You may be familiar with this situation.

Your agency engages a freelancer to help you with client projects. Maybe that freelancer uses agency equipment and materials to create the work product, is engaged for an indefinite period of time, is asked to track time on each project, and is paid on a monthly basis. You give the freelancer a 1099 which means the freelancer is automatically considered a contractor, right?

Not necessarily.

It’s no secret that regulators in many states are making it increasingly difficult to classify talent as an independent contractor to your agency, vs. an employee.

How do you make sure your agency is on the right side of this issue so that you avoid violating a rule or a worker misclassification?

Part of the answer is that It matters more how a worker is treated, and the processes your agency uses to separate them from its employees, than how they strictly look on paper. This is not to say that the contract between the agency and the contractor does not matter – it does, very much. But courts and lawmakers look at whether the treatment of the contractor by the agency corresponds to the terms of their contract, and at how the agency works to create an “arms-length” relationship between it and the contractor.

The misclassification of independent contractors as employees is not an uncommon problem among agencies. Often, workers (i.e. freelancers) will be hired as independent contractors based on the financial benefits of doing so for the agency, but then ultimately treated like employees, which can lead to a host of legal issues and financial penalties for the agency.

Let’s look at what the legal distinction between a contractor and an employee is, what the risks are of misclassifying workers, and what safeguards you should have in place to best protect your agency from this kind of misclassification.

1. What is the legal distinction?

At a high level, contractors and employees differ in how much control and independence they have in their work – their schedule, time spent on a project, and method of working. Employees are required to adhere to a regular (usually 40-hour) weekly schedule as established by the employer and often track their time; whereas contractors have more control in choosing when, where, how, and how long they work on a project. Unlike employees who work according to their employer’s direction and receive certain employee benefits (i.e. paid time off), contractors perform their work without the agency telling them how to do it and do not receive employee perks or benefits. Since contractors create their own schedule, they get paid based on the amount of time they spend working or on some other terms the parties agree about, such as a flat project fee.

There are various tests at the federal and state level that are used to evaluate whether a worker is an employee or a contractor. The IRS has identified some helpful factors that can be broken down into three categories: behavioral control, financial control, and relationship dynamics.

• Behavioral control looks at how the worker performs his or her duties. If the worker is given specific instructions (i.e. where to work from, what tools or equipment to use, when to work) or trained on how to do his or her job, then that suggests an employment relationship. A contractor should be solely responsible for how he or she performs the work.
• Financial control is all about how the worker is compensated for his or her work. Some of the important questions to ask here are: Is the worker responsible for his or her own expenses related to the project? Is the worker available to be hired elsewhere? Are you paying the worker a flat fee based on the time and materials he/she uses for the project? If the answer to these questions is “yes”, the worker leans more towards a contractor. Unlike an employee, a contractor does not usually get reimbursed for expenses (or may only be reimbursed for reasonable, pre-approved ones), may (ideally, should) be receiving compensation from other agencies or at least available to be hired by them, and should be receiving payment based on the specific project he or she is hired for, not based on a payment schedule.
• The type of relationship between the agency and contractor also matters. If you hire a worker for an ongoing or indefinite period of time, that suggests an employment relationship. Likewise, if you extend benefits, like holidays, paid time off, and/or sick days, to the worker, that is indicative of an employment relationship, too.

In addition to these IRS factors, there are state tests that touch on the extent of control the worker has over his or her performance. It’s important to remember that just one factor, by itself, may not be enough to indicate one type of relationship over the other. Instead, you have to look at the totality of the circumstances, i.e. all the relevant factors together, to see if the worker is falling into one camp.

2. What are the risks of misclassifying?

Misclassification can have some serious consequences. If you call a worker a contractor when they are really found to be classified as an employee, you could be liable under the federal Fair Labor Standards Act (FLSA) for payment of back wages and back taxes, audits and fines related to I-9 violations for not having proper employer verification requirements for all workers, and penalties for failing to withhold FICA tax and maintain workers’ compensation insurance for the misclassified worker. In addition to these weighty financial consequences, you also face damaging the reputation of your business.

It’s important to remember that there is no regard for intentionality when it comes to this analysis. It doesn’t matter if you knowingly or unknowingly misclassified a contractor. The consequences (though they can be steeper for intentional conduct) apply regardless.

3.What should my agency do now?

 Have a comprehensive contract.

Make sure that you have clear contracts with each freelancer you hire and that those contracts are consistent in the way they describe the responsibilities and expectations of the freelancer.

You should have specific language in the contract that the freelancer is engaged as an independent contractor, is solely responsible for his/her own taxes associated with any compensation received from your agency, and cannot act on behalf of the agency, i.e. cannot sign contracts for the agency.

A big differentiating factor between contractors and employees is their ability to be hired by and work for someone else. We recommend language that clearly states that the contractor has the right to work with other agencies and that your agency has the right to hire other contractors that engage in the same or similar services.

You will also want to be sure that your contract includes robust indemnification, work IP ownership (especially related to the use of artificial intelligence), confidentiality, and non-solicitation clauses.

Treat freelancers differently and consistently than you do employees.

It’s not an uncommon scenario for agencies to hire a freelancer on an ongoing basis, pay the freelancer according to a regular pay period, and require the freelancer to report time spent on a project in the agency’s project management software. This setup is a problem waiting to happen for your agency. It has many of the qualities of an employment relationship that you need to avoid – ongoing engagement, regular pay periods, and time reporting requirements. If this has become your agency practice, you should look into changing how you structure that freelancer’s contract and payment. One key shift is to engage with and pay the freelance contractor differently than you compensate an employee.

Additional measures your agency should implement now to avoid misclassification are to:

(1) strongly suggest that the freelancer have their own LLC or other entity so that your agency can engage them on a company-to-company basis,

(2) have the freelancer invoice you for services completed (vs time input directly into their project systems), and

(3) consider engaging and paying the freelancer on a per project basis (whether hourly or flat fee) based on the invoice(s) provided, and

Lastly, you should consult your accountant to discuss the tax implications of these decisions as well.

For further information on how to best protect your agency when hiring contractors, see our other blog post on the topic: https://www.legalandcreative.com/2023/05/some-common-agency-independent-contractor-scenarios/