Last month we discussed several ways to increase the profitability of your business by reducing operational costs. One of the cost-cutting methods I suggested was to trim from your payroll any employee who did not either make or save money for your business. Based upon this advice, I received several inquiries asking about the use of independent contractors in place of employees. I even received a question regarding the utilization of unpaid interns as a labor source.

Why use independent contractors?

When legal, it is almost always advantageous for a business to classify its workers as independent contractors. Independent contractors are liable for 100% of the employment taxes owed on their income, and they are not eligible to receive paid time off, healthcare benefits, or retirement benefits. In addition, the tortious actions of independent contractors are not the vicarious liability of the business for which they work..

Sign me up, I want all my employees to be independent contractors!

Establishing that a worker is an independent contractor is rarely simple but not always possible. By default, every worker is an employee unless the business can show a principal-contractor relationship rather than an employer-employee relationship. Misclassifying an employee as an independent contractor also carries stiff penalties from the IRS and state taxing authorities, not to mention civil liability to the employee.

The IRS formerly used what was known as the “Twenty Factor” test to determine if a worker could be properly classified as an independent contractor. Under pressure from Congress and business and labor representatives, the IRS recently attempted to refine and simplify the test by condensing the twenty factors into three groups of eleven factors. As you might imagine, the test did not really become simpler, as each of the eleven factors must be examined and weighed, and there is no clear way for an average employer to decide which factors will weigh more heavily than others.

The independent contractor test.

The three groups into which the eleven factors used to determine if a worker may legally be classified as an independent contractor are (1) behavioral control, (2) financial control, and (3) relationship type. While a detailed analysis of each factor is beyond the scope of this discussion, the general idea of each group is as follows:

Behavioral Control

The idea behind behavior control is to examine how a worker completes his or her tasks. Independent contractors must not be subject to the direction and control of their principals. If the business has the right to direct how the worker completes tasks, the worker is likely an employee. Even if the business does not actually control the way work is done, having the unexercised right to direct and control is sufficient to establish behavioral control.

Another form of behavioral control is training. Independent contractors are not permitted to receive training from their principals. If a business gives training to a worker, it establishes that the business wants the worker to complete tasks in a specific manner; this is indicative of the behavioral control an employer exerts over an employee. If periodic or continuing training is provided by a business, this provides an even stronger indication of an employer-employee relationship.

Financial Control

Independent contractors frequently make significant investments in the tools and instrumentalities used to perform tasks. Employees, to the contrary, are usually supplied with everything needed to complete their work by the employer. There are no set investment figures by which to judge the significance of a worker’s investment, and this factor alone is never dispositive, but independent contractors generally have their own computers, their own software, and other similar tools. A worker using the tools of a business is likely to be considered an employee.

The opportunity for profit or loss is another consideration of financial control. Independent contractors are usually paid by a flat fee for a job, while employees are guaranteed a regular wage amount for an hour, week, or other period of time. Most expenses are reimbursed to employees, while independent contractors generally pay their own expenses. If costs increase, an independent contractor may be paid less than the cost of completing a task and lose money, shifting the loss to the employer. Showing an opportunity for profit or loss is a great way to support an assertion that a worker is an independent contractor.

Type of Relationship

A worker might contractually agree to independent contractor status in writing, but the IRS is not required to follow a contract stating that a worker is an independent contractor. Instead, the IRS will look at how the business and the worker interact..

Independent contractors usually work on a specific project or for a specific period of time, whereas an ongoing relationship is indicative of an employer-employee relationship.

The importance of the worker’s role in the business is also examined. If a worker provides services key to the success of a business, these services are more likely to be performed under the direction and control of the business, meaning the worker is an employee and not an independent contractor.

Interns. Did someone say free labor?

I gained a tremendous amount of legal experience as a law student toiling away in windowless rooms with five other unpaid interns, just to have the honor of doing “real work” for an actual attorney. You probably have your own internship horror stories. Unfortunately, federal labor laws were drastically changed in January 2010, and the internships we all remember with such fondness are much more heavily regulated.

The current state of the Fair Labor Standards Act (FLSA) defines the term “employ” very broadly. Covered and non-exempt individuals who are “suffered or permitted” to work must be compensated under the law for the services they perform for an employer. However, there are some circumstances under which individuals who participate in “for-profit” private sector internships or training programs may do so without compensation.

The Supreme Court of the United States has held that a person whose work serves only his or her own interest need not be compensated. This may apply to interns who receive training for their own educational benefit if the training meets certain criteria. The determination of whether an internship or training program meets this exclusion depends upon all of the facts and circumstances of each such program, but the following six criteria must be applied when making this determination:

1. The internship, even though it includes actual operation of the facilities of the employer, is similar to training that would be given in an educational environment;

2. The internship experience is for the benefit of the intern;

3. The intern does not displace regular employees, but works under close supervision of existing staff;

4. The employer that provides the training derives no immediate advantage from the activities of the intern, and on occasion its operations may actually be impeded;

5. The intern is not necessarily entitled to a job at the conclusion of the internship; and

6. The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship.

Unlike the test for determination of employee versus independent contractor status, which is a balancing test, ALL THE CRITERIA listed above must be met for an employment relationship to not exist under the FLSA’s minimum wage and overtime provisions. If even one of the six criteria are not met, the intern must be a paid employee.

Conclusion.

It is possible for a business to replace certain employees with independent contractors in order to reduce costs. However, a business needs to be very careful in selecting which positions might be good candidates for the use of independent contractors and which positions should continue to be filled by employees.

Furthermore, while I always felt that trading my time for experience and a few extra lines on my resume as an unpaid intern was a worthwhile exchange, it seems the federal government now disagrees.

Before classifying workers as independent contractors or bringing unpaid interns into your business, always speak with a trusted advisor who is knowledgeable in federal and state labor and employment laws.