships and avoid liability for misclassifying them.
- Create, execute, and maintain appropriate contracts with each independent contractor that you engage. Consult with an attorney to ensure that you have appropriate contracts in place. Be aware, however, that a written contract alone will not prove that a worker is an independent contractor. It is only the starting point. You must still be able to demonstrate the factors described above (i.e. freedom from control).
- Use independent contractors that have an established business. If you use independent contractors who are performing their services for multiple businesses at the same time as your own, it is more likely they will be viewed as independent contractors rather than employees.
- Use independent contractors that provide services that are not integral to your core business. Do not hire contractors to perform the same or similar services as your regular employees.
- Do not engage a former W-2 employee of your company on a 1099 basis. A former employee will often return to perform the same or similar tasks as performed in their previous employee role, which increases the likelihood that he or she will be viewed as an employee.