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By: Jeffrey Bosley, Davis Wright Tremaine LLP
LEXIS PRACTICE ADVISOR RESEARCH PATH: Labor & Employment > Independent Contractors > Agreements and Restrictive Covenants > Practice Notes > Independent Contractor and Consulting Agreements
An effective independent contractor agreement will withstand both judicial and regulatory scrutiny of independent contractor status and provide a practical framework for the parties’ relationship. This article will help you determine the legitimacy of independent contractor status for the worker at issue and assist you in drafting and negotiating a defensible independent contractor agreement.
Preparing an effective independent contractor agreement requires a thorough and individualized review of the parties’ anticipated relationship under the applicable independent contractor test(s).
Assessing the proper classification of a particular worker is complicated by the multitude of tests used to evaluate worker status. Courts and administrative agencies have also reached conflicting determinations concerning a worker’s proper classification on the same or very similar facts. In some cases, the disparate conclusions resulted from applying different tests; in other cases, a court or agency emphasized different factors or issues within the same test. See, e.g., Alexander v. FedEx Ground Package Sys., Inc., 2014 U.S. App. LEXIS 16585 (9th Cir. 2014) (FedEx drivers are employees due to the employer’s right to control the manner and means of employee’s job performance); c.f., FedEx Home Delivery v. Nat’l Labor Relations Bd., 563 F.3d 492 (D.C. Cir 2009) (FedEx drivers are independent contractors mostly due to “entrepreneurial opportunities” factors).
The two primary tests for determining independent contractor status are the common law “right to control test” and the “economic realities test,” which applies in the Fair Labor Standards Act (FLSA) context. As discussed in greater detail below, these two tests (and their variations) reflect different approaches to assess a common fundamental question: Does the company possess the right to control the manner and methods by which the worker performs the desired services? The greater the level of control a company retains over the methods and means used by a service provider to complete a project, the greater the risk that a court or agency will deem the service provider to be an employee.
The economic realities test also helps analyze another fundamental question in cases where the court applies this test: Is the worker economically dependent on the user of the individual’s services, or is the worker really in business for himself or herself (and thus an independent contractor)? See Department of Labor (DOL) Administrator’s Interpretation No. 2015-1, (July 15, 2015).i
Liability and penalties resulting from an investigation or audit by a taxing authority—such as the Internal Revenue Service (IRS)—pose one of the greatest risks of worker misclassification. To determine whether to classify a person as an independent contractor or an employee, the IRS applies a 20-factor test that derives from the common law right to control test. Another agency, the Equal Employment Opportunity Commission (EEOC), utilizes 16 factors. Under either approach, you must evaluate the totality of the circumstances to gauge whether the worker possesses sufficient autonomy to qualify as an independent contractor. The full 20-factor IRS test is located at Rev. Rule 87-41 (I.R.S. 1987), 1987-1 C.B. 296,ii and you can find additional IRS guidance in IRS Publication 1779 (Rev. 8-2008).iii The EEOC’s 16-factor test can be found in the EEOC Compliance Manual Section 2: Threshold Issues (2000).vi
The IRS has recently grouped the 20 factors into three basic categories:
(1) Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job?
(2) Financial. Who controls the financial aspects of the worker’s job? (This includes items like how the company pays the worker, whether it reimburses the worker’s expenses, who provides tools and supplies, etc.)
(3) Type of relationship. Have the parties entered into written contracts, and does the company provide employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the company’s business?
See Independent Contractor (Self-Employed) or Employee? Internal Revenue Service.v
The IRS cautions companies to weigh all of the applicable factors to determine a worker’s status as an independent contractor or employee.vi No “magic” number of factors will “make” a worker an employee or an independent contractor.vii
Rather, the analysis boils down to which party bears control over the means and method of providing services.
The Supreme Court’s Application of the Right to Control Test to Worker Classification Issues Under Federal Laws That Do Not Clearly Define “Employee”
The U.S. Supreme Court has held that unless a statute clearly indicates otherwise, the common law agency test applies to worker classification issues under federal laws. Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318, 323-24 (1992). In applying the common law test to federal laws that do not clearly define “employee,” the Supreme Court stated in Darden that to determine whether an individual possesses requisite control over the manner and means of production to justify independent contractor status, a federal court will examine the following factors, with no one factor being decisive:
Courts and agencies adjudicating FLSA issues employ a different test, commonly referred to as the “economic realities” test. See, e.g., Bartels v. Birmingham, 332 U.S. 126, 130 (1947); Henderson v. Inter-Chem Coal Co., 41 F.3d 567, 570 (10th Cir. 1994); DiPilato v. 7 Eleven, Inc., 662 F. Supp. 2d 333, 346-347 (S.D.N.Y. 2009); see also DOL Administrator’s Interpretation No. 2015-1 (July 15, 2015).ix The economic realities test requires analysis of the worker’s economic independence. While an employee generally depends on his or her employer for income and opportunities, an independent contractor engages in his or her own business, generally shares some risk of success or failure in the contractor relationship, and can earn income from other sources.
In July 2015, the Administrator of DOL’s Wage and Hour Division, David Weill, wrote that the “goal of the analysis [under this test] is to determine the underlying economic reality of the situation and whether the individual is economically dependent on the supposed employer.” Weill also opined that this test is broader than the common law right to control test and that under this test, “most workers are employees under the FLSA.”x While not binding on courts, courts may adopt the reasoning set forth in this recent Interpretation as persuasive. You should stay advised of developments in your jurisdiction concerning this issue.
The DOL also offers the following questions for consideration when applying this test:
See DOL Fair Labor Standards Act Advisor—Independent Contractors.xi For additional detailed information on the FLSA’s economic realities test, see Applying the Economic Realities Test: Worker Classification Under the FLSA.xii
Some courts have applied a hybrid test to determine independent contractor status, which incorporates factors from both the right to control and economic realities tests. See, e.g., Wilde v. County of Kandiyohi, 15 F.3d 103, 105 (8th Cir. 1994); Deal v. State Farm Cnty. Mut. Ins. Co. of Texas, 5 F.3d 117, 118-119 (5th Cir. 1993).
Many states apply another test called the ABC test, particularly in the unemployment context. See Applying the ABC Test to Determine Worker Classification Status.xiii While the specific language of this test varies state by state, the general factors are (A) whether the worker performs work free from control or direction; (B) whether the worker performs the work outside the company’s usual business or the worker can perform the work off company premises; and (C) whether the worker customarily engages in an independent trade, occupation, or business.
The application of each of these three factors varies state by state. In Connecticut, for example, if any one of the factors is not satisfied, the worker will be an employee for state unemployment tax purposes (even though the worker may still be deemed an independent contractor under federal law). See Connecticut General Statutes Section 31-222(a)(1)(B (ii) and State of Connecticut Employment Security Division, Unemployment Compensation Tax Division Self-Assessment of the Employer Employee Relationship for CT Unemployment Taxes.xiv Other states may require the satisfaction of only two of the three factors. See, e.g., Johnson v. Mont. Dept. of Labor & Indus., 240 Mont. 288 (1989). In states that use the ABC test, you will also want to explore how courts and agencies have applied the specific test at issue.
When drafting the independent contractor agreement, you should keep in mind the relevant tests for independent contractor status. Although the agreement alone will not dispose of any challenge to a worker’s classification, it can provide helpful evidence about the parties’ intent and, in some cases, establish a safe harbor defense to a taxing authority. See Navigating Statutory Safe Harbors Including Section 530 of the Revenue Act of 1978.xv See also IRS Fact Sheet Regarding the Section 530 Safe Harbor.xvi
In addition to drafting the agreement with the applicable tests in mind, the parties must also be certain the relationship will conform to these requirements in practice. For example, the drafter should ask whether the company can adhere to the agreement’s requirements, such as limited supervision of process, invoicing of payments, etc. A reviewing court or agency will look beyond the terms of the agreement and review the relationship as it exists in practice.
The following subsections discuss and provide drafting guidance concerning common provisions in independent contractor agreements.
At the outset, the agreement should clearly state that the company has engaged the service provider, and the person or entity providing services has agreed to be engaged, as an independent contractor. The opening paragraphs or whereas clauses can also highlight that the organization engages the independent contractor because of his or her special or unique skills, for a specific task, for a limited term, and for limited purposes. These introductory clauses also often contain representations by the provider that he or she possesses such skills, equipment, and training.
Courts and agencies have found long-term or indefinite engagements to favor employee status. Many organizations seek to limit the engagement to short periods, such as six months, or preferably, on a project basis. Similarly, an agreement that either automatically renews, or that the parties regularly renew, may imply employee status. You should specify a term for the agreement, provide that the agreement will not renew automatically, and require that any extensions be in writing. The employer should carefully review extensions on a case-by-case basis.
The right to discharge a worker at-will and the right of the worker to resign at-will more commonly reflect an employment relationship than an independent contractor relationship. Establishing a definite term, either by time or project, creates risk for both parties, which better aligns with an independent contractor relationship.
Courts and agencies also disfavor early termination at the unlimited discretion of either party. Rather, early termination for material breach—such as failure to perform or meet an agreed-upon progress target—better reflects an independent contractor relationship than termination without cause. You may also wish to consider a notice provision that includes the opportunity to cure defects in performance as part of any early termination procedure.
Manner and Method of Providing Services
In this section of the agreement, you have the opportunity to clarify that the independent contractor effectively functions as his or her “own boss.” In particular, this freedom should ideally include deciding when and where the independent contractor performs services as well as controlling the manner and methods of production. To that end, you should state that the independent contractor retains latitude to control the manner and methods of his or her work. If practicable, the independent contractor should make his or her own schedule and use his or her own worksite tools and resources. You can (and should) specify, however, the end result or final product desired.
During the term of the agreement, you should distinguish the manner of oversight from any method commonly used with employees. For instance, weekly one-on-one meetings with a supervisor or weekly status reports—which are the norm in employment relationships—should be avoided with contractors.
Services Provided Are Preferably Not an Integral Part of the Principal’s Business
An independent contractor’s duties and responsibilities should not generally comprise core functions of the business. For example, a painter engaged by a software company to paint a building exterior will more likely be deemed an independent contractor than a painter engaged by a house painting business who receives paint and painting tools from the hiring party to paint a residence. The distinction is harder to draw in the case of a computer programmer working in the information technology department of a large company. In cases where the distinction may be blurred, it is especially important to define the role as limited in time and scope and to emphasize other elements of the relationship that suggest independent contractor status, such as unique skills or capabilities.
The company should consider selecting a manner of payment that differs from how it pays employees. Companies often pay employees biweekly and/or on an hourly basis. Alternative payment options include monthly payments or completion of- task payments. If the parties agree upon hourly billing, the agreement should clearly specify that the organization has no obligation to pay overtime compensation.
The company should not pay its independent contractors through the normal payroll mechanism using company time sheets or standard salary mechanisms. Rather than time sheets, the independent contractor should submit an invoice, including a business name, if applicable, and an Employer Identification Number or other business or tax identification numbers. And the company should pay the independent contractor as it would other vendors.
Companies can also use incentive pay to show shared risk and reward. For example, early-completion bonuses may be more effective than close supervision in achieving a result and may also help buttress the independent contractor classification.
A worker’s receipt of medical and other standard employee benefits exemplifies employee status and weighs strongly against independent contractor status. The company should avoid payment of employee benefits if possible, and the agreement should clearly state that the contractor will not receive any benefits provided to the company’s employees. Many persons who are experienced contractors will have secured benefits for themselves through other sources. If not, as an alternative to providing these benefits, you can work with a contractor to factor these costs into the project rate paid under the contract.
If the company withholds taxes for the contractor as it does for its employees, this practice will substantially weaken any argument for independent contractor status. You should draft a provision specifying that the independent contractor bears sole responsibility for his or her own tax obligations and that the hiring party will issue the contractor an IRS Form 1099 rather than a W-2.
The contractor should also agree that he or she must withhold taxes as appropriate for any assistants or employees, and to the extent permitted by law, agree to indemnify and hold the company harmless for any taxes, penalties, costs, or interest claimed or owed for amounts paid under the agreement.
Consistent with the concept of shared risk, the contractor should indemnify the company for any actual or claimed liability caused by its negligence or misconduct. The company should require the contractor to provide proof of insurance sufficient to protect the company from such claims. If a company misclassifies an independent contractor, it may still incur penalties for not providing workers’ compensation insurance; however, ensuring that a contractor has personal insurance may help mitigate exposure for out-of-pocket medical expenses or other damages. In some cases, and in some states, the company may wish to make clear that the contractor must add the company as a named beneficiary for any applicable insurance coverage.
You should incorporate express protections in the agreement for the company’s trade secrets and proprietary and confidential information as well as for the confidential information of other parties as applicable. You may also want to consider restrictions on solicitation of employees and customers, and depending on applicable law and business needs, a non-compete. See Understanding, Negotiating, and Drafting Non-competesxvii; Understanding, Negotiating, and Drafting Customer Non-solicitation Agreementsxviii; and Understanding, Negotiating, and Drafting Employee Nonsolicitation Agreements.xix
However, you should not include an exclusivity clause. By definition, an independent contractor who is “in business for himself or herself” may take on other assignments. An exclusive arrangement implies that the contractor depends economically on the company. An overly broad noncompetition clause may have the same effect as an exclusivity clause and, consequently, present the same problems. You should expressly state in the agreement that the independent contractor may accept other assignments. If a legitimate business need exists to restrict certain engagements, you should narrowly craft such restrictions (i.e., unless such assignments would result in an actual or apparent conflict of interest or the use of confidential and/or proprietary information or trade secrets).
You should also ensure that the company retains ownership of intellectual property shared with the contractor and owns any work product created by the contractor. An employee’s inventions—such as a product protected by copyright—may be a work made for hire or owned by the company as a matter of law. Inventions of a contractor, however, must be assigned through the contractor. The scope and specificity of these provisions will vary based on the value of the work product and the type of protection desired, i.e., copyright, trademark, or patent. In some cases, you should specify in the agreement power of attorney and an agreement to cooperate in perfection of the protection. Certain state laws may also contain specific language concerning requirements for the assignment of inventions; companies should review these laws with counsel experienced with these issues to determine whether they apply in the context of an independent contractor agreement.
The agreement should also limit the contractor from including or intertwining others’ intellectual property in work product made for the company pursuant to the agreement. If this situation is unavoidable, the company should carefully negotiate and obtain appropriate licensees and permissions.
For more information concerning intellectual property rights, please see Assignment of Inventions and Works Made for Hire.
You should specify that the contractor retains authority to select his or her own agents, if any. The agreement should also prohibit the contractor from representing himself or herself to third parties as a company employee or representative and from binding the company to any agreements with others.
Because laws vary from state to state concerning independent contractor status, you should consider a choice of law and venue provision that maximizes the chance that the most favorable law will apply and that provides predictability to the parties as to enforcement. You should also consider a venue for the parties to resolve disputes, such as the city of the company’s primary place of business. Another helpful provision to consider is an agreement to accept service of process in a convenient manner, such as by first-class mail or e-mail, as opposed to personal service.
For some contracts, the parties may prefer arbitration. Because the law concerning the enforceability of arbitration agreements continues to evolve, you should review the latest precedent in these areas before providing for arbitration or a class action waiver. For more information on arbitration provisions, please see the practice note entitled Drafting an Arbitration Clause.
You should include a statement that the agreement constitutes the complete agreement of the parties. You should also include a statement that the parties may only extend or modify the agreement in writing. This language will help minimize the risk of claims of estoppel, detrimental reliance, and other quasi-contractual claims for compensation based on parole or extrinsic evidence. You should specifically incorporate key documents, or policies such as billing guidelines, by reference. Other documents that you may wish to expressly incorporate include ownership or assignment of inventions agreements, non-disclosure agreements, and conflicts of interest policies. See Assignment of Inventions; Understanding, Negotiating, and Drafting Non-disclosure Agreementsxx; and Developing Conflicts of Interest Policies.xxi
As counsel preparing an independent contractor agreement, you may as a practical matter have to negotiate with two parties: the hiring party and the contractor.
The hiring party may desire an independent contractor arrangement even when the circumstances do not warrant such classification. You should stress to the hiring party the substantial consequences of misclassification. See Understanding Risks of Independent Contractor Misclassification.xxii You may need to advise the hiring party that the desired independent contractor arrangement does not satisfy the relevant test(s) for independent contractor status. While a business may enjoy many advantages when it retains a contractor for a specific project, the classification decision cannot solely rest on convenience for the company or the desire of a contractor to avoid tax withholding.
The contractor may also request that the agreement contain certain terms that seem entirely reasonable in an employee relationship but that weaken the independent contractor classification. You must be prepared to deny such requests. If possible, you should offer lawful alternatives to maintain independent contractor status in a defensible manner.
You should encourage negotiation between the parties. The engagement of an at-will employee rarely involves significant negotiation. But, in the independent contractor context, arm’slength negotiation in the formation of the agreement may support independent contractor status. Accordingly, you should preserve documentation regarding the negotiations. You should also request helpful documents from the contractor, such as the contractor’s federal Employer Identification Number, a resume and/or promotional materials used by the contractor, and advertisements or documents concerning other current or prospective engagements between the contractor and other companies.
On March 11, 2015, the Northern District of California issues two decisions involving key players in the “on-demand,” “sharing,” or “gig” economy: Uber and Lyft. See O’Connor v. Uber Techs., 82 F. Supp. 3d 1133 (N.D. Cal. 2015); Cotter v. Lyft, Inc., 60 F. Supp. 3d 1067 (N.D. Cal 2015). Both cases highlight the substantial potential risk of misclassification. Plaintiffs brought each case as a class action seeking to obtain benefits provided by the California Labor Code to employees, such as reimbursement for expenses and payment of a minimum wage. Both cases involve potentially thousands of drivers. The court denied summary judgment in each case. Subsequently, the court certified a class for certain issues in the Uber case, and that matter is set for trial on June 20, 2016. In Lyft, the partied agreed to $12.25 million settlement, which also includes “forward-looking changes to [Lyft’s] business practices,” such as specific restrictions on the ability to terminate drivers, greater information for drivers concerning prospective passengers, and an agreement that Lyft will bear the cost of future individual arbitrations. See Cotter v. Lyft, Inc., Case No.: 3:13-cv-04065-VC, Notice of Motion and Motion and Memorandum of Points and Authorities in Support of Plaintiff’s Motion for Preliminary Approval of Class Action Settlement, filed January 26, 2016, at 11-12. The settlement requires court approval, and the judge has asked the parties to provide additional input on several questions, including whether the settlement moves the drivers closer to independent contractor status. If so, the judge asked whether this aspect of the settlement is contrary to the original goal of the lawsuit—a finding the drivers are employees—and prevents approval of the settlement. See Cotter v. Lyft, Inc., Case No.: 3:13-cv-04065-VC, Order Requesting Further Briefing and Continuing Hearing on Motion for Preliminary Approval of Class Action Settlement, filed February 11, 2016, at 2-3.
These cases and others involving the “gig” or “sharing” economy raise difficult issues and are more complex than many traditional contractor classification questions. Judge Chhabria observed in the Lyft decision that “the test the California courts have developed over the 20th century for classifying workers is not very helpful in addressing this 21st Century problem.” Lyft, Inc., 60 F. Supp. 3d at 1081. He also stated that “the jury in the case will be handed a square peg and asked to choose between two round holes.” Id. Uber and Lyft are not alone in facing this challenge. Other companies in numerous other industries face this dilemma, including companies that provide technology to connect customers and service providers in the lodging, household task, delivery, construction, childcare, and dining industries. Some of these companies have elected to move to an employment model, while others continue to navigate a landscape of potentially conflicting regulatory rulings and court decisions. As courts continue to decide these cases, they will provide additional guidance under all of the above tests.
Companies today are facing increased regulatory exposure from state and federal agencies in addition to class action and other litigation risk. See “Misclassification of Employees as Independent Contractors,” DOL Wage and Hour Division.xxiii As of January 6, 2016, the DOL had established partnerships with 27 states and the IRS to investigate potential misclassification of contractors.
In addition to increased judicial and regulatory activity, legislative initiatives to extend certain rights and benefits to workers in the gig or shared economy are being debated at a local, state, and federal level. While the legal landscape continues to evolve, the independent contractor model remains a viable option in many jurisdictions as long as you properly evaluate, document, and adhere to the parameters of the independent contractor relationship.
Jeffrey Bosley is a partner in the Employment Services Group of Davis Wright Tremaine LLP, based in the firm’s San Francisco office.
i. DOL Administrator’s Interpretation No. 2015-1, (July 15, 2015), http://www.dol.gov/whd/workers/misclassification/ai-2015_1.pdf. ii. Rev. Rule 87-41 (I.R.S. 1987), 1987-1 C.B. 296, https://advance.lexis.com/api/permalink/eb75d4c0-77bc-4512-ad78-74ceb14dc915/?context=1000522. iii. IRS Publication 1779 (Rev. 8-2008), http://www.irs.gov/pub/irs-pdf/p1779.pdf. For more information on the IRS’s independent contractor test, see Applying the “Usual Common Law Rules” Test & Worker Classification Under Federal Income Tax Law, http://advance.lexis.com/api/document?collection=analytical-materials&id=urn:contentItem:5D3S-YH11-F8SS-612F-00000-00&context=1000522. iv. EEOC Compliance Manual Section 2: Threshold Issues (2000), http://www.eeoc.gov/policy/docs/threshold.html. v. “Independent Contractor (Self-Employed) or Employee?,” Internal Revenue Service, http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee. vi. Id. vii. Id. viii. Id. ix. DOL Administrator’s Interpretation No. 2015-1, supra note 1. x. DOL Administrator’s Interpretation No. 2015-1, supra note 1, at 2. xi. DOL Fair Labor Standards Act Advisor—Independent Contractors, http://www.dol.gov/elaws/esa/flsa/docs/contractors.asp. xii. Applying the Economic Realities Test: Worker Classification Under the FLSA, https://advance.lexis.com/api/permalink/afa8f98e-e619-475f-b358-f45bb8196b33/?context=1000522. xiii. Applying the ABC Test to Determine Worker Classification Status, https://advance.lexis.com/api/permalink/0426ec8d-cc7d-452b-bd30-ef843250aae7/?context=1000522 xiv. State of Connecticut Employment Security Division, Unemployment Compensation Tax Division Self-Assessment of the Employer Employee Relationship for CT Unemployment Taxes, https://www.ctdol.state.ct.us/uitax/abctest.doc. xv. Navigating Statutory Safe Harbors Including Section 530 of the Revenue Act of 1978 by Littler Mendelson, P.C., https://advance.lexis.com/api/permalink/94916347-f3ff-4de7-84f7-9dc162bd32a9/?context=1000522. xvi. IRS Fact Sheet Regarding the Section 530 Safe Harbor, http://www.irs.gov/pub/irs-pdf/p1976.pdf. xvii. Understanding, Negotiating, and Drafting Non-competes, https://advance.lexis.com/api/permalink/19462671-0d7a-4040-901b-ffeec7da9531/?context=1000522. xviii. Understanding, Negotiating, and Drafting Customer Non-solicitation Agreements, https://advance.lexis.com/api/permalink/285f845b-b56c-45e2-9854-4c7f26a50434/?context=1000522. xix. Id. xx. Understanding, Negotiating, and Drafting Non-disclosure Agreements, https://advance.lexis.com/api/permalink/205cba77-48e7-4105-b166-b300cec75a47/?context=1000522. xxi. Developing Conflicts of Interest Policies, https://advance.lexis.com/api/permalink/c60ad4fa-f6bf-4db7-95ac-feeada659b87/?context=1000522. xxii. Understanding Risks of Independent Contractor Misclassification, https://advance.lexis.com/api/permalink/d33951c3-8557-479a-ae71-274c4c241d4f/?context=1000522. xxiii. Misclassification of Employees as Independent Contractors, DOL Wage and Hour Division, http://www.dol.gov./whd/workers/misclassification.