TRAVERSE CITY – In few other industries has the independent contractor arrangement flourished as it has in the tech sector. Programmers and network consultants hold themselves out as independent contractors on a work for hire basis. Employers look for workers on a project or task basis and, thus, are also motivated to look seriously at independent contractor relationships.
There are many pitfalls to the independent contractor relationship which can cause a serious setback for both the independent contractor and the company if things should go wrong. Companies and contractors in exploring these relationships must consider a variety of factors in entering into such a relationship.
As importantly, independent contractor agreements are subject to review from a variety of government agencies including the IRS, state unemployment compensation insurance agencies, state workers’ compensation insurance agencies, the United States Labor Department and the NLRB. An improperly conceived or drafted independent contractor agreement can cause serious problems down the line. Here are some of the issues you need to look at.
Will the IRS consider your relationship one of employer/employee or as an independent contractor?
The IRS (and other government agencies) will look at any self-proclaimed independent contractor arrangement very carefully. If the IRS comes in after the fact and determines that the relationship was really one of employer/employee, they will be looking for penalties for failure to withhold appropriate taxes on employee salaries and other penalties. Thus, if an employee is misclassified, the employer may be responsible for paying back wages for overtime pay with interest, social security taxes, unemployment insurance, the value of group health and other benefits, taxes and workers’ compensation for a miscategorized employee. Moreover, liquidated damages and penalties may very well be imposed, as may criminal penalties.
Typically, the IRS looks at the employer, as opposed to the employee to make up the difference in withholding. Thus, employers must be extremely careful about hiring independent contractors as they may be liable for tens or hundreds of thousands of dollars in withholding taxes and penalties if the IRS should ultimately conclude that the independent contractor base should really have been treated as employees.
So what factors does the IRS look at in determining whether or not a worker is an employee or an independent contractor? There are 20 plus factors that the IRS uses in this determination, including whether the person has multiple clients (looks like an independent contractor) or only one client (looks more like an employee). The IRS and other government agencies typically look at whether a worker:
Can earn a profit or suffer a loss from the activity;
Can be fired by the hiring firm;
Furnishes the tools and materials needed to do the work;
Is paid by the job or by the hour;
Works for more than one firm at a time;
Invests in equipment and facilities;
Pays his or her own business and traveling expenses;
Has the right to quit without incurring liability;
Receives instructions from the hiring firm;
Is told in what sequence or order to work by the hiring firm;
Receives training from the hiring firm;
Performs the services personally;
Hires and pays assistants;
Sets his or her own working hours;
Works full-time for the hiring firm;
Provides regular oral or written progress reports to the hiring firm;
Provides services that are an integral part of the hiring firm’s day-to-day operations.
Essentially, these issues come down to the ?economic realities of the situation? and ?control.? The economic reality test focuses on whether a worker is economically dependent upon a hiring firm.
Who owns the intellectual property?
Unlike employers and employees, independent contractors tend to be far more autonomous when doing work for companies. Independent contractor agreements need to be spelled out in exacting detail to cover such issues as compensation, duration and who owns the intellectual property developed during the relationship.
For instance, if a software development company hires an independent contractor to develop code, the company should not presume that it will own the copyright in that code at the end of the relationship absent an express provision in the contract which deals with this issue. In general, copyrightable works produced by the independent contractor are owned by the contractor, even if you pay for the work done, unless you obtain an assignment of the work or it is otherwise spelled out in the independent contractor agreement. This is in contrast to work done by employees, which is typically considered owned by the employer if developed during the course of the employment.
Non-Competition and Non-Solicitation Agreements.
Typically, we advise against non-compete provisions since such a provision may cause the IRS to conclude that the worker is ?dependent? on the company and thus an employee. If you limit an independent contractor from other employment, you are creating a heavy presumption that the worker is really an employee. You can draft a meaningful non-solicitation agreement, however, which precludes the contractor from soliciting your employees to quit or change jobs.
Confidentiality Agreements.
A company should always make sure that it obtains an agreement up front with the independent contractor to keep all confidential and trade secret information confidential, even after the independent contractor relationship ends. Absent such an agreement, a company may be deemed to have waived its right to keep such information confidential and may lose the trade secret status of any inventions or other proprietary information.
Business 2 Business:
I always encourage independent contractors to start their own business (LLC or the like) so that they appear and act more like an independent company. This can really help if the IRS takes a look at your relationship.
Written Agreements:
Written agreements are not absolutely controlling in classifying a person as either an employee or contractor. However, they are very important and should always be drafted carefully. A well crafted contractor agreement can set expectations and include a lot of the terms necessary to reduce the risk that a government agency will take issue with your classification of a worker as an independent contractor.
In one well publicized case, Microsoft Corporation faced a class action lawsuit by a large number of independent contractors seeking back pay and benefits from workers who believed that they should have been treated as employees. In a separate action, the IRS sought back taxes and penalties against Microsoft Corporation. Microsoft ultimately settled the class action for millions of dollars and paid millions more in back taxes, not to mention legal fees. If a tech company decides to aggressively use independent contractors as part of its workforce, it should do so carefully and with good legal counsel. Any money you spend up front will be far less than the potential penalties you will suffer if the government steps in and reclassifies your contractors as employees.
Enrico Schaefer is an attorney in Traverse City, Michigan specializing in technology issues. He practices throughout the state of Michigan. You can contact Enrico at 231-932-0411 or visit TraverseLegal.com.
