August 9, 2024

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Introduction

Nonprofit organizations across the country play a crucial societal role by aiding those in need. However, due to their not-for-profit ethos, these organizations often face funding and human resources constraints. To overcome these challenges, many nonprofits turn to independent contractors to obtain specialized skills and expertise in a cost-effective manner. Hiring independent contractors can be a valuable strategy, but it also comes with its own set of considerations and responsibilities that nonprofits should be aware of. In particular, different government agencies define and classify the term “independent contractor” differently; it is important to understand this distinction to ensure that your organization is not accidentally treating contractors in a way that would inadvertently classify them as employees. In this article, we explore the key factors nonprofits should consider when hiring independent contractors.

Governing Bodies

Before engaging independent contractors, nonprofits must understand the legal and regulatory requirements that apply to such working relationships. Misclassifying a contractor as an employee can lead to legal and financial consequences, described in detail below. It is therefore essential to understand the distinction between employees and independent contractors to ensure compliance with labor laws and tax regulations.

There are three main government agencies that are concerned with an organization’s classification of its employees and contractors:  

(1) the Internal Revenue Services,  

(2) the U.S. Department of Labor and  

(3) the relevant state agencies, including state departments of labor, taxing agencies, workers’ compensation boards, and employment development departments.

Each agency has a different test for determining whether an individual is classified as an employee or an independent contractor. The IRS oversees this classification for purposes of determining appropriate tax withholding, while the U.S. Department of Labor is primarily concerned with worker protections, particularly with respect to minimum wage and overtime pay. State agencies may have a number of roles, but primarily tend to be concerned about this classification for purposes of state unemployment benefits and taxation.

·       U.S. Internal Revenue Service: The IRS primarily focuses on control and independence in the working relationship between an organization and the contractor. The IRS uses a three-factor test (Behavioral Control, Financial Control, and Relationship) to determine whether an individual is an independent contractor or an employee. The Behavioral Control prong examines the extent of control the hiring party has over what the work is and how the work is performed. The Financial Control prong assesses the extent of financial investment and risk taken by the worker as opposed to the organization. This can include how the worker is paid, how expenses are reimbursed and what tools/supplies the worker utilizes. The Relationship prong examines the nature and type of relationship between the parties, specifically with respect to benefits. The more control an organization exercises, the more likely the IRS is going to classify the worker as an employee rather than an independent contractor. Further information can be obtained from the IRS Website.

·       U.S Department of Labor: The U.S. Department of Labor, specifically the Wage and Hour Division, focuses on the “economic reality” of the working relationship between an organization and a worker. This Economic Realities Test includes a variety of factors such as the degree of control a worker has over a project, the worker's opportunity for profit or loss, the skill and initiative required, the permanency of the working relationship, and the integration of the worker's services into the hiring party's business. Further information regarding the factors that the U.S. Department of Labor uses can be found on the DOL Website.

·       State Agencies:  The tests applied at the state level will be specific to the jurisdictions where an organization operates and should be researched by an organization in consultation with a local attorney prior to making an employee versus contractor hiring decision.

Consequences

Given the multiple layers of the employee versus contractor classification, it is not uncommon for an organization to unintentionally misclassify its employees or contractors. The penalties for such misclassification can be severe, depending on which agency’s test your organization fails to pass.

At the IRS level, if a worker is misclassified as a contractor but is technically an employee, any employer portions of Social Security and Medicare taxes that have not been paid on behalf of a misclassified contractor would need to be paid. Often the Social Security Administration/IRS will also require an organization to be responsible for the taxes that have not been withheld from a worker’s paycheck.

At the U.S. Department of Labor level, any disputes regarding overtime pay with a contractor that is technically an employee may turn into costly litigation.

However, the most common situation in which misclassification issues occur is when a worker is classified as a contractor, the worker later seeks unemployment benefits, and the state discovers that the employer has not been paying for unemployment insurance. This is prevalent at the state level, as 501(c)(3) organizations are exempt from federal unemployment taxes. In this situation, a nonprofit will be liable for back taxes for unemployment insurance, plus penalties and interest. This penalty can become quite costly.

What should your organization do?

The most important thing an organization can do when deciding whether to hire an independent contractor or an employee is to make an informed decision with the aid of an attorney. The organization should first consider each of the tests outlined above and structure the relationship with that worker in a way that matches either an employee relationship or a contractor relationship. Hiring employees versus independent contractors is an important financial decision to avoid incurring too many expenses associated with hiring employees. The decision also depends on the specialized needs of your organization. Nonprofits typically have a specific mission and values, which can require a certain level of control over the nature of a worker’s work product.

Properly classifying your workers can be accomplished through appropriate contract drafting with your workers, outlining the scope of work, timelines, payment terms, and any other relevant terms. Specifically for independent contractors, a contract should address:  

• that the contractor is responsible for paying his own self-employment taxes,  

• that he is not eligible to receive state unemployment insurance or other company benefits, and  

• that he should maintain his own insurance if desired or required by law.  

Regardless of the chosen relationship, both parties to the agreement should also clarify the intent of the relationship: the contract should clearly state that the worker is either an employee or an independent contractor. Although this contract language alone is not enough to classify a worker as an employee or a contractor without satisfying the tests above, it should still be in every contract to avoid ambiguity.

In summary, due to the many federal and state laws that govern worker relationships with their organizations, making a determination about whether your workers are employees or independent contractors is a fairly complex issue that requires understanding the relationship tests from both the IRS and U.S. Department of Labor, as well as state-specific requirements. It is only after careful determination of the needs of your organization that you can make the decision whether to hire employees or contractors.

Disclaimer: The information in this blog post (“Post”) is provided for general informational purposes only and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice from the Napa Legal Institute or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.