Legal Watch: Worker Classification

Security providers hire two types of workers — employees and independent contractors — and the rules for each can differ.

Employees are subject to a wide array of state and federal tax requirements. For example, employers must withhold taxes and pay other taxes on the employee’s behalf. There also are complex and burdensome recordkeeping and reporting requirements. On the other hand, these requirements do not apply to independent contractors, providing an incentive to classify workers as independent contractors. Businesses that wrongly classify employees as independent contractors, however, face significant tax and related liabilities, including penalties and interest.

Initially, it is the employer that determines if a worker is an employee or an independent contractor. The decision is subject to review by a number of government agencies, including the IRS, the U.S. Department of Labor, the employer’s state tax department, and state authorities that administer unemployment compensation and worker compensation. The more workers that are classified as employees, the greater the amount of money that must be paid to these agencies. Employers must withhold and pay taxes from employees’ pay; however, independent contractors pay their own taxes, which means the government must wait for its money and bears the risk that the contractor will properly report income and pay taxes.


Determining the Worker Type

The IRS applies a 20-factor test in determining if a worker is an employee or independent contractor. The tests focus on financial controls, behavioral controls and the relationship between the parties.

Financial controls looks at whether the worker has an effect on financial decisions: Does the worker have a significant investment in tools or other assets? Does the worker have unreimbursed expenses? Does the worker provide services to others in the marketplace, or are all worker’s service performed exclusively on the employer’s behalf? Can the worker realize a profit or loss on a job or does the worker get paid no matter what?

Behavioral controls look at whether the employer has the right to direct and control the manner in which the worker performs the work. Control is not what is important — the right to control is enough, even if the employer does not exercise the right. The more control, the higher the likelihood the IRS will classify the worker as an employee. The right to control exists where the employer has the right to tell the employee: where to do the work, what tools to use when doing it, what work must be completed, and the order in which the work must be done.

The relationship test focuses on the connection between the employer and worker. Is there a written contract stipulating terms and conditions? Are there benefits such as vacation pay, healthcare benefits, pension benefits or other benefits typical of employment? Again, does the worker perform services solely for the employer or does the worker earn income from others? There are important documentation and recordkeeping requirements, too.


Impact on your Business

Both the Department of Labor and IRS are stepping up enforcement, with random audits, and levying financial penalties for violations of the classification rules. States are also getting into the act with new laws penalizing employers for misclassifying workers. Worker classification is important. Done right, it can save your business money. Done wrong, it can cost you big bucks.

Make sure you take the steps necessary to protect your interests. If you use independent contractors, they should incorporate. Sign a written contract with their company. Make sure the independent contract or purchases liability insurance and names you as an additional insured.

If you use independent contractors to sell residential security systems, you may be protected under an IRS safe harbor applicable to the sales of consumer products by door-to-door salesmen; however, the safe harbor does not apply to installers.

Proceed carefully and make sure to include knowledgeable professionals when structuring your relationship.


Eric Pritchard co-chairs the electronic security group of Kleinbard Bell & Brecker LLP. Pritchard focuses his practice on the electronic security industry with an emphasis on acquisitions. This column does not constitute legal advice; please contact an attorney with specific questions.