June 21, 2012

New Case Clarifies Test for Contractor Status

By Mark Wiletsky

Many organizations rely on independent contractors–sometimes referred to as consultants or just contractors–to perform a variety of services.  But determining who is a contractor, as opposed to an employee, is not an easy task.  A variety of state and federal rules apply, each with different factors and tests.  If you misclassify an individual, the penalties can be severe.  For example, in Colorado, a business may be fined up to $5,000 per misclassified employee for the first offense, and up to $25,000 per misclassification for subsequent violations if the violations were willful.  Businesses may also be liable for back taxes, interest, failure to pay overtime, and a variety of other penalties for failure to provide benefits.  Therefore, it's very important to ensure an independent contractor fits the tests for contractor status.  A new Colorado case provides some important guidance on this subject.

In Softrock Geological Services, Inc. v. ICAO, the Colorado Court of Appeals had to decide whether an individual who provided services to Softrock as a contractor over a three-year period, without performing similar services for others during that period, was a contractor or employee.  Under Colorado's unemployment statute, an individual is presumed to be an employee unless the organization demonstrates that the individual: (1) is "free from control and direction in the performance of the service" and (2) "is customarily engaged in an independent trade, occupation, professional, or business related to the service performed."  The second part of the test is often difficult to prove.  A number of Colorado cases have concluded that unless the contractual arrangement is relatively brief, an individual must perform services for more than one entity to be a contractor.  Such a test, however, places a heavy, and often unfair, burden on businesses.

Businesses do not always track the outside activities of a consultant, and a consultant may choose to work for only one entity for a period of time.  Recognizing this, the Court of Appeals in Softrock concluded that it is improper to classify an individual as an employee solely because that person did not perform similar services for others while performing services for the alleged employer.  Instead, the failure to perform services for others is merely one factor to be considered.  The other factors include: the existence of a quality standard; payment of a salary/hourly rate as opposed to a fixed or contract rate; ability to terminate the individual for limited reasons, such as failing to produce results or violating the contract; whether training is provided; whether tools and benefits are provided; whether the individual is subject to a set schedule or has authority to set his or her own schedule; payment to a business or tradename as opposed to an individual; and whether the individual and the business have combined operations or maintain separate and distinct operations.  The court remanded the case to the Industrial Claims Appeals Office for reconsideration, though it is possible this case will be reviewed by the Colorado Supreme Court. 

The court's guidance in Softrock is helpful because many times, individuals will meet the test for contractor status even though they choose to perform work for only one entity for an extended period.  Still, as this case demonstrates, repeatedly retaining an invidual to perform services as a contractor over an extended period, without confirming that he or she is working for others, is risky.  As a result, it is best to ensure that individuals are, in fact, working for others or making their services available to others while performing services for your business.

Here are some additional tips to keep in mind when retaining a contractor:

1. Don't classify someone as a contractor just because that person asks to be a contractor.  The business bears the responsibility, and liability, for appropriately classifying its workers.

2. A signed contract is not enough.  A court or auditor will look beyond the contract to determine whether the individual meets the appropriate tests for contractor status.

3. Do not pay an individual; instead, ensure you are paying a tradename or business entity.  Payment to an individual is a red flag for auditors, even when the person is legitimately a contractor.

4. Avoid hiring former employees as contractors, unless you are certain they meet the test for contractor status.  Again, this is a red flag for auditors, as employees are sometimes reclassified as contractors even though their actual duties have not changed.

5. Get a business card, print out a website, or maintain some other evidence that the individual has a business and makes his or her services available to others.  This type of evidence can be very helpful in the event of an audit.

6.  Get your attorney involved early to ensure the person meets the appropriate tests.  Although a written agreement is not dispositive, it can help, and analyzing the issue before an audit is generally better than analyzing it for the first time during or after an audit has begun.

7. Do not treat the individual like an employee, i.e., do not have the person sign an employment contract, do not evaluate the individual with the same forms you use for employees, and if you give the person a business card, be sure it notes the individual is a contractor.

8. Do not retain someone as a contractor with the idea of hiring that person as an employee if he or she does well.  Most likely, that person will not fit the tests for contractor status.

9. Do not assume that individuals performing short-term projects or part-time work are automatically contractors.  Often times, they are part-time or short-term employees.

10. When in doubt, err on the side of employee status. 

Contractor misclassification is a big issue in Colorado and many other states.  Therefore, be cautious when retaining contractors, and be sure they meet the appropriate tests for contractor status.

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