One of the hardest things to explain to our business clients is how to classify their workers. That is, are they employees or independent contractors? This issue generally comes up one of two ways. Either the client is audited by a governmental agency, most commonly the Texas Workforce Commission (“TWC”) after TWC has received a claim for unemployment from a former worker who was classified as an independent contractor, but whose unemployment filing draws the attention of the TWC; or from the Department of Labor (“DOL”) who has received a complaint related to overtime.
Or, occasionally, the issue arises during discussions about business operations. So what is the big problem with classifying workers, and why is it so difficult to understand? Well first, there are three tests—the TWC, the DOL, and the IRS—all of which are different. Second, as the saying goes, “if it ain’t broke, don’t fix it.” Businesses often operate successfully for years, and the fact they haven’t been hit yet means they believe they are doing it right.
First, let’s talk about the three tests, then we will apply them to explain the difference between employees and independent contracts using a Star Wars example. That is, an Imperial Stormtrooper is an employee, but Boba Fett and the other bounty hunter scum are independent contractors.
The TWC uses a twenty part test which examines the following: instructions; training; integration into operation; rendering of personal services; ability to hire helpers; continuing relationship; set hours of work; full time required; location of the performance; control of order; reporting; payment at regular intervals; payment of expenses; furnishing tools; investment in business; realization of profit or loss; ability to work for others; services available to the public; right to discharge; right to quit.
The TWC conveniently provides this test on their website at: http://www.twc.state.tx.us/files/businesses/form-c-8-employment-status-comparative-approach-twc.pdf. This test will be applied to determine whether an employer should be paying unemployment insurance and whether a former worker is entitled to unemployment insurance.
Notice that the TWC does not consider a worker’s title or if they have signed a contract called an Independent Contractor Agreement. The TWC is the administrative body who applies their own test. In this way they are judge, jury, and executioner. As such, most employers will lose this hearing, and while the employer has the right to appeal to a district court, the expense of litigation often outweighs the costs of compliance, making litigation a poor business decision.
The DOL applies the Fair Labor Standards Act (“FLSA”), which defines employee as “any individual employed by an employer.” Employ is defined as including “to suffer or permit to work.” The concept of employment in the FLSA is very broad and is tested by “economic reality.” In determining the economic reality, each employment relationship is unique and fact specific. Some grey areas arise for employers when enlisting the help of independent contractors, trainees, volunteers, and interns. Some employers have incorrectly thought that a contract naming a person an independent contractor was sufficient by itself to avoid an employer-employee relationship. In fact, despite a contract stipulating an individual is an independent contractor, the relationship and conduct between the individual and the company can establish an employer-employee relationship. The Supreme Court has set out a framework for whether or not an independent contractor is considered an employee under the FLSA. No one factor listed is controlling.
- The extent to which the worker's services are an integral part of the employer's business;
- The permanency of the relationship;
- The amount of the worker's investment in facilities and equipment;
- The nature and degree of control by the Employer;
- The worker's opportunities for profit and loss; and
- The level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise
The IRS applies yet another test, similar to the TWC, yet not quite identical. The IRS looks at three main categories—behavioral control; financial control; and relationships. Behavioral control is determined by examining the level of instructions given on when, where, and how to work; an examination of the evaluation system; and the training provided to the worker. Financial control looks at the worker’s investment in the equipment they use; how expenses are treated; whether the worker can realize a profit or a loss; whether they can sell their services to the market; how the worker is paid. The relationship factor looks at whether there is a written contract; if the worker gets benefits; the permanency of the relationship; whether the services provided by the worker are a key aspect of the business. A more in depth explanation can be found at https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee.
So what makes a Stormtrooper an employee? The Empire provides them their iconic uniforms and equipment; the Empire trains them, their service is integral to the Empire’s domination; they ostensibly work full time; perform their services at Empire bases; their work relationship seems to be permanent; the Empire exercises complete control over the Storm Troopers; and based on their combat performance they do not seem to have the level of skill, initiative, or judgment necessary for success as an independent enterprise; is presumably paid on a regular basis; and follows command without question.
Let’s contrast this to Boba Fett. He has his own uniform, gun, and ship; he is self-trained; works for the highest bidder; picks his own hours and assignments; travels across the galaxy; works only for a time; can realize a profit or a loss depending on his own initiative; has independent discretion; is highly skilled; offers his services to the public; gets paid only when he gets his quarry; and even talks back to Darth Vader (“He’s no good to me dead.”).
In the real world, these distinctions are not quite so clear. A business must examine both its own operations as well as how the worker fits those operations under the rubric of these three tests to determine whether to classify its worker as an employee or independent contractors.