Kramer, Elkins & Watt

Employee or Independent Contractor?

Employee or Independent Contractor?

Whether an individual worker can or should be classified as an employee or independent contractor is a crucial question that every employer needs to answer before bringing on a worker. This article is focused on issues facing Wisconsin employers.

This article is broken down into two sections:

  • FAQs
  • Tests which include both Wisconsin and Federal

As an initial matter, note that this article uses the word “worker” when referring to an individual who could be either an employee or an independent contractor, for the purpose of working through the relevant tests.  All employees are workers, but not all workers are employees, in the way the terms are used herein.

FAQs:

Can an employer decide whether a worker is either an independent contractor or an employee?

Generally, no. A worker providing services for a business is either an independent contractor or an employee. No single worker can ever be both. Oftentimes, I hear from business owners that are trying to determine whether they should make their worker an independent contractor or an employee. But, the reality is that a variety of tests based on the circumstances of the work performed will determine that fate. Of course, adjustments to the parameters of the work the worker is completing, and other aspects of the relationship with the worker, can be made to place the worker firmly in one category or another.

I have a written contract that says my worker is an independent contractor, and he agreed to it. We are good, right?

No. Employers and workers cannot contract out of the legal requirements that must be met in order to classify a worker as an independent contractor. The actual terms and conditions governing the worker’s work will determine whether a worker is an employee or independent contractor. In other words, if it walks like a duck and talks like a duck, it’s a duck, even if the contract says it’s a goose.

What is the difference between an independent contractor and a subcontractor?

Subcontractor is just another name for independent contractor, and is often used in particular settings, like the construction industry. Other common names are “1099” and “1099 employee.” 1099 refers to the tax document given to independent contractors from a business to document the amount of money paid to the independent contractor through the year. So, the term “1099 employee” is a contradiction because an employee receives a W2 and an independent contractor receives a 1099.

Does an employee need to work a certain amount of hours each week to be considered an employee?

No. An employee can work one hour, forty hours or more each week and be considered an employee.

What is a misclassification?

When a business has a worker that is in its books as an “independent contractor”, but whose job function, duties, or description qualifies them as an employee under any of the tests below, the issue is referred to as a “misclassification.” Such misclassification issues are one of the more common issues seen with our business clients, and unfortunately often the most costly.

How do businesses get caught for misclassification?

Oh, let me count the ways……

  1. UI Application. The most common issue that we see occurs through an application for unemployment insurance (“UI”) benefits. A former worker might lose work, either from the business, or a subsequent job, and then applies for UI benefits. The application requires the former worker to list all former employers and sources of income. A worker might list the business, and that will put the business on Unemployment Insurance Division’s radar to investigate why no UI taxes were paid in by that employer for that worker. Note, UI taxes are paid on wages, per employee, not just based on total wages paid out by a business.
  2. Injury. Another issue that pops up frequently is where a worker sustains an injury on the job. If the injury is serious enough for medical care, the worker will likely need to provide info regarding insurance, including worker’s compensation insurance, and the company for whom the worker was providing services. This will place the company on Worker’s Compensation Division’s radar for investigation.
  3. Complaint. A disgruntled worker may file a complaint with the Department of Labor (federal agency) or Department of Workforce Development (Wisconsin agency) regarding the practices of a business, such as failure to pay minimum wage or overtime.
  4. Tax Issues. The IRS has been known to raise a red flag about a company for various tax related filings, for example where a worker receives a 1099 and a W-2 in the same year.  
  5. Audit. A variety of different agencies can just determine to audit a business, for any reason – Worker’s Compensation, Unemployment Insurance, Department of Labor, IRS, and more.

What are the risks of misclassification?

In the event of a misclassification, the employer will be responsible to pay all uncollected taxes, all worker’s compensation premiums, as well as penalties and interest, and any wages the worker may be owed by virtue of actually being an employee (for example, if the amount paid to the worker did not account for overtime pay, but the worker’s duties entitled them to overtime). The penalties can be severe, and we’ve had clients facing six figure payments.

My business advisor/accountant said I could classify my worker as an independent contractor, why does my lawyer disagree?

I have had many clients come to me and say that they received advice from an accountant or business advisor or some other third party to just classify a worker as an independent contractor, instead of an employee. I don’t know exactly why these third parties suggest this in any given situation, but I can hazard a guess. My guess is that the third parties do not know about all of the stringent employee v. independent contractor tests that exist, and they are relying only on the more lenient IRS test. But, truth be told, I’m not certain. What’s important for businesses to keep in mind is that, while tax advice from an accountant is key to the operation of a business, a full legal analysis under each test for each worker needs to be completed in order to avoid misclassification. More on the tests, below.

Is an independent contractor easier administratively than an employee?

Usually, at least at the outset. But, the administrative headache in fixing a mistake down the line makes it only a short earned gain (and often an expensive one).

How much more does it cost to have an employee compared to an independent contractor? 

This will depend on the situation, but employers can be expected to pay the following:

  • FICA (Federal Insurance Contributions Act) – 7.65% of total wages (6.2% goes to Social Security and 1.45% goes to Medicare)
  • Unemployment Insurance
    • The rate is based on each employer’s UI claim history, industry and amount of payroll. Employers pay UI taxes on the first $14,000 for each employee, per year. The rate for most starting companies with payroll under $500,000 will be 3.05%.
  • Worker’s Compensation
    • Rates are first based on industry to assess risk, then total wages paid by an employer in a given policy year come into play. High worker’s compensation rates are seen in industries with higher risk of injury.
    • For example, KEW’s rate is $.36. In other words, we pay $360 annually for every $100,000 in payroll. As a law office, we are low risk for injury. A landscaping company can expect a rate closer to $1.00, or in other words to pay $1,000 annually for every $100,000 in payroll.

Note, in an independent contractor set up, the worker is responsible for 100% of the taxes (FICA and UI), whereas in an employee set up the employer pays a share of the taxes. So, paying a worker as an employee and not an independent contractor will save that worker money in taxes.

 

How do I know if my worker is an employee or an independent contractor?

 Perhaps the most frustrating part about this question is that the answer depends on which test is used to make this determination. Various Wisconsin and federal agencies have tests. So, it is possible for a worker to be considered an independent contractor under one test, but to be considered an employee under another test.

Also note, in all of these tests, the burden is on the employer to prove that the worker is actually an independent contractor.

 

Wisconsin Tests

Wisconsin Worker’s Compensation Test

Let’s start with the most restrictive test: Worker’s Compensation. The test for determining whether a worker is considered an independent contractor is in Section 102.07(8) of the Wisconsin statutes.

In order for a worker to be an independent contractor and not an employee the worker needs to meet ALL NINE of the following conditions:

  1. Maintains a separate business with his or her own office, equipment, materials and other facilities.
  2. Holds or has applied for a federal employer identification number with the federal internal revenue service or has filed business or self-employment income tax returns with the federal internal revenue service based on that work or service in the previous year.
  3. Operates under contracts to perform specific services or work for specific amounts of money and under which the independent contractor controls the means of performing the services or work.
  4. Incurs the main expenses related to the service or work that he or she performs under contract.
  5. Is responsible for the satisfactory completion of work or services that he or she contracts to perform and is liable for a failure to complete the work or service.
  6. Receives compensation for work or service performed under a contract on a commission or per job or competitive bid basis and not on any other basis.
  7. May realize a profit or suffer a loss under contracts to perform work or service.
  8. Has continuing or recurring business liabilities or obligations.
  9. The success or failure of the independent contractor’s business depends on the relationship of business receipts to expenditures.

Employers are often shocked to see some of the factors on this list.

  • In the digital age that we now exist where many jobs are done by computer and can be completed anywhere, numbers 1 and 4 can often be rather slim and scaled down.
  • One that often jumps out as an issue is number 6. Note that this factor does not recognize a situation where a worker is paid by the hour.

The Department of Workforce Development (“DWD”) has a helpful tool for working through the Worker’s Compensation test which can be found here: https://dwd.wisconsin.gov/worker-classification/wc/independent.htm

Wisconsin Unemployment Insurance Test

The state of Wisconsin’s Unemployment Insurance Test is also a rather restrictive test. It is codified at Section 108.02(12) of the Wisconsin statutes. Note, this is the test for general private employers, and other tests exist for nonprofit employers, public employers and other types of employers, which are not explained in this article.

This test has two parts.  In the first part, to be considered an independent contractor, the worker needs to perform the work free from the control or direction of the employing unit, and the following nonexclusive factors are considered:

  1. Whether the individual is required to comply with instructions concerning how to perform the services.
  2. Whether the individual receives training from the employing unit with respect to the services performed.
  3. Whether the individual is required to personally perform the services.
  4. Whether the services of the individual are required to be performed at times or in a particular order or sequence established by the employing unit.
  5. Whether the individual is required to make oral or written reports to the employing unit on a regular basis.

In addition, in the second part of the test, the worker needs to meet 6 OR MORE of the following conditions to be an independent contractor:

  1. The individual advertises or otherwise affirmatively holds himself or herself out as being in business.
  2. The individual maintains his or her own office or performs most of the services in a facility or location chosen by the individual and uses his or her own equipment or materials in performing the services.
  3. The individual operates under multiple contracts with one or more employing units to perform specific services.
  4. The individual incurs the main expenses related to the services that he or she performs under contract.
  5. The individual is obligated to redo unsatisfactory work for no additional compensation or is subject to a monetary penalty for unsatisfactory work.
  6. The services performed by the individual do not directly relate to the employing unit retaining the services.
  7. The individual may realize a profit or suffer a loss under contracts to perform such services.
  8. The individual has recurring business liabilities or obligations.
  9. The individual is not economically dependent upon a particular employing unit with respect to the services being performed.

As you can see, there is certainly some overlap between this test and the Worker’s Compensation test. One interesting factor in the Unemployment Insurance test not present for the Worker’s Compensation test is the last one – that the worker not be completely economically reliant on the company. This is a common fact pattern for certain employers and workers – that the worker only performs work for one employee and is therefore, economically dependent upon that employer.

The DWD has created a similar tool for determining whether a worker is an employee or independent contractor under the Unemployment Insurance test: https://dwd.wisconsin.gov/worker-classification/ui/allothers/ee_ic.htm

Wisconsin Fair Employment Act Test (“Economic Realities” Test)

The economic realities test is the least restrictive of the Wisconsin tests, and it is not based on statute, but rather on case law. Originally laid out in Spirides v. Reinhardt, 613 F.2d 826, 180 U.S.App.D.C.93 (1979), a D.C. Circuit case, the case was adopted by Wisconsin in Moore v. LIRC, 175 Wis.2d 561, 499 N.W.2d 288 (1993).

The economic realities test or the Spirides test is used to determine whether a worker is an employee under the Wisconsin Fair Employment Act, which prohibits discrimination in employment. In order to be able to bring a claim for discrimination, a worker must first be an employee. The test looks at a number of factors in making the determination between employee and independent contractor. No single factor is exclusive or required, but they are viewed as whole in analyzing the worker’s situation.

The factors to be considered include the following:

  • What degree of control does the company exert over the worker? The courts have determined this first factor to be the most important.
  • The type of occupation and whether such work is typically completed under the direction of a supervisor or is done by a specialist without supervision;
  • The skill required for the particular occupation;
  • Whether the company or the worker furnishes the equipment used as well as the location for work;
  • The length of time for which the worker has worked;
  • Whether the work is paid for by time or by the job;
  • How the work relationship is terminated, for example by one or both parties, and with or without notice or explanation;
  • Whether any leave is provided;
  • Whether the work is an integral part of the company’s business;
  • Whether the worker accumulates retirement benefits
  • Whether the worker pays social security taxes
  • The intention of the parties.

Again, we see some factors that are similar to factors used in the Wisconsin Worker’s Compensation and Unemployment Insurance tests, as well as some that are different. Note, the federal Seventh Circuit Court of Appeals has also adopted this test.

Wisconsin Labor Standards Bureau Definitions of Employee

The Labor Standards Bureau has three definitions of employee, existing in the sections of Wisconsin statues as noted below. Although not technically a test for determining whether a worker is an employee v. independent contractor, if a worker does not meet the definition of one of these tests, the worker will be found to not be an employee.

Employment Regulation Definition

The following definition, codified under Wis. Stat. § 103.001(5), is used for purposes of determining compliance with employment regulations such as working conditions, overtime, and restrictions on minors working. Note, the indicated statute number within provides for a narrow exception for real estate license holders:

(5) “Employee” means, except as provided in s. 452.38, any person who may be required or directed by any employer, in consideration of direct or indirect gain or profit, to engage in any employment, or to go or work or be at any time in any place of employment.

Minimum Wage Definition

Under the minimum wage section of the Wisconsin statutes, employee is defined in Wis. Stat. § 104.01(2)(a), with a few exceptions listed in Wis. Stat. 104.01(2)(b):

(2)(a) “Employee” means every individual who is in receipt of or is entitled to any compensation for labor performed for any employer.

(b) “Employee” does not mean:

  1. Any individual engaged in the house to house delivery of newspapers to the consumer or engaged in direct retail sale to the consumer.
  2. An individual excluded under s. 452.38.
  3. Any individual engaged in performing services for an employer described in sub. (3) (b)if that individual is not considered under 29 USC 203 (e) (4), as amended to April 15, 1986, to be an employee for the purposes of the fair labor standards act, 29 USC 201 to 219, or if that individual is exempt under 29 USC 213, as amended to April 1, 1990, from being paid at least the federal minimum hourly wage under 29 USC 206 (a) (1).
  4. Any individual engaged in performing services for an employer described in sub. (3) (b)if that individual is not subject to the civil service laws of the employer and if that individual is an elective officer; is on the personal staff of an elective officer, other than a member of the legislature; is appointed by an elective officer to serve on a policymaking level; or is an immediate adviser to an elective officer with respect to the constitutional or legal powers of the elective officer’s office.
  5. Any individual whose primary duty is making sales, as defined in 29 USC 203(k), or obtaining orders or contracts for services or for the use of facilities for which a consideration will be paid by the client or customer and who is customarily and regularly engaged away from the employer’s place of business in performing that primary duty.

Wage Payment Definition

For purposes of wage payments, claims and collections, the following definition of employee is used, and codified in Wis. Stat. § 109.01(1r):

(1r) “Employee” means any person employed by an employer, except that “employee” does not include an officer or director of a corporation, a member or manager of a limited liability company, a partner of a partnership or a joint venture, the owner of a sole proprietorship, an independent contractor or person otherwise excluded under s. 452.38, or a person employed in a managerial, executive, or commissioned sales capacity or in a capacity in which the person is privy to confidential matters involving the employer-employee relationship.

In general, the Labor Standards Bureau presumes that a worker is an employee unless the worker meets those certain exceptions found in Sections 104.01(2)(b) and 109.01(1r) of the Wisconsin statutes.

Federal Tests

Fair Labor Standards Act – Federal Test

According to the United States Supreme Court, whether a worker is an employee or an independent contractor under the Fair Labor Standards Act is tested by “economic realty.” The Court has found the following factors to be significant in making the determination:

  • The extent to which the work completed by the worker is central to the business of the principal.
  • The permanency of the relationship between worker and principal.
  • The extent of the contractor’s investment in equipment, materials and facilities.
  • The nature of the control exerted by the principal over the worker.
  • The extent to which the contractor might incur a loss or realize a profit.
  • The degree of initiative, judgment and/or foresight required by the contractor to succeed in open market competition.
  • The extent to which the contractor independently organizes and operates its business.

Internal Revenue Service (IRS) – Federal

The IRS is interested in making sure that Employees are not misclassified as Independent Contractors because such a misclassification means that the IRS would not be receiving taxes collected through employment. Employers are required to pay Unemployment taxes (employer paid only) and withhold and pay Social Security and Medicare (both employer and employee paid) as well as federal and state withholding (employee paid only), on wages paid to an employee, but Employers are generally not required to withhold taxes on payments to Independent Contractors.

The IRS uses a three-category test to determine the amount of control and independence of the worker. The three factors are as follows:

  • Behavioral. Does the principal control the way in which the worker works? That is, does the company determine the hours worked and the way in which the worker does her job?
  • Financial. Does the company determine certain business aspects of the relationship such as how the worker is paid, what is reimbursable and who provides tools/supplies?
  • Relationship of the Parties. Are written contracts in place that describe the relationship between the parties? Does the company provide any benefits such as insurance or paid time off? How permanent is the relationship? Are the services performed by the worker a key aspect of the company’s business?

The IRS advises businesses to carefully weigh all of the above factors and indicates that there is no magical number of factors that would conclusively make a worker an independent contractor.

Note, the IRS has definitions for various types of workers in addition to the employee and independent contractor – a statutory employee, statutory nonemployee and a government worker. The IRS provides additional guidance about these types of workers on its website:

https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee

 

That’s all folks!

Thanks for sticking with me on this long “Independent Contractor or Employee?” spiel. The information in this article is designed to provide you with a working understanding about the difference between an employee and independent contractor.

The attorneys at Kramer, Elkins & Watt, LLC regularly consult with business owners regarding the proper classification of workers. Contact KEW today for any additional guidance for your business.