It seems like everyone you meet these days is an independent contractor, or at least thinks he is. Independent contractors can be computer consultants, over-the-road truckers, doctors or gravediggers. You name it, virtually anything you can do as an employee you can also do as an independent contractor. However, especially for the person doing the hiring, the significance of the characterization -- independent contractor or employee -- can be enormous.

Under a variety of laws, if the person being hired is an employee, the employer must withhold federal and state income taxes1 and the employee's share of social security taxes,2 in addition to paying the employer's share of social security taxes3 as well as unemployment and insurance taxes and worker's compensation insurance.4 On the other hand, if the person you've hired is an independent contractor, you don't have these obligations.5 Because the liabilities can be large when the government comes along later to collect what you should have withheld or paid in the first place,6 whether the people you hire are employees or independent contractors may mean virtually the world to you.

The Issue of Control

So what's an independent contractor? According to the courts it's a mixed question of law and fact,7 which is another way of saying it's often quite hard to tell. The primary issue is one of control. If you have the power to control how the worker does her job (specifically, the means and manner of performance), she is more likely to be an employee8 and you're liable for the payroll tax obligations I've mentioned; if you have little or no control over how she does her job, she's more likely to be an independent contractor and you're off the hook in that regard. The cases are legion on this control issue and almost always turn on a close review of the nitty gritty factors of the job in question.9

Neve v. Austin Daily Herald 552 N.W.2d 45 (Minn. App. 1996) illustrates well the judicial contortions courts can go through trying to articulate something clearly when it's not all that clear. Darla Neve was a motor route carrier for The Austin Daily Herald, the local newspaper for a southeastern Minnesota community. The Herald treated her as an independent contractor, paying her on a weekly basis with the understanding that she would take care of her own tax liabilities. Under a written independent contractor agreement, Neve was required to deliver bundles and single newspapers to customers within a fixed territory. She provided her own vehicle and maintained her own automobile insurance.

But the commissioner of economic security determined that Ms. Neve was an employee of the newspaper, rather than an independent contractor, and sought delinquent reemployment [unemployment] reinsurance taxes that the paper supposedly should have been paying. The issue boiled down to the question of whether the Herald exercised sufficient control over how Neve did her job to make her an employee.

The Herald dictated: (1) the people to whom Neve was to deliver newspapers; (2) the exact location of deliveries (a plastic tube in rural areas as opposed to the doorstep of subscribers who lived in town); (3) the deadline by which all deliveries were to be made; and (4) bagging procedures for inclement weather.10 In addition, Neve (who'd been supplied with a copy of the paper's "motor route policy") had to: (5) maintain a consistent order of delivery so that people got their papers at roughly the same time every day; (6) keep detailed records concerning the exact number of papers delivered to merchants and vending machines; and (7) promote the Herald at every opportunity.11

On the other hand Neve had a good deal of latitude to do things her own way. She: (1) had no set working hours; (2) operated her own vehicle when delivering papers; (3) in practice varied the time and order of deliveries; 4) could and did hire substitutes; and (5) was to assume sole responsibility for her tax liabilities.12

Did the newspaper control the way Neve did her job enough to make her an employee for whom it should have been paying reinsurance taxes? The Minnesota Court of Appeals said no. Relying heavily on the custom in the newspaper industry, and emphasizing the needs of the customer, the court held that the Herald's requirements reflected "only the publisher's insistence that the carrier supply what the publisher had promised to the customer: a dry newspaper delivered in a timely and convenient fashion on a relatively consistent schedule."13

According to the court, the fact that the newspaper told Neve how to do virtually her entire job, and that she had to comply with the newspaper's wishes or face termination, was not enough to make her an employee. Rather the newspaper's instructions related to the "definition of Neve's task and not to the means of accomplishing it."14 If all of this seems perfectly clear, then I've got some property in the Everglades I'd like to talk to you about.

But, regardless of the actual outcome of the case, the Neve decision demonstrates the perils of the independent contractor vs. employee characterization for the employer. Apparently the understanding between Neve and the Herald was that she'd take care of her own tax obligations. Just as apparently, she did not -- at least not the ones at issue in the case. Then one day the commissioner of economic security came knocking at the Herald's door looking for delinquencies. If you, the employer, treat a group of workers as independent contractors and they don't meet their payroll tax obligations, your liability -- especially with interest and penalties -- can quickly grow.

The Solution, Sort Of

What can employers do to protect themselves? In the first place, if you have substantial control over the way the people you hire do their jobs, you should treat them as employees, (i.e., issue W2s, withhold income taxes, etc.) because that's probably what they are. But if you really believe the people you're hiring are independent contractors, here are some things to pay attention to.

• Watch What the Competition's Doing. Like the court in the Austin Daily Herald case, the law gives a great deal of credence to the custom in the industry. Generally speaking, the employer who reasonably relied on a longstanding, recognized practice of a significant segment of the relevant industry may be relieved of withholding obligations.15 You're not exactly home free if you're in line with the rest of your industry, but you've overcome a rather large hurdle. However you must have actually relied on the industry custom, so find out what your competitors are doing before you make your withholding decisions. If you're the only one who's hiring independent contractors you've probably got a problem.
• Don't Switch Horses. Secondly, don't switch horses in the middle of the stream and suddenly start treating a worker you once treated as an employee as an independent contractor.16 Likewise, don't treat a worker as an independent contractor when you've previously treated other workers in substantially similar positions as employees.17 The previous characterization rules and, basically, you're stuck with it. In a similar vein, all federal tax returns including information returns must have been filed from the start on a basis consistent with the worker being an independent contractor.18
• Make An Informed Decision. It is wise to make any decision to treat a worker as an independent contractor on the basis of judicial precedent, rulings of the IRS, or professional advice. The important thing here is that the decision to treat the worker as an independent contractor must have actually been based upon such information at the time it was made, and not simply rationalized later.19 Similarly, if the employer has been examined by the IRS in the past and no employment tax assessment was made for individuals holding positions substantially similar to that of the worker in question, you're probably in pretty good shape.20
• Have a Written Contract. Like The Austin Daily Herald, you can try to use a written contract to insulate yourself from employment tax liability in the independent contractor situation. But the first thing you should know about such contracts (and virtually every case involving one will say this) is that they are not determinative of the situation.21 In other words, you can't save yourself with a clever contract. There is no substitute for the true facts of the relationship between you and the person you've hired, and you really can't get around them.

Its limitations notwithstanding, a written contract is a good idea. It provides some evidence of what you envisioned the employment relationship to be, and gives you a framework in which to conduct the relationship so that you'll be reminded to keep taking the necessary steps to insure (as much as possible) that the worker qualifies as an independent contractor.

At the bare minimum the independent contractor agreement should contain the following:

1. a recital of the parties' understanding that the worker is going to be employed as an independent contractor;

2. a detailed description of the independent contractor's responsibilities, including especially the following types of things:

a) that he will provide, maintain and insure his own equipment;

b) that she will pay her own income taxes and social security taxes, as well as her own unemployment and worker's compensation insurance;

c) that he will be responsible for hiring his own workers, withholding their taxes, and paying all other employment tax obligations on their behalf;

d) that she will maintain her own general liability insurance;

e) that he will be paid by the job; and

f) that she will determine and be responsible for how she accomplishes the job.

The actual provisions of any particular independent contractor agreement will vary with the situation and there are certain subjects, such as termination procedures, that are usually best avoided altogether. How can you later argue that you had no control over how the individual did his job if you had the contractual power to terminate him?22 Nonetheless the above list should give you a basic idea of the types of things the contract must cover. The important thing to remember is that once you have your contract, you must live by it. Make sure that both you and the independent contractor are honoring its provisions; and that you are not usurping her control over how she does her job.

Conclusion

The independent contractor area is a complicated one and I have been trying to simplify it, a dangerous undertaking at the least. However the main thing for the employer to understand is that if she has a good deal of control over how her workers do their jobs, they may well be characterized as employees at judgment day.

The best things the employer can do to protect himself are:

1. Pay attention to what your competitors are doing in terms of hiring. If they're using employees where you're using independent contractors, reconsider.

2. Try to frame any instructions you give to your independent contractors in terms of what the customer wants (e.g., workers in uniform; promptness, courtesy, etc.) rather than how the job should be done; remember The Austin Daily Herald and the clean dry newspaper.

3. Don't switch horses in the middle of the stream.

4. Base your decision to use independent contractors on something substantially more than a hunch that it's O.K.

5. Have a written contract; and

6. Last but by no means least, pray.

Notes
1 26 U.S.C. 3402; Minn. Stat. Ann. 290.92.

2 26 U.S.C. 3102(a).

3 26 U.S.C. 3111.

4 26 U.S.C. 3301; Minn. Stat. Ann. 268.051, subd.1(a); Minn. Stat. Ann. 176.181, subd.2.

5 United States Mutual Trucking Co., 141 F2d 655,658 (6th Cir. 1944); General Investment Corp. v. U.S., 823 F.2d 337, 340 (9th Cir. 1987); Halfhill v. U.S.I.R.S., 927 F. Supp. 171 (W.D. Pa. 1996).

6 See e.g., 26 U.S.C. 6672; Minn. Stat. Ann. 290.92, subd. 6a.

7 Neve v. Austin Daily Herald, 552 N.W.2d 45, 47 (Minn. App.1996), citing Blue & White Taxi v. Carlson, 496 N.W.2d 826, 828 (Minn. App. 1993); Lakeland Tool & Engineering v. Engle, 450 N.W.2d 349, 352 (Minn. App. 1990); Wise v. Denesen Insulation Co., 387 N.W.2d 477, 479 (Minn. App. 1986), citing Darvell v. Paul A. Laurence Co., 239 Minn. 55, 59, 57 N.W.2d 831, 834 (1953).

8 Neve, supra, 552 N.W.2d at 48.

9 See e.g. Air Terminal Cab, Inc. v. United States, 478 F.2d 575 (8th Cir. 1973), cert den. 414 U.S. 909, 38 L. Ed.2d 146, 94 S.Ct. 228; Morish v. United States, 555 F.2d 794, 214 Ct. Cl. 166, 77-1 U.S.T.C. Para 9424 (Ct. of Cl. 1977).

10 Neve, supra, 552 N.W.2d at 48.

11 Id.

12 Id.

13 Id.

14 Id.

15 26 U.S.C. 3401 note [Setting forth the Safe Harbor Rules carried forth from the Revenue Act of 1978, Section 530]; General Investment Corporation v. United States, supra, note 5, 823 F.2d at 340; IRS Letter Ruling 9625002, Feb. 28, 1996.

16 26 U.S.C. 3401 note; Institute for Resource Management, Inc. v. United States, 22 Ct. Cl. 114, 90-2 U.S.T.C. Para.50,586 (Ct. Cl. 1990).

17 26 U.S.C. 3401 note; Henry vs. United States, 793 F.2d 289, 86-2 U.S.T.C. Para 9,512 (Fed.Cir. 1986).

18 26 U.S.C. 3401 note.

19 Id., IRS Letter Ruling 9625002, supra note 15.

20 26 U.S.C. 3401 note.

21 Dunnell's Minnesota Digest, Employment, Section 1.01(g); see e.g. Neve, supra, note 7.

22 But see Neve, supra, note 15.

JEFF ALDEN is an attorney in Minneapolis whose practice focuses on a wide variety of problems encountered by small businesses. He can be reached at jfalden@msn.com.