Are Your Workers Independent Contractors or Employees?
Whether companies treat workers as employees or independent contractors will have an impact on (1) the workers’ pay and benefits; (2) the employer’s costs; and (3) state and federal revenues in terms of what taxes are collected.
For employees in Arizona, employers must withhold state and federal income tax, social security, and Medicare taxes from the employees pay in accordance with the Form W-4 Employee’s Withholding Certificate. Employers must also provide employees with workers’ compensation and unemployment insurance, pay minimum wage, pay overtime to non-exempt employees, provide earned paid sick time, and comply with E-Verify. Depending on the size of the company, employers may also need to consider other employment laws such as the Americans with Disabilities Act, the Fair Labor Standards Act, or the Family and Medical Leave Act.
For independent contractors in Arizona, the company will require the worker to complete a Form W-9 Request for Taxpayer Identification Number and Certification, will pay the worker for the job done in the amount agreed upon, and will provide the worker and IRS with a Form 1099-NEC (replacing form 1099-MISC in 2021 for non-employee compensation) and Form 1099-MISC for any other miscellaneous payments.¹
So, how do you know if a worker is an employee or an independent contractor? Arizona law, the Department of Labor (DOL), and the Internal Revenue Service (IRS) each have their own list of indicative factors. So, the answer is, it depends.
Arizona State Law
Arizona courts and state agencies use a “right to control” test to determine whether a worker is an employee or an independent contractor. It is the possibility of control, not the actual control of a worker’s activities that determines the issue. The test, found in A.R.S. ¶23-902, examines: (1) whether an employer “procures work to be done for the employer by a contractor over whose work the employer retains supervision or control,” and (2) whether “the work is a part or process in the trade or business of the employer.” A.R.S. ¶23-902(B). The worker is an employee if these factors are met. If however the worker is “not subject to the rule or control of the business for which the work is done, but is engaged only in the performance of a definite job or piece of work, and is subordinate to that business only in effecting a result in accordance with that business design,” the worker is an independent contractor. A.R.S. ¶23-902(C).
Courts consider the totality of the circumstances and other indications of control between the worker and company. The factors considered are:
- The duration of the employment;
- The method of payment;
- Who furnishes necessary equipment;
- The right to hire and fire;
- Who bears responsibility for workmen’s compensation insurance;
- The extent to which the employer may exercise control over the details of the work; and
- Whether the work was performed in the usual and regular course of the employer’s business.
Arizona law regarding the employment of workers without authorization to work in the United States, A.R.S. § 23-211 (6), defines “independent contractor” as “any individual or entity that carries on an independent business, that contracts to do a piece of work according to the individual’s or entity’s own means and methods and that is subject to control only as to results. Whether an individual or entity is an independent contractor is determined on a case-by-case basis through various factors, including whether the individual or entity:
- a) Supplies the tools or materials;
- b) Makes services available to the general public;
- c) Works or may work for a number of clients at the same time;
- d) Has an opportunity for profit or loss as a result of labor or service provided;
- e) Invests in the facilities for work;
- f) Directs the order or sequence in which the work is completed; or
- g) Determines the hours when work is completed.”
The “Economic Reality” Test
Federal courts and government agencies use what they call the “economic reality” test to determine employee status. The Ninth Circuit applies six factors to make that determination:
- The degree of the alleged employer’s right to control the manner in which the work is to be performed;
- The alleged employee’s opportunity for profit or loss depending upon his managerial skill;
- The alleged employee’s investment in equipment or materials required for his task, or his employment of helpers;
- Whether the service rendered requires a special skill;
- The degree of permanence of the working relationship; and
- Whether the service rendered is an integral part of the alleged employer’s business
The right of an employer to control the work remains a central consideration in the economic reality test, but the economic reality test covers situations where the worker is not directed or controlled by the employer but, nevertheless, as a matter of economic reality, depends on the employer.
The Title VII Common Law Agency Test
When the applicability of Title VII is at issue, courts and government agencies use the common law agency test which has 12 factors:
- The skill required;
- The source of the instrumentalities and tools;
- The location of the work;
- The duration of the relationship between the parties;
- Whether the hiring party has the right to assign additional projects to the hired party;
- The extent of the hired party’s discretion over when and how long to work;
- The method of payment;
- The hired party’s role in hiring and paying assistants;
- Whether the work is part of the regular business of the hiring party;
- Whether the hiring party is in business;
- The provision of employee benefits; and
- The tax treatment of the hired party.
The IRS 20-Factor Test and New IRS Grouping Test
For income tax and payroll withholding purposes, courts and government agencies use both a 20-factor test published by the IRS to determine employee status and a grouping test. The 20-factor test looks at:
- Whether the employer has the right to control how the work results are achieved, and if there are instructions regarding when, where, and how to work;
- Whether the employee has been trained to perform services in a particular manner;
- Whether the services are integrated into business operations, showing the employee is subject to direction and control;
- Whether the services are rendered personally, showing the employer is interested in the methods as well as the results;
- Whether the employer or the worker hires, supervises, and pays the assistants;
- Whether the employee has a continuing relationship with the employer, even if work is performed at irregular intervals;
- Whether the employee has set hours of work established by the employer;
- Whether the employee ordinarily devotes full time service to the employer or the employer may have a priority on the employee’s time;
- Whether the work is performed on the premises of the employer or at a location determined by the employer;
- Whether the employee is required to perform services in the order or sequence set by an employer;
- Whether the employee must submit reports to the employer;
- Whether the employee is paid by the hour, week, or month; or instead, paid as an independent contractor by the job or on a straight commission;
- Whether the employee’s business and travel expenses are generally paid by the employer and are subject to the employer’s regulation and control;
- Whether the employee is furnished with significant tools, materials, and other equipment;
- Whether the independent contractor has a significant investment in the facilities she uses in performing the services for someone else;
- Whether the independent contractor can make a profit or suffer a loss;
- Whether the independent contractor is free to provide her services to two or more unrelated persons or firms at the same time;
- Whether the independent contractor makes her services available to the general public;
- Whether the employee can be fired, or whether the independent contractor cannot be fired so long as she produces a result that meets the specifications of the contract; and
- Whether the employee has the right to quit her job at any time without incurring liability.
See IRS Rev. Rul. 87-41 (1987).
Effective January 1, 2020, the IRS began to “group” factors and focus on three areas: (1) Behavior Control; (2) Financial Control; and, (3) the type of relationship of the parties. If after reviewing these categories it is still unclear, the company or the worker can fill out the Form SS-8 Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will review the facts and circumstances and officially determine the worker’s status. It can take up to 6 months to get this determination.
Conclusion
There is no magic set of factors that combine to result in a conclusion that the worker is an independent contract or employee. You should think of the analysis as more of a scale that tips in one direction or the other based on the number of factors that apply. If the conclusion is not clear or is a close call, your next step will be to consider the risks and penalties associated with a potential misclassification to see if that is a risk your company wants to take. And don’t forget about DIBS agreements which can create a rebuttable presumption that the worker is in fact an independent contractor and not an employee under Arizona state law. My next article, The Consequences of Misclassifying Employees as Independent Contractors, will discuss the risks of misclassification in more detail.
¹ Note that in September 2019, U.S. Rep. Eleanor Holmes Norton introduced a H.R. 4235 called the “Protecting Independent Contractors from Discrimination Act of 2019.” This bill requires that independent contractors be treated as employees under Title VII of the Civil Rights Act, the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Americans with Disabilities Act, the Rehabilitation Act, and the Genetic Information Nondiscrimination Act. If passed, the bill would allow independent contractors to sue employers for discrimination based on race, sex, religion, color, national origin, age, disability and genetic heredity. Norton’s bill has no co-sponsors and was last referred to the House Committee on Education and Labor on September 6, 2019. I do not expect the bill to gain momentum any time soon but am monitoring it.