If your startup is misclassifying independent contractors, you can be liable for significant taxes and fines, including among other liabilities: failure to pay minimum wages or overtime pay; failure to provide benefits; violations of anti-discrimination laws that only protect employees; violations of state law; unpaid employment taxes, and unemployment insurance. Because of the nature of a startup, employee misclassification is a very serious issue that many startups will face and will literally not be able to afford the consequences.
Plain and simple, independent contractor and employee status are characterized based on conduct not written agreement or titles. Of course, when acting in a true independent contractor relationship, you want to protect yourself against any claims of wrongful classification, so you should always have a written agreement and clear delegation of titles. In the legal world, we call it ‘belt and suspenders’. It’s like if your pants fell down while you were pitching in front of a room full of investors who are ready to spend. Conduct trumps all but the agreements might save you.
If you ever find yourself with a potential misclassification, hopefully you catch it before it happens. If not, depending on the jurisdiction, courts will apply various tests to determine whether someone is an independent contractor or employee; however most tests come down to determining ‘the level of control the company has over the worker’ with various factors to decide on the large issue of control. These same tests can help you AVOID misclassification in its tracks.
FLSA Independent Contractor Test
The Federal Labor Standards Act (FLSA) sets forth an “Economic Realities Test” which most jurisdictions have adopted. The test considers six different factors of control in determining whether the ‘economic realities’ of the parties create a relationship where the worker is dependent on the company to which they provide their services. Courts will analyze the totality of the parties’ relationship, including:
- Degree of control
- The relative investment in facilities
- The worker’s opportunity for profit and loss
- The permanency of the parties’ relationship
- The skill required for the work
These factors are precedent from United States Supreme Court Case, United States v. Silk (1947). Some courts have added this sixth factor: Whether the worker’s services are integral to the company’s business. The Department of Labor enforces the FLSA.
IRS Independent Contractor Test
In addition to the FLSA test, the IRS employs an Independent Contractor Test. The IRS general rule is:
“an individual is an independent contractor if the person for whom the services are performed has the right to control or direct only the result of the work and not the means and methods of accomplishing the result.”
The IRS examines several factors to decide on the right to control including behavioral control, financial control, and the relationship between the parties. All of which are applied with various weight depending on the relevant industry.
Want to know more? Check out Rubicon’s: Independent Contractor v. Employee Checklist.