Employee Or Independent Contractor? Differences Between State And Federal Regulations Catch Employers In The Middle

As the Commonwealth of Mass-achusetts faces a severe budget deficit, the state has been utilizing all available additional means to generate revenue. This phenomenon may subject local employers to scrutiny with regard to their classification of workers as independent contractors and the potential loss of savings that such outsourcing is designed to generate. 

Some local businesses, including many in health care, utilize independent contractors and are finding themselves in the crosshairs of state auditors. The standards used by the Internal Revenue Service (IRS) and Massachusetts agencies including the Department of Revenue (DOR) and the Division of Employment and Training (DET) are in conflict with regard to how they determine the status of workers designated as independent contractors. Businesses frequently assume that if they comply with IRS standards and regulations, they are in compliance with Massachusetts state law regarding classification of independent contractors. In fact, federal and state law are radically different.

The Internal Revenue Service employs a 20-factor test to determine whether a worker is an employee or an independent contractor for purposes of federal taxation.

he degree of importance of each of the 20 factors is applied in the practical context of the actual job, and a determination is made as to whether the worker is in fact an employee or an independent contractor. A key element in conferring independent contractor status is whether the employer has the power to direct and control the worker’s activities. Direction and control over an employee is established when the employer has the right to require compliance with instructions.

Factors considered in arriving at this result include such things as:

• Requiring regularly scheduled hours of work;

• An expectation that work be performed on-site;

• Utilization of performance reviews;

• A requirement to report and/or attend meetings;

• The right of the employer to discharge the worker; and

• The furnishing of materials or tools to the worker.

A combination of these factors, if found, support a conclusion that a particular worker is in fact an employee and not an independent contractor for federal tax purposes.

Factors that support the conclusion that the worker is an independent contractor include the existence of additional established clients and the advertising of the same or similar services to other members of the public. No single factor carries more weight than another. It is the sum result of all 20 factors that determines whether a worker is classified as an employee or as an independent contractor. Clearly, there is more art involved in making this determination than science.

Massachusetts wage and unemployment law apply an entirely different and much narrower analysis when it comes to independent contractors. The wage and hour laws (M.G.L. c. 149) and the unemployment law (M.G.L. c. 151A) presume that any worker is an employee unless an employer can establish that the worker is free from control and direction regarding his or her performance while serving a client, and also that the services are either performed outside of the usual course of the business which retains the services or that the services are performed outside of all of the retaining companies’ places of business. Another measure is that the individual providing the services is customarily engaged in an independently established occupation, profession, or business of the same nature as that involved in the service performed.

All three tests must be met to qualify a worker as an independent contractor. Cases decided under both statutes disregard contracts or documents signed by a worker which states that he or she is an independent contractor. Courts also ignore an employer’s practice of failing to withhold federal or state tax, unemployment compensation taxes, or the fact that a Form 1099 is issued. None of these facts are considered to be determinative of the actual relationship between the parties.

How do these seemingly private and arcane business relationships come to the attention of state auditors? Usually, the presumed independent contractor/ employee relationship ends badly. The disgruntled independent contractor then makes a report to the Fair Labor and Business Practices division of the Massachusetts Attorney General’s Office, which is empowered to enforce Massachusetts laws relating to the payment of wages. Another, more likely path to an audit occurs when the former independent contractor mistakenly believes that he or she is entitled to unemployment compensation and makes an application for unemployment benefits.

Obviously, an independent contractor cannot collect unemployment compensation benefits; however, an application for such benefits triggers an investigation and hearing by the Division of Employment and Training. If the division determines that a company has misclassified an employee as an independent contractor, it will audit the company for unpaid benefits on behalf of that worker, seek compensation for payment during the worker’s tenure with the company, and demand payment for other, similarly situated workers.

The differences between federal law and state law give rise to significant confusion on the part of employers. It is important to remember that having a clean bill of health from the IRS by no means insulates you from liability under Massachusetts wage and hour laws or Massachusetts unemployment law. It is the employer’s duty to overcome the presumption under state law that anyone who performs work for a business is in fact an employee of that business. This legal nuance impacts professional corporations particularly hard.

It is recognized that a licensed professional such as a doctor, dentist, or lawyer is usually not susceptible to the type of supervision and control which is the essence of the analysis under federal law. Under the state statutes, however, it is incumbent upon the employer to establish the three separate conditions enumerated above in order to satisfy state regulators that the worker is indeed an independent contractor. The fact that the worker was free from direction or control of the employer is not enough.

For example, a dentist who is compensated as an independent contractor, but who performs the same type of dentistry services at the same location as his employer, would, under Massachusetts law, be considered an employee. If, however, this practitioner offered or specialized in orthodontics, and if orthodontics was not offered by other practitioners at the same location, he may safely be classified as an independent contractor provided he was free from direction and control by the employer over the performance of his work. Another means of qualifying as an independent contractor is if the services offered, in our example general dentistry, were performed outside all of the places of the employer’s business. The classic example would be a satellite office staffed solely by an independent contractor/dentist who was free from direction and control by the employing entity.

The differences between federal and state statutes and regulations give rise to significant uncertainty when making business decisions as to independent contractors. If the relationship is challenged, it is incumbent upon an employer to provide evidence sufficient to overcome the presumption that anyone who does work is in fact an employee and not an independent contractor.

The onus of proper classification is on the employer, and misclassification can give rise to unexpected costs in the event of an audit. It is wise to consult with your financial or legal advisors prior to embarking on what you perceive to be an independent contractor relationship.

Robert S. Murphy Jr., Esq. is a trial attorney with Bacon & Wilson, P.C, handling all types of litigation in both state and federal courts; 413-781-0560; rmurphy@bacon-wilson.com.