The distinction between an "employee" and an "independent contractor" can have critical implications.

An important issue all contractors face is whether a subcontractor (or the employee of a subcontractor) is considered your "employee" under the law. While most of us use the word in everyday conversation without thought, the distinction between an "employee" and an "independent contractor" can have critical implications.

This designation is important for several reasons. An obvious advantage to labeling workers as "independent contractors" is the savings on payroll, withholding taxes and related benefit expenses. However, just calling someone an "independent contractor" is not conclusive to the Internal Revenue Service, the National Labor Relations Board or the Occupational Safety and Health Administration. Second, if a worker is deemed an "employee," any on-the-job injuries to the worker, as well as worker's compensation claims arising from those injuries, will be the responsibility of the employer. Third, if a worker is an "employee," any personal or property damage arising out of that employee's actions will likely be the responsibility of the employer.

Under the law, it is not enough to label or call a party an independent contractor. Agencies like the IRS, NLRB and OSHA will determine on their own who is and who is not an "employee" by considering the circumstances of the worker's employment. The test generally applied is one of control and "economic realties." According to these tests, courts and governmental agencies usually consider six factors: (1) the degree of control exerted by the alleged employer over the worker; (2) the worker's opportunity for profit or loss; (3) the worker's investment in the business; (4) the performance of the working relationship; (5) the degree of skill required to perform the work; and (6) the extent to which the work is an integral part of the alleged employer's business.

1. Control. All contractors should look to the nature of the relationship with their subcontractors in light of these six factors, the first and most important being control. Control is determined by looking at how a contractor delegates the work to be done on a project. The greater the involvement by the contractor in controlling how the worker performs his tasks, the more likely it is that the worker will be considered an "employee."

2. Opportunity for Profit and Loss. When looking at the worker's opportunity for profit or loss, the subcontractor bidding process is an important factor. If the contractor has influence beyond the bidding process on the final price that is charged for the subcontracted work, the more likely the subcontractor will be considered an employee. For example, the subcontractor must have the ability to control its own profit margins, the salaries of its workers, and the prices it pays for its materials to be considered "independent."

3. Investment in the Business. Investment by the contractor - even in small part - in the business of the subcontractor will quickly erode the "independent contractor" relationship. "Independent" means independent - physically, practically and financially. Frequently, courts have ruled that subcontractors that are even minimally owned by the general contractor will be considered "employees" in workers compensation claims, wage and fringe benefit claims, and lawsuits arising from the conduct of the worker (for example, sexual harassment claims).

4. The Performance of the Working Relationship. The more hands off a contractor is with the subcontractor in the performance of the subcontracted work, the more likely it will be considered an independent contractor. While employees of the contractor and the subcontractor may work together on a job site, if the contractor's employees and the subcontractor are all performing the same tasks, it will be difficult to justify a distinction between the workers if the independent contractor relationship is challenged.

5. Degree of Skill. The more skilled the subcontracted work, the more likely the workers will be considered independent contractors. Hired laborers and maintenance personnel are usually not considered independent contractors.

6. Part of the Employer's Business. The closer the subcontracted work is to the business area of the contractor, the more likely it is that the workers will be legally found to be "employees."

While the key to establishing an independent contractor relationship with a subcontractor is the circumstances of the employment, it never hurts to get as much supporting documentation as possible. Frequently, disputes as to independent contractor or employee status arise because the parties failed to delineate their relationship prior to the performance of the work or the project. Job assignments are made orally or with no more than a one-page invoice or purchase order, job tickets or billing sheets. To reduce governmental challenge or later litigation, contractors should consistently use written subcontracts and independent contractor agreements that are tailored to your business and spell out the independent relationship. While use of these agreements will not completely protect your business from governmental scrutiny or plaintiff's lawyers, in most cases, they provide adequate insulation from challenge.

An understanding of the employee/independent contractor distinction, combined with the proper work environment and well-drafted supporting documents can protect your business from the time and expense of audits, adverse tax rulings and litigation. The cost of developing these contracts is reasonable, and they do not need to be complicated. A carefully drafted document will clarify the parties' relationships as to independent status, insurance requirements and risk assumption. Investing money today in organizing this important aspect of your business is money well spent.