Top 10 Legal Issues Facing Entrepreneurs in Pennsylvania

Topic 7: Employees vs. Independent Contractors

In the completion of a given project or business goal, the entrepreneur will often be faced with a multitude of decisions to make in reaching her objective. One such common decision is whether to hire someone as an “employee” or an “independent contractor.” At first glance, this distinction may not seem important. However, there are a number benefits and detriments that will flow to the entrepreneur based on this classification. For example, hiring someone as an “employee” will probably cost more (in taxes, benefits, training, equipment, etc.) and will generally leave your business much more exposed to employment-related litigation, but will generally offer more control and protection over any intellectual capital produced (See Topic 10 for a more detailed discussion on protecting intellectual capital in various contexts). Conversely, hiring someone as an “independent contractor” might cost less, provide more flexibility and will generally cut off liability to the hiring business, while holding the independent contractor solely liable for its work. (But hiring an independent contractor might provide less protection over intellectual capital – See Topic 10). For example:

Joe is starting a carpet manufacturing business, which then distributes the carpet to retailers nationwide. Joe is faced with hiring qualified persons to deliver his products to his retailers. If Joe hires the delivery person as an “employee” and that employee negligently causes an accident while on a delivery, the injured person will generally be able to sue the delivery employee individually and Joe’s company as a whole. This is because the employer (here Joe’s company) is legally responsible for the acts of its employees that are within the course of their employment. On the other hand, if Joe hired an “independent contractor” for the delivery, only the independent contractor would generally be liable for his negligence.

The legal concept making a company responsible for the acts of its employee within the course of employment is called respondeat superior. Under the respondeat superior doctrine, an employer is vicariously liable for the negligence of an agent or employee acting within the scope of his or her agency or employment, although the principal or employer has not personally committed a wrong. Under such circumstances, the law imputes the employee's wrong to the employer without requiring the fault or knowledge of the employer.¹ It should be noted that acts ‘within the course of employment’ are in no way limited to when an employee is making deliveries like the above example, but extends to any conduct of an employee in furtherance of her employer’s business. Now that you understand the legal consequences of hiring someone as an “employee” versus an “independent contractor”, it is imperative to be able to make the distinction between the two.

Simply calling or classifying someone as an “independent contractor” or “employee” is not dispositive legally or for tax purposes. In reviewing whether a particular person is an employee or independent contractor in your company, a court and the IRS will look at similar criteria to flesh out the distinction and so should you. In fact the IRS publishes a form² setting out twelve criteria, very similar to what a court will look at, that can be used for this purpose:

1. The right to control the activities of the person. (This is the most important factor for both the IRS and a court. The stronger the right to control, the more likely it is an employee and not an independent contractor.)
2. Who supplies the tools?
3. Who supplies the place where the work will be done? (If the person is going to work on your property on a regular basis it will be hard to show they are an independent contractor.)
4. What costs are borne by the worker?
5. Can the worker profit from her managerial skills? (Can the worker make a profit above and beyond the value of her time?)
6. What special skills are provided by the worker? (The more skill the worker has the better the chance of classification as an independent contractor.)
7. Is the relationship long term or short term? (Longer term is more common for employees.)
8. Is the service ancillary to your business?
9. How are the payments structured? (Fixed payments tend to follow employees while pay-by-the-job schemes tend to follow independent contractors.)
10. Do your fringe benefits apply to the person?
11. How do the parties treat the transaction?
12. What is the custom in the trade or industry?

After taking in to account the benefits and detriments, including tax consequences, the protection of intellectual capital and susceptibility for legal liability in a given project, the informed entrepreneur will be able to assess which relationship will work best in reaching her business objective. Once it is determined which employment relationship is desirable, the entrepreneur should take great care that it will be recognized as such by the IRS and the courts. Keeping the above criterion in mind, with special attention to the question of who controls the activities of the person, will allow the business entrepreneur to create the employment relationship she intends to.

¹ Hamilton v. Carrell, 243 F.3d 992, 2001 FED App. 0076P (6th Cir. 2001).

² IRS Form SS-8

Topic 8: Compliance with Federal Discrimination Mandates ›