Unemployment and Independent Contractors

What you need to know to avoid issues

Over the years, we’ve received many questions about how unemployment works with individuals that the employer considers to be independent contractors. Usually, it involves a frantic call from the client concerned about an audit that is going to be conducted by their state’s unemployment department to determine if these individuals are truly independent contractors.

Often what occurs is that an individual files an unemployment insurance (UI) claim against that company and the state informs them they are ineligible because they don’t have insured wages. Naturally, the claimant objects to this situation and provides the state with information that challenges their status as an independent contractor. This results in the audit.

The results of an unfavorable audit can be very expensive for an employer as the state has the power to require the payment of back taxes, along with any applicable penalties and interest. Misclassified workers will not only cost you grief and aggravation from the state UI division, but also from a host of other regulatory bodies.

How is independent contractor status determined?

The standard that is applied for determining if an individual is an employee or an independent contractor is the same as used by the Internal Revenue Service.

The rule of thumb is that a person is an independent contractor if the paying entity only controls the result of the work or service, but not what will be done or how the work will be completed.

There are three common law rules that are applied to determine the control and independence of the proposed independent contractor:

1. The Behavioral Rule – Does the paying company control or have the right to control what and how the worker performs the services? The evaluation will include the type of instructions provided to the worker, the degree of the instruction, and what kind of evaluation or training is provided by the paying entity. If the paying company dictates items such as what tools or equipment must be used, where to purchase needed supplies, or the sequence of the tasks to complete the work, it is likely that this person is going to be considered an employee. The key element is whether the paying business has retained the right to control the worker’s performance.
2. The Financial Control Rule – Does the paying business have the right to control the financial aspects of the work being conducted? This may include the method of payment, if the work is being conducted by the worker for personal profit or loss, and if are they being reimbursed for expenses they incur during the performance of the work.If the employee is being paid a regular wage instead of a flat negotiated fee, it is likely an indication that they are an employee and not an independent contractor. There are exceptions to this standard, such as lawyers who are often paid by an hourly rate. In those cases, the question will fall to the other standards such as unreimbursed expenses and if the contractor controls their profit or loss on the project.
3. Type of Relationship – What is the permanency of the relationship? Does the work have a defined period which after that period the relationship ceases? Does the individual perform services that are crucial or a key aspect of the business? If the individual performs elements of the business that are crucial, the more direct control the paying entity has on that individual. Finally, does the paying entity provide benefits such as vacation or sick pay, health insurance etc. to the individual? Providing these benefits will be key in swinging the decision to that individual being an employee.

Another common test is whether that individual can market and perform services for other entities. If the paying company dictates exclusivity to that individual’s services, it is unlikely they will be considered an independent contractor.

Evaluating your employment relationships using these rules could potentially save you time, money and aggravation. For more information go to this link to review the specific IRS regulations regarding independent contractors.