The line between who is an employee and who is an independent contractor is often a difficult one to draw, with significant (adverse) consequences for employers if they err in their designation. Different state and federal agencies have different standards for distinguishing between employees and independent contractors. Under any statutory scheme, however, there are two crucial areas. The first focus is control. The second is a determination on whether or not the contractor has his own business.

Independence. To qualify as an employee, an employer must exercise control over the person. Control means dictating the means and methods by which work is done, as opposed to just requiring a particular result. If an electrician comes into a house to install a fixture, the home owner does not tell the electrician to use particular tools, but rather just wants the fixture properly installed (i.e. the result). The electrician himself chooses how he will do the job and at the end of it he gives the home owner a bill to pay. An employee, however, is given direction as to how to accomplish the task. That shows control. More evidence of control is the manner of payment. If the person is paid by the hour or on a salary, as opposed to a lump sum for the project, that evidences that the putative employer is not paying for just a result, but is controlling the means by which the result is obtained. If the company supplies health insurance, paid vacation hours, or personal days to someone claimed to be an “independent contractor,” that is almost a dead giveaway to an agency (e.g. Department of Labor) that the person is in reality an employee.

Business ownership. The next crucial focus is whether the contractor has his own business. This may be established in a number of ways, such as the possession of business cards, advertising in the Yellow Pages or elsewhere, the filing of a Schedule C, self-employment tax return, or proof of incorporation and conducting the business like a corporation. The burden of proof is on the employer who wants to prove that is contractor is not its employee and it may prove difficult securing, for example, someone’s tax return so it can be turned over to the governmental agency conducting the audit or investigation. One good, impressive method for showing a true, independent business is for the company to make out the checks to the other “corporation” and not to the person, as an individual.

Another issue is the exclusivity of the arrangement. If a person is working solely or virtually solely for one company and derives the vast percentage of his income/compensation from that one company, that evidences an employer-employee relationship. To the contrary, independent contractors may work for dozens, if not hundreds of companies in a given year.

Exposure. An audit by a state Department of Labor typically occurs when an individual applies for unemployment compensation. As there have been no unemployment contributions made for the independent contractor (or others similar to him), this may often trigger a complete audit of all employees and can end in huge fines for a company and payment of unemployment contributions in arrears. If the contractor has worked more than forty hours, there may be exposure for overtime under the Fair Labor Standards Act and/or state wage-hour laws. Obviously, the specter of an IRS audit, and demand for FICA and social security taxes for the employee(s), also looms on the horizon.

The Answer? A well-drafted independent contractor agreement may help. A carefully drafted document will contain all the provisions that demonstrate, on paper, that an individual is an independent contractor not an employee. Even the best drafted document, however, will not help if the actual circumstances vary from what is on the paper. As most audits go awry for the employer on the independent business part of the test, the employer must be constantly on guard to ensure that its contractors have evidence that establishes the fact that they truly have a “business.” If not, it is the employer who may well get “the business” from governmental agencies in unanticipated audits.