Worker Classification: What’s In a Name?

Last year, FedEx lost a class action lawsuit, requiring it to reclassify approximately 2,300 drivers as employees in California. Despite FedEx entering into operating agreements that classified the employees as independent contractors, the California Court of Appeals for the Ninth Circuit noted that FedEx controls the appearance of its drivers and their vehicles, the times drivers work, and aspects of how and when drivers deliver packages.

So its drivers were deemed to be employees under the California Labor Code. This decision contradicts a previous IRS audit of FedEx driver classification that decided not to treat the drivers as employees. Keeping track of two separate worker classifications could prove an ongoing administrative nightmare for FedEx.

This high profile case should act as a reminder to all manufacturers and distributors to make a clear distinction between employees and independent contractors.

Here’s what you need to know to get it right.

Three Distinguishing Characteristics

Workers generally are employees for federal tax purposes if the company controls and directs the jobs they perform and how they perform them. The IRS has grouped the degree of control into three general categories of evidence: 1) behavioral control, 2) financial control, and 3) affiliation, including each side’s intent and how they respectively perceive their relationship.

In analyzing the status of your workers, pay close attention to such factors as:

Degree of control

If an employer exercises significant control over how and when a worker performs duties or has the right to do so, this factor indicates employee status.

Investment in equipment and facilities

Employees usually rely on their employers for things such as office space and tools. When the worker covers most or all of the cost of equipment and facilities used for the job, this factor indicates independent contractor status.

Opportunity for profit or loss

A given project’s success or failure usually doesn’t threaten employees’ paychecks. Conversely, workers who can realize a profit or suffer a loss as a result of their services are usually deemed independent contractors.

Possibility of discharge

If you can fire a worker, he or she likely is an employee. Contractors generally can’t be dismissed as long as they produce the work under contract.

Relationship of work to employer’s core business

When the worker’s duties relate to the employer’s core business it indicates employee status, while work related to a tangential enterprise indicates independent contractor status.

Permanency of relationship

Lack of permanency between the employer and worker indicates independent contractor status.

Additionally, if the employer and the worker believed the same thing at the time they entered into their arrangement, this factor can indicate either employee or independent contractor status, depending on the facts.

Policies to Prevent Classification Mishaps

If you currently use contractors — or are considering doing so — it’s a good idea to establish procedures that help ensure you don’t inadvertently misclassify any workers. First, require contractors to sign a written operating agreement outlining your relationship with them and ask for tangible evidence of their autonomy. This may include copies of letterhead, invoices, logos, business cards and advertisements. Also record their federal employer identification numbers and equivalent state numbers, if they operate through their own corporations.

Over time, managerial practices may inadvertently violate the original intent of a contractor’s operating agreement, crossing the fine line between contractor and employee. So, it’s also a good idea to develop a checklist or questionnaire to gather facts about those you classify as contractors. Periodically compare how you’re currently treating contractors to the factors described above. Then you should know whether you’re properly classifying workers.

Hot Button

The issue of whether to classify workers as employees or independent contractors has been a hot button with the IRS and state taxing agencies for several years. Improper classification can be a costly mistake, requiring you to pay back taxes, penalties and unpaid benefits. Consult with your tax and legal advisors to make sure you’re playing by the rules.

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