The distinction between employees and independent contractors is often overlooked by emerging companies. However, the significance of this distinction in New York State cannot be overstated. As discussed further below, a worker’s classification has an important impact on (1) tax; (2) insurance, such as unemployment and worker’s compensation; (3) employment benefits, such as 401(k) contributions and earned sick time and (4) wage and hour laws, such as minimum wage and overtime.
Classification as an Employee vs. Independent Contractor Matters
A worker’s classification as an independent contractor rather than an employee has significant implications with respect to tax withholdings. For an employee, the company is required to withhold state and federal income taxes, Social Security tax, Medicare tax and unemployment tax from wages paid. For an independent contractor, the company does not have to withhold these taxes. In addition, the company must complete a W-2 form for each employee and will be charged a fee for each W-2 not properly filed. The penalties for worker misclassification can be significant and include fines as well as an assessment (and requirement to pay) retroactive taxes. Please note that these penalties increase in the event of an intentional misclassification, which can carry with it criminal penalties.
If a worker is designated as an employee on the company’s records, the company becomes liable for unemployment insurance contributions and interest. In an event of a misclassification, an employer is likely to be required to make back-payments directly to the employee along with additional fines to the New York Department of Labor (the “Department of Labor”). The amount of unemployment insurance payments due is determined by the Department of Labor through an analysis of the company’s filing of the Quarterly Combined Withholding, Wage Reporting and Unemployment Insurance Return. The fines, in turn, depend on lateness of the filing/payment, as well as the company’s reporting history.
Additionally, employers of employees are required to provide overtime pay to non-exempt employees who work more than forty hours in a work week, paid time off consistent with a company policy, earned sick time and other leaves consistent with state and federal law, and break time. Employees are also subject to minimum wage laws. While companies who engage independent contractors are not subject to these requirements (and it may seem more cost efficient to classify a worker as an independent contractor), worker misclassification is a serious violation which comes with significant penalties in New York State. There is increased scrutiny around these relationships in recent years, and employers should conduct a full analysis with legal counsel prior to engaging an individual as an independent contractor.
Distinguishing between an Employee and an Independent Contractor
While there is no specific test that determines whether an employer-employee relationship exists, the courts rely on a variety of factors to assess the degree of control that an employer exerts over a worker. These factors include the level of the employer’s supervision and, more specifically, whether the employer determines the manner, means and results of the work being performed. This often depends on the worker’s skill level—unskilled workers are typically employees, since they require a high level of supervision, while workers who establish their own businesses free from the supervision or direction of an individual employer frequently become independent contractors. Additionally, unlike employees, independent contractors tend to choose when, where, and how they perform services and do not require prior permission for absences.
Compensation also plays a hand in distinguishing between an employee and an independent contractor. Employees are typically paid a salary or an hourly rate (i.e. a set rate of pay determined by the company) and, in such cases, the employer assumes the risk of profit or loss. Independent contractors, on the other hand, usually negotiate their own rate.
Employees and independent contractors can also be identified by the freedom, or lack thereof, to take on other work. Employees tend to have exclusive arrangements with their employers, which prevent them from performing services for competitors. Independent contractors advertise to the general public, have few restrictions on solicitations and have the freedom to offer services to any other businesses.
Notably, even an existence of a formal agreement between an employer and employee that designates a worker as an independent contractor, does not necessitate that the worker is an independent contractor under the law. The New York State Department of Labor explains that when making this determination, it (and the courts) examine the facts of each specific relationship, outside of the four corners of any written agreement.