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State of Independence

Words: Timothy AhoContractors regularly enter into agreements that define an individual or entity as an “independent contractor.” This designation can be critically important on multiple levels. Many contractors have found that paying lip service to this label without proper support can come back to haunt the contractor and trigger vicarious liability, imposition of tax liability, and even resulting IRS liens.

Vicarious Liability and Employees

Vicarious liability is a legal concept whereby the law makes an employer liable for the negligent acts or omissions of its employees. The test in most states is to ask whether the negligent act or omission of the employee occurred within the “scope of employment.” Many cases thus turn, not only on whether the employee was negligent, but also whether the negligence really happened in the scope of employment. There are reported cases in many states defining whether travelling to and from work events, after-hours gatherings, and other similar ventures are really within the “scope of employment.” The same questions are litigated when an employee engages in intentional acts of violence that the employer claims are outside employment.

These questions of vicarious liability raise important questions of liability in tort versus contract. Claims in contract involve the breach of an express or implied agreement between the parties. In contrast, claims in tort involve breaches of duties imposed by common law. An easy example is the general duty that the law requires people to use reasonable care in their activities. When someone sues a driver for negligence in the operation of a motor vehicle, the suit is a claim “sounding in tort” that the driver breached the legally imposed duty to exercise reasonable care while driving.

These distinctions can become quite important in determining the impact of whether someone is an employee. A true “independent contractor” is legally separate from the hiring organization. The acts of the independent contractor do not impose vicarious tort liability on the person hiring that individual or entity. In the case of construction projects, a contractor may still be contractually liable for the quality of an independent subcontractor’s work effort. By comparison, the contractor may not be vicariously liable in tort for the negligence of a subcontractor. Instead, an injured party would need to show that the contractor itself was negligent to establish liability. It should be emphasized that many construction contracts include indemnity, insurance and other risk-shifting contract terms that can change this basic common law landscape.

The Tax Man Cometh

In addition to limiting vicarious tort liability, another significant reason for hiring independent contractors is to limit payroll taxes. Employers are responsible for payroll withholding from employee paychecks for FICA tax and Medicare withholdings. In addition, employers also have their own shares of taxes to pay on employee payroll burden. In order to avoid these expenses, it may be advantageous to hire independent contractors.

Defining “Independent”

The question of who is truly independent can turn on a number of factors. There is not necessarily a bright line black-and-white test to define the correct answer. One significant factor is whether the employer exercises control over the worker and how the worker does their job. Other factors include whether business aspects of the worker’s job are controlled, such as reimbursement of expenses and how the worker is paid. The greater a contractor exerts day-to-day or moment-to-moment control over a worker, the greater the likelihood of a finding that the worker is actually an employee.

Potential Impacts

The failure to properly classify individuals may come back to haunt contractors. By exercising strict control over the worker’s efforts, the contractor may ensure solid performance on the job. The contractor may, however, purchase significant vicarious tort liability.

Perhaps more important, failure to properly classify a worker can trigger significant tax liabilities for withholding. In certain cases, the IRS may determine there was no reasonable basis for the classification of a worker as an independent contractor. Such a finding may result in not only imposition of liability for taxes, but also exposure to penalties and interest. IRS tax remedies can extend to imposition of personal liability on the business owners and are often extremely harsh. As such, properly classifying employees and documenting proof of the same can be critical to the viability of your business.
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