Employers pay the price if they don’t follow the rules on who is and isn’t an independent contractor.
Are they employees of yours or 1099 independent contractors? On Jan. 6, 2021, the U.S. Department of Labor clarified the guidelines for classifying workers as independent contractors under the Fair Labor Standards Act, which among other things establishes minimum wage and overtime pay for private-sector employees. The final rule, which went into effect March 8, is important because employers now have clearer guidance when classifying workers as independent contractors.
When veterinary employees are misclassified as independent contractors, a common reason is to avoid state and federal tax-withholding requirements and payroll taxes. The practice issues a 1099 form to the independent contractor at year’s end and the worker is responsible for reporting the income, which is subject to a self-employment tax. Misclassification can result in serious problems, including taxes, fines and penalties for the employer.
On the other hand, individuals classified as employees are entitled to certain benefits and protections under state and federal laws. The practice is responsible for withholding a portion of the employee’s earnings for tax purposes.
Let’s dive into the Labor Department’s new rule.
Economic Reality Test
The federal government adopted a test designed to determine whether individuals are in business for themselves (independent contractors) or are economically dependent on an employer for work (employees).
The economic reality test takes into account six factors. All of them are important, though the final rule gives the most weight to Nos. 4 and 5.
- The first factor is the permanency of the relationship between the parties. The general rule is that a more permanent relationship weighs in favor of an individual being classified as an employee.
- The second factor relates to this question: How much skill is required to perform the job? For example, in situations where an individual’s profits increase based on initiative, judgment or foresight, a finding that the individual is an independent contractor is more likely.
- For the third factor, the government considers the individual’s personal investment in job equipment or materials. In the same vein, comparing the capital invested by the worker with what the employer provides is an indicator. In cases where individuals invest a significant amount of money into job equipment or tools, they’re likely to be considered independent contractors. Property such as a vehicle, which might be necessary for the job but can be used outside of work hours, might not be considered.
- Under the fourth factor, the government assesses whether the person could create more or less profit depending on her skill and expertise. Workers are more likely to be considered independent contractors if they demonstrate greater control over the profitability of their jobs.
- The fifth factor is the degree of control an employer exercises over how the work is performed. Workers are more likely to be classified as independent contractors if they exhibit greater control over their schedule and the manner of performing work, for instance by selecting projects or choosing to work for other parties, including competitors.
- The last factor is whether the services received from the individual are an integral part of the employer’s business. Under the Fair Labor Standards Act, the more integral the worker’s services to a business, the less likely she will be considered an independent contractor.
The final rule also explains that the actual practices of the worker are more important than what might be contractually or theoretically possible. In other words, veterinary practice owners will not be shielded from scrutiny or penalties simply because they entered into formal independent contractor agreements with a worker. Regardless of the existence of such a contract, the law and the courts will closely analyze a worker’s conduct. If the practices of the worker indicate she is truly an employee, an independent contractor agreement will hold little weight.
Finally, note that the final rule expressly rejects the stringent “ABC test” adopted by many states and codified into law by California in January 2020. Under the test, workers are considered employees unless they:
- Are free from the control of the hiring entity.
- Perform work outside of the hiring entity’s business.
- Are customarily engaged as an independent contractor and thus are in business for themselves.
Audits and Potential Penalties
I’ve seen a substantial increase in independent contractor audits by state labor departments and the IRS. If an agency finds that a veterinary practice misclassified a worker as an independent contractor, the business likely will be deemed responsible for unpaid employment, disability and social security taxes, plus any interest and penalties. Also, misclassified independent contractors might be entitled to retroactive insurance coverage and other benefits granted to properly classified employees. If the worker is deemed a nonexempt employee and worked more than 40 hours in any given week, she would qualify for retroactive overtime pay.
The only fail-safe way to survive an audit is to classify workers properly under federal and state laws. Here are nine best practices for correctly maintaining an independent contractor classification.
- The worker establishes a business entity under a federal employer identification number (EIN). The veterinary practice will contract with the business rather than the worker personally.
- The worker procures general and professional liability insurance, if applicable.
- The worker is solely responsible for paying taxes on revenue received from the practice.
- The worker does not receive any benefits or bonuses from the practice.
- The worker establishes work and vacation schedules.
- The worker signs a written agreement stating that she is an independent contractor, that she meets the criteria of an independent contractor, and that she will indemnify and hold the practice harmless if the Department of Labor or IRS determines otherwise.
- The practice specifically states that the employee handbook does not apply to individuals who are independent contractors.
- The independent contractor provides the practice with an invoice of charges representing the monies earned, which the practice will pay within a certain number of business days.
- The independent contractor picks and chooses the work to be performed and can decline particular assignments.
Legal Lingo columnist Peter H. Tanella chairs Mandelbaum Salsburg’s National Veterinary Law Center. He has advised hundreds of veterinarians on practice acquisitions, sales, mergers, partnerships, joint ventures and associate buy-ins, the structuring of management service organizations, and the development of practice succession strategies. He can be emailed at [email protected].
WORDS OF ADVICE
A U.S. Department of Labor fact sheet stresses these three points:
- Employers may not misclassify an employee for any reason, even if the employee agrees.
- You are not an independent contractor under the Fair Labor Standards Act merely because you work off-site or from home with some flexibility over work hours.
- Whether you are paid by cash or by check, on the books or off, you might still be an employee under the Fair Labor Standards Act.