Determining the Difference Between an Independent Contractor and an Employee
Contributor, J. Seth Grove
Due to the heavy presence of the oil and gas industry, Texas has seen a tidal wave of Fair Labor Standards Act and employment lawsuits. Oilfield companies have been penalized millions of dollars for failure to properly comply with employment laws. At the forefront of this issue is the improper classification of workers as independent contractors rather than employees.
Proper classification of individuals as employees or independent contractors can be a very costly decision for an employer. For example, a landman’s eligibility for overtime payments hinges on whether she is an employee of the company or an independent contractor. Unfortunately for employers, the distinction between an employee and an independent contractor is not always clear, is subject to multiple legal tests, and the resulting classification can occur through unknowing or unintentional actions between the company and the individual.
More importantly, improper classification has the potential to subject an employer to unpaid overtime wages and employment taxes. True employee status results in the employer’s obligation to withhold income taxes, withhold and pay social security and Medicare taxes, and pay unemployment tax on wages paid to an employee. Conversely, a company does not generally have to withhold or pay any taxes on payments made to an independent contractor.
The definition of an independent contractor may seem obvious, but it is not always so clear. Rather, various federal and state agencies use multiple tests when classifying an individual as an independent contractor or employee. The existing tests are the IRS 20-Factor Test, the U.S. Department of Labor Test, and the Texas Workforce Commission’s Test.
A. IRS 20-Factor Test
The Internal Revenue Service uses a 20-factor test (hereinafter “IRS 20-Factor Test”) to determine whether an individual is an employee or an independent contractor. The IRS developed the test as a means to ensure proper tax withholdings by employers, and the test primarily focuses on who controls how the work is performed. By examining these twenty factors, courts can determine the validity of an independent contractor classification of an individual. The factors include:
• Level of instruction
• Amount of training
• Degree of business integration
• Extent of personal services
• Control of assistants
• Continuity of relationship
• Flexibility of schedule
• Demands for full-time work
• Need for on-site services
• Sequence of work
• Requirements for reports
• Method of payment
• Payment of business and travel expenses
• Provision of tools and materials
• Investment in facilities
• Realization of profit or loss
• Work for multiple companies
• Availability to public
• Control over discharge
• Right of termination
When applying the IRS 20-Factor Test, the company’s role/actions and individual’s role/actions are compared with each other. For example, in examining flexibility of schedule, an employer typically sets and controls the number of hours that an employee works, whereas an independent contractor controls her own working hours and schedule. Additionally, the provision of tools factor considers how an individual is furnished materials and equipment, by determining whether the individual supplied the materials necessary to complete a job or whether the company furnished the materials to the individual.
No particular factor outweighs another in the IRS 20-Factor Test. Further, not all factors must be present to result in an employer-employee relationship. Rather, the IRS 20-Factor Test serves as a guide to determine an individual’s status as independent contractor or employee.
However, the most important thing for an employer to consider generally relates to the employer’s control of the working individual. An individual with little control over how to perform the work, when to do the work, and where the work is performed, has the potential to be labeled an employee under the IRS 20-Factor Test.
B. Fair Labor Standards Act Tests
A second test used to determine whether an individual is an employee or an independent contractor is based on the Fair Labor Standards Act (hereinafter “FLSA”). An employer’s failure to correctly determine if an individual is an employee under this test can expose the employer to liability for unpaid overtime, liquidated damages, and attorney fees.
The United States Supreme Court has stated that there is no definition that addresses all issues relating to the employer-employee relationship under the FLSA. The determination of the relationship cannot be based on isolated factors or upon a single characteristic, but rather depends upon the circumstances of the entire activity. The classification is determined using an economic realities test (hereinafter “Economic Realities Test”). In applying the Economic Realities Test, courts have generally ruled that a worker’s status is determined through an examination of the employer’s ability to control how the work is administered and completed.
1. Department of Labor’s Economic Realities Test
The Economic Realities Test is a six-factor test applied to examine a worker’s economic independence. The Economic Realities Test takes into account:
1. The extent to which the worker’s services are an integral part of the employer’s business (e.g. Does the worker play an integral role in the business by performing the primary type of work that the employer performs for his customers or clients? Does the worker perform a discrete job that is one part of the business’ overall process of production? Does the worker supervise any of the company’s employees?);
2. The permanency of the relationship (e.g. How long has the worker worked for the same company?);
3. The amount of the worker’s investment in facilities and equipment (e.g. Is the worker reimbursed for any purchases or materials, supplies, etc.? Does the worker use his or her own tools or equipment?);
4. The nature and degree of control by the employer (e.g. Who decides on what hours to be worked? Who is responsible for quality control? Does the worker work for any other company(s)? Who sets the pay rate?);
5. The worker’s opportunities for profit and loss (e.g. Did the worker make any investments such as insurance or bonding? Can the worker earn a profit by performing the job more efficiently or exercising managerial skill? Can the worker suffer a loss of capital investment?); and
6. The level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise (e.g. Does the worker perform routine tasks requiring little training? Does the worker advertise independently via yellow pages, business cards, etc.? Does the worker have a separate business site?).
2. The TWC 20-Factor Test
TheTexas Workforce Commission (hereinafter “TWC”) is an employment agency with its own regulations and requirements.The TWC created its own 20 factor test (hereinafter “TWC 20-Factor Test”) to determine who may be properly classified an independent contractor. This test is now formalized in the Texas Administrative Code and was adapted from the IRS 20-Factor Test.
The TWC provides what is known as the Form C-8 to help determine if a worker is an employee or independent contractor. The Form C-8 states that:
nder the common law test, a worker is an employee if the purchaser of that worker’s service has the right to direct or control the worker, both as to the final results and as to the details of when, where, and how the work is done. Control need not actually be exercised; rather, if the service recipient has the right to control, employment may be shown.
The TWC reinforces the principle that it does not matter the label that an employer assigns an individual (e.g. agent, contract labor, subcontractor, etc.). Whether a worker is an employee or independent contractor is based on the employer’s control over the worker as determined under the TWC 20-Factor Test.
When considering how the issue of employee versus independent contractor can potentially affect a company’s operations, the company must be vigilant and aware of how it is identifying, controlling, and paying workers. While it is proper to pay an individual as an independent contractor if the individual qualifies as such under the above tests, simply giving the individual a 1099 Tax Form does not in fact classify a worker an independent contractor. Improper classification, failure to withhold taxes, and failure to properly track hours can be a very costly mistake for any employer.
Irs.gov, Independent Contractor (Self-Employed) or Employee?,https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee (last visited June 6, 2016).
See IndependentContractors, United States Dep’t of Labor, http://www.dol.gov/elaws/esa/flsa/docs/contractors.asp (last visited June 6, 2016).
 40 Tex. Admin. Code § 821.5 (West 2013).
 Employment Status – A Comparative Approach, 1, http://www.twc.state.tx.us/news/efte/appx_e_twc_ic_test.html (last visited June 6, 2016).