Article
Independent Contractors: Keeping Them Independent
Regardless of the business, management looks to provide services and products in a manner that is the most cost effective. One option explored by many public entities is the use of independent contractors to complement the work done by staff or to perform work previously done by employees.
No matter the reason for the use of an independent contractor, the organization must recognize and control the risks that are associated with them. Any savings expected from the use of a contractor can quickly vanish if good risk management strategies are not considered, such as:
- Factors to identify an independent contractor.
- Risks associated with misclassifying an independent contractor.
- Risk management strategies to prevent or mitigate loss.
- How MCIT coverage does or does not respond when a claim is made by or against a contractor.
This discussion does not include independent contractors involved in the building construction industry.[1]
Who Is an Independent Contractor?
Different laws, such as the Minnesota Workers’ Compensation Act, Fair Labor Standards Act, Family and Medical Leave Act, Minnesota Unemployment Insurance Law and various other federal and state tax laws, have different tests to evaluate the employer-employee relationship, depending on the issue at hand. Generally, not one set of factors definitively distinguishes an employee from an independent contractor. Likewise, no one set of factors applies to all situations.
The general common law test established by the Minnesota courts (Guhlke v. Roberts Truck Lines, 128 N.W.2d 324, 326 (Minn. 1964)) uses the following five factors to distinguish an independent contractor from an employee:
- The right to control the means and manner of performance
- The mode of payment
- The furnishing of tools and materials
- The control over the premises where the work is done
- The right of the employer to discharge
The degree of control that the organization exerts over the manner and method of performing the work is generally the primary factor considered in analyzing an individual’s work status.
Department of Labor and Industry Rules
The Minnesota Department of Labor and Industry (DLI) has promulgated administrative rules (Minnesota Rules 5224.0330 and 5224.0340) that provide guidance on the control and manner of performance typical of an independent contractor.
The following guide was developed using DOLI’s rules. Generally, the more control an organization has over the individual, the greater the likelihood that the individual is an employee.
Does the individual have authority and control over his or her assistants; have the ability to hire his or her own assistants; or pay his or her assistants directly?
If yes, likely an independent contractor
Is the individual required to comply with detailed instructions about when, where and how he or she is to work, including the order or sequence in which the services are to be performed?
If yes, likely an employee
Is the individual required to submit regular written or oral reports relating to the method in which services are performed?
If yes, likely an employee: Independent contractors may be required to provide periodic progress reports to establish entitlement to payment or compliance with the contract.
Is the individual required to perform his or her work on the organization’s premises even if it could be done elsewhere?
If yes, likely an employee: The less autonomy the individual has regarding where the job will be performed, the more likely the individual is an employee.
Does the individual have the right to hire a substitute to perform the work without the organization’s knowledge?
If yes, likely an independent contractor: The less autonomy the individual has regarding how and by whom a job will be performed suggests the individual is an employee. However, personal performance by an independent contractor may be appropriate where the individual is hired on the basis of professional reputation.
Does the individual work at frequently recurring, though somewhat irregular intervals, either on call or whenever work is available?
If yes, likely an employee
Has the organization established a set of regular working hours for the individual performing the work?
If yes, likely an employee: The less autonomy the individual has regarding work hours, the more likely the individual is an employee.
Will the organization provide training for the individual?
If yes, likely an employee
Does the agreement with the individual or the volume of business to be performed require the individual to devote all of his or her work time to the organization’s business or project?
The more time the individual dedicates to completing the work of the organization, the more likely the individual is an employee. However, the nature, scope and timeline for completion of the project may be integral to the contract, so other factors must be considered.
Does the individual work for more than one person in the organization or for a number of persons or firms at the same time?
If yes, likely an independent contractor
Does the organization provide the tools, materials and supplies to the individual so that he or she can complete the work?
If yes, likely an employee
Does the organization pay the individual’s approved business or travel expenses or both?
If yes, likely an employee
Is the individual paid on a per job basis (rather than by the hour, week or month), wherein he or she is responsible for incidental expenses?
If yes, likely an independent contractor: Payment by the job may include a predetermined lump sum that is computed by calculating the number of hours required to do the job at a fixed rate per hour or by periodic partial payments based upon percentage of job price or percentage of job completed.
Is the organization responsible for enforcing standards or restrictions that might be imposed by regulatory or licensing agencies?
Not dispositive: The organization can enforce standards or restrictions imposed by regulatory or licensing agencies on an independent contractor.
Does the organization have the right to discharge or terminate the individual with little notice, without cause or for failure to follow specified rules or methods?
If yes, likely an employee
Are the individual’s services available to the public?
If yes, likely an independent contractor: This may include the individual’s offering of services to the general public by having an office or assistants; having a business license; displaying a sign in front of the business or having a listing in a business directory or a business listing in a telephone directory; advertising in a newspaper, trade journal or magazine, among other things.
Is the individual in a position to realize a profit or suffer a loss as a result of his or her services, as evidenced by:
- Hiring, directing, paying assistants?
- Providing his or her own office, equipment, materials or other facilities for work?
- Having continuing or recurring financial liabilities or obligations related to his or her work?
- Having a profit or loss depending on receipts and expenditures?
- Incurring expenses related to his or her work that are paid by the individual?
- Performing specific jobs for prices that were agreed upon in advance?
- The performance of services having an effect on his or her business reputation and not the reputation of those that that have purchased the individual’s services?
If yes, likely an independent contractor
Does the individual have the right to terminate the working relationship at will and without incurring liability for failure to complete the work?
If yes, likely an employee: If the individual is responsible for completing a job satisfactorily and is liable for failure to complete the work, he or she is likely an independent contractor.
Has the individual made a substantial investment in facilities to be used for performing his or her services?
If yes, likely an independent contractor: If the organization furnishes all the necessary facilities (i.e., equipment or premises necessary for the work, exclusive of tools, instruments, clothing and similar items provided as a common practice in an individual’s particular trade), the individual is likely an employee.
Is the individual responsible for his or her own negligence, personal behavior and work actions in contact with customers and the general public?
If yes, likely an independent contractor
IRS Categories
The Internal Revenue Service has identified three broad categories—behavior control, financial control and relationship of the parties—to determine whether an individual is an employee or an independent contractor. These categories generally encompass the 20-factor test previously developed by the IRS. More information about the service’s tests can be found in IRS Publication 15-A, “Employer’s Supplemental Tax Guide” and Publication 1779, “Independent Contractor or Employee.”
An organization may request assistance from the IRS in making this determination by completing Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Upon receiving this form, the IRS reviews the facts and circumstances, and officially determines the worker’s status. This process may take several months to complete.
The Minnesota Department of Revenue also has a fact sheet explaining Minnesota income tax withholding responsibilities as they relate to classification of independent contractors.
Risk Associated with Misclassification
Workers’ Compensation
An organization is responsible for work-related injuries and illnesses sustained by an employee in the normal course of employment. Generally, an organization is not responsible for injuries sustained by an independent contractor or the employees of the contractor. Workers’ compensation is the exclusive remedy available to an injured employee. If the individual is actually an employee and not an independent contractor, the organization may be responsible for providing workers’ compensation benefits.
Although an independent contractor and his or her employees do not have access to the organization’s workers’ compensation benefits, the independent contractor does have the ability to initiate legal action against a third party (the organization) for damages sustained while performing work for the organization. Typically, the claim will allege negligence by the organization relative to the maintenance of the organization’s premises.
To protect the organization from a workers’ compensation claim by a contractor or the contractor’s employees, the organization should require that the contractor provide proof of workers’ compensation/employer’s liability coverage for his or her employees. Absent this protection, the organization may be responsible for the injuries sustained by employees of an uninsured contractor while performing work for the organization. Sole proprietors are not required to carry workers’ compensation coverage for their own injuries.
Employment Laws and Tax Ramifications
Absent a contract that specifically defines the relationship between the individual and the organization as that of an independent contractor, the possibility exists that an employer-employee relationship could be demonstrated. Should an individual be determined to be an employee, the organization runs the risk of having to make the individual whole, which could include back wages, health benefits and contributions to retirement benefits, such as PERA and Social Security.
Moreover, an organization that misclassifies an employee as an independent contractor may be responsible for employment taxes for that individual. The organization may also be obligated for any other benefits included in applicable personnel policies and/or collective bargaining agreements.
If the individual is determined to be a nonexempt employee, the Fair Labor Standards Act would require the organization to compensate the individual for hours worked in excess of a 40-hour work week at the rate of time and a half.
Violation of state and federal laws may include penalties.
Strategies to Prevent or Mitigate Loss
Establish a Contract
The use of an independent contractor to deliver goods or perform services for the organization can be a prudent strategy to transfer risk from the organization, provided that a contract that transfers this risk exists. A contract provides guidance for the courts should a dispute arise.
The following are provisions to consider when entering into an agreement with an independent contractor. This list is not all inclusive, and not every item may be appropriate for every situation. Organizations are encouraged to consult with their legal counsel prior to drafting or entering into any contracts or agreements.
Terms and Conditions
- State that the independent contractor agrees to provide services solely as an independent contractor.
- Nothing should imply a right to employment or benefits.
- The agreement should clearly state that the independent contractor will be responsible for payment of all state and federal taxes for his or her operation.
- Require compliance with all applicable federal and state laws, including the Minnesota Government Data Practices Act (MGDPA).
- Whenever a contract requires that data on individuals be made available to a contractor, the MGDPA requires that the contractor maintain the data in accordance with the MGDPA. (Minn. Stat. § 13.05, subd. 6.)
- Whenever a government entity enters into a contract with a private person to perform any of its functions, the government entity must make it clear in the contract terms that all of the data created, collected, received, stored, used, maintained or disseminated by the contractor in performing those functions is subject to the requirements of the MGDPA and that the contractor must comply with those requirements as if it were a government entity. (Minn. Stat. § 13.05, subd. 11.)
- Ensure that the contractor understands the contract is subject to audit per Minn. Stat. § 16C.05 subd. 5.
- Require the independent contractor to abide by any policies or rules related to the worksite, including visitor policies and anti-discrimination and harassment policies.
Scope of Work
- Define expectations regarding the final product: The independent contractor has the independence to make day-to-day decisions on how to get the job done.
- The independent contractor has the ability to hire and fire assistants if needed.
- The independent contractor should be held solely responsible for the work product and the actions of any assistants.
- No additional payments should be made to the independent contractor simply because assistants are hired. No payment should be directed to any assistant.
- Set forth the reasons that the independent contractor is required to provide the services personally, such as reputation, specialized experience, training or expertise.
- Do not require specific attendance or hours of work.
- The organization may limit access by the independent contractor to its buildings and facilities.
Compensation
- Never pay by the hour or week. Payment should be on a fee-for-service basis (i.e., paid at the end of the project, specified project benchmarks, etc.).
- Do not pay the independent contractor using the organization’s payroll system. An independent contractor will be issued a 1099 form, so it will be necessary to have the independent contractor provide his or her tax ID on a W-9 form.
Insurance
- Require evidence of general liability and workers’ compensation insurance.
- The limits of liability should at a minimum match the tort caps found in Minnesota Statutes § 466.04. (Refer Certificates of Insurance and Coverages and Liability Limits for Independent Contractors.)
- Require the organization be named as an additional insured on the independent contractor’s liability insurance policy. Obtain a copy of the additional insured endorsement.
- Include an indemnification and hold harmless clause favorable to the organization. The following is sample language that needs to be modified or tailored to fit each individual situation:
The [independent contractor] agrees to defend, indemnify and hold [organization’s name], its employees and officials harmless from any claims, demands, actions or causes of action, including reasonable attorney’s fees and expenses arising out of any act or omission on the part of the independent contractor or its subcontractors, partners or any of his/her agents or employees in the performance of or with relation to any of the work or services to be performed or furnished by the [independent contractor] or its subcontractors, partners or any of his/her agents or employees under the agreement.
Equipment and Supplies
- Require the independent contractor to provide his or her own materials, tools and equipment.
- If there is a business reason for allowing the independent contractor to use the organization’s tools or equipment, provide an explanation for this in the agreement (e.g., a contractor hired to work on the organization’s computer system may need access to the organization’s computers to complete the project for which he or she is hired).
Duration
- Require completion dates in the agreement but do not require that the independent contractor work solely for the organization until the project is complete.
- Consider allowing the contractor to subcontract but only with the express permission of the organization.
Termination and Remedies
- Include termination provisions in the agreement including termination upon notice and termination for specific acts of nonperformance, breach of contract or default.
- Consider including a provision that would impose some sort of penalty, such as a monetary payment to the organization, if the independent contractor terminates the contract without cause or without providing the proper notice.
Policies and Procedures
- The agreement must be executed by the chair of the board (of commissioners/directors) as authorized by board action.
- The board may delegate this responsibility to a designee, but this should be by board action.
- Review collective bargaining agreements and policies to ensure that the organization is not violating any terms or conditions relative to engaging an independent contractor.
Comply with the Contract
Once the agreement has been executed, it is imperative that the organization and independent contractor comply with the terms and conditions of the contract, especially as it relates to the interaction and direction given to a contractor.
If a conflict gives rise to litigation or a question on the employment status of an individual, the fact finder will likely look not only to the contract but also to the context of the working relationship. The court and/or other agencies responsible for employment issues may find that an employer-employee relationship exists despite an agreement that states otherwise.
MCIT Coverage Exclusions
Although MCIT coverage is broad, limitations and exclusions exist. The rationale for these exclusions is the limited ability to spread the risk that results in expensive coverage and lack of reinsurance coverage for a catastrophic loss, which would place MCIT at risk.
Covered Party
An independent contractor does not meet the definition of a “covered party” in the MCIT Coverage Document. MCIT coverage applies only to covered parties, which are defined to include:
- Any elected or appointed official of the member
- Any employee or authorized volunteer of the member
- Any person officially appointed by the member to a board or commission of the member as authorized by law
- Any law enforcement personnel of the member
“Member” means the entity named in the declarations section of the MCIT Coverage Document including any department, subdivision, committee, commission or board under its jurisdiction, control and direction. Absent a well-drafted contract, the organization may be exposed to risk associated with the work performed by the contractor.
Breach of Contract
MCIT excludes coverage for any claim based upon penalties for failure to comply with a contractual obligation; breach of contract; or cost estimate overruns on any contract or project whether the contract or agreement is written or oral.
This clause specifically excludes any coverage for damages or claim expenses based upon, caused by or arising from the exchange of information or negotiations in anticipation of an agreement, whether or not one is executed.
Create a Clear Distinction
Drawing a bright line between an independent contractor and an employee, being able to relinquish control of the work performed by the independent contractor and having a well-drafted contract are critical to managing the risks associated with the use of independent contractors.
For additional information or assistance on issues related to independent contractors, members should contact their MCIT risk management consultant 1.866.547.6516 .
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