Among the issues that regularly expose employers to regulatory actions is misclassifying employees as independent contractors.
Editor’s note: This is part five in an ongoing restaurant series. Prior installments: Restaurants, Part 4: The Undocumented Alien Trap Restaurant Start-ups: Hour and Wage Requirements Part 3 Restaurant Start-Ups: The Lease Part 2 Restaurant Start-Ups: The Lease Part 1
Among the most significant traps for employers in every industry, including in the restaurant industry, is that of misclassifying “employees” as “independent contractors,” a practice that can expose companies and their principals to liability under Labor, Tax, and Immigration laws. Depending on the situation, there are various balancing tests associated with evaluating whether a person is an “employee” or an “independent contractor.”
A. Fair Labor Standards Act: The Economic Realities Test
The Fair Labor Standards Act (“FLSA”), which prescribes federal labor standards for U.S. employers, identifies the following balancing-test factors in determining if a worker should be defined as an “independent contractor”:
1. The extent to which services rendered are an integral part of the principal’s business;
2. The permanency of the relationship;
3. The amount of the alleged contractor’s investment in facilities and equipment;
4. The nature and degree of control by the principal;
5. The alleged contractor’s opportunities for profit or loss;
6. The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor; and
7. The degree of independent business organization and operation.
The way to understand these factors is to consider that an independent contractor is supposed to be operating “independently” from the principal, and thus be able to determine her own working conditions and form of organization.
B. The Three Factor Test Employed by the Internal Revenue Service (IRS)
The IRS also has a test which considers the following factors in determining if a worker is an independent contractor for purposes, among other things, of determining Trust Fund violations, and assessing Self-Employment taxes:
1. Behavioral control:
Does the principal have the right to direct and control what work is accomplished and how work is done, though instructions, training, or other means;
2. Financial Control.
Does the principal have the right to control the financial and business aspects of the worker’s job, including whether the worker has the right to be reimbursed for expenses; is expected to invest in the facilities or tools used in performing the service; can provide her services to third parties; realizes profits and losses in providing the service, and is paid in accordance with payroll policies.
3. Relationship of the Parties.
Have the principal and the worker entered into a formal contract; Does the principal pay the worker benefits, such as health care, insurance, sick pay, disability, etc.; Whether the service is permanent or relates to a self-defined project; The extent to which the worker’s services are a “key’ aspect to the services provided by the principal.
In common with the FLSA’s Economic Realities Test, the IRS also considers whether the worker’s services are key to the type of service provided by the principal, and to what extent the principal is “controlling” how the worker does her job.
Interestingly, both standards consider whether the worker is in the position of realizing profits and losses associated with her work activity, implying that a factor favoring defining a worker as an “independent contractor” is whether the worker operates in the manner of an entrepreneur in terms of assuming risks of profit and loss. An independent Contractor is also expected, under both tests, to invest in the tools of her trade.
C. State Labor Department Tests
State Labor agencies may also prescribe their own definition of “independent contractors”. As our previous article on the Undocumented Worker Trap pointed out, it is these state agencies that are more likely than the IRS or the U.S. Department of Labor to audit businesses like restaurants.
Among the factors the New York State Department of Labor looks at in determining whether there exists an “employer-employee relationship,” are the following:
1. Whether the work is full time in nature;
2. Whether the worker can set their work hours;
3. Whether the worker is required to attend staff meetings or training session;
4. Whether the employer can direct the worker when, where and how to do their job;
5. Whether the worker is directly supervised by the principal or another employee;
6. Whether the principal provides the worker with the facilities, equipment and tools, or supplies to do her work;
7. Whether the principal sets the rate of pay;
8. whether the principal provides compensation in the form of a salary, hourly pay, commissions etc.;
9. Whether the principal provides reimbursement or allowance for business or travel expenses;
10. Whether the principal provides the worker fringe benefits;
11. Whether the principal requires the worker to render personal services;
12. whether the services are “an integral part of the business”;
13. Whether the worker has business cards or other identification indicating that the worker is working for the principal;
14. Whether the principal allows the worker to work for other parties.
The New York State Department of Labor also has a balancing test to define an “independent contractor” (“IC”), which takes into consideration the following factors:
1. Whether the IC offers services to the public at large;
2. Whether the IC advertises her services, has business cards, a telephone listing, stationary, bill heads, indicating that the IC is in businesses for herself;
3. Whether the IC carries insurance; maintains an office, or other facility;
4. Whether the IC assumes the risk of profit and loss associated with providing services;
5. Whether the IC has the freedom to determine work hours and controls how the work is performed and is not required by the principal to attend training sessions or staff meetings.
6. Whether the IC has invested in facilities, equipment, and supplies so that she is able to provide the service in question.
State Law may also, as it does in New York, prescribe that certain services are, by definition, going to implicate an employer—employee relationship even though the common law definition of an “employee” may not quite fit. For instance, commissioned salespersons and delivery drivers are considered to be “employees” as a matter of New York statutory law.
The Take Away:
- Before an employer represents a worker as being an “independent contractor” and so, therefore, exempt from wage reporting and withholding rules, a careful analysis should be performed to determine whether the worker may be more accurately considered an “employee.” Remember that the legal presumption is that a worker is an “employee” unless a principal can advance evidence of her being an “independent contractor.”
- There are several tests for determining whether a worker is appropriately classified as an “independent contractor.” Generally, a good place to start is how state law defines what it means to be an “independent contractor” as opposed to an “employee.” This is because state agencies are most active in investigating misclassification claims. Definitions may differ from state to state, but the ultimate inquiry is whether the principal can control the working conditions of the worker by defining when and how the worker is supposed to perform services.
- Among the criteria most compelling in showing when a worker is an independent contractor are (1) whether the worker is in business for herself and markets her services to the public; (2) whether the worker is allowed to work for more than one company at the same time; and (3) whether the type of service provided by the worker is incidental (not key) to the principal’s income-generating activities.