Is a “Hybrid Independent Contractor” Relationship Right for You?

It is generally understood that a worker can either be an employee or an independent contractor. If the worker is an employee, the worker is duly treated as an employee in all respects, with the employer dutifully covering various employment benefits, and paying all applicable employment/payroll taxes, including social security and medicare taxes, state and federal unemployment taxes, and workers’ compensation taxes. Conversely, if the worker is classified as an independent contractor, the worker is accordingly treated as an independent business owner, with the hiring company being exempt from paying any employment/payroll taxes, or providing any employment benefits.

A third scenario many businesses find themselves in – often at the conclusion of an L&I or ESD audit – is in a defective independent contractor relationship arrangement. One in which workers who have been classified as independent contractors are found not to be independent contractors because the business’s relationship with the contractor fails to meet satisfy key parts (or each part) of an applicable independent contractor test. As a result of not satisfying the independent contractor test in full, the contractor by default, is treated as a misclassified employee, thus subjecting the hiring business to back taxes, along with penalties and interest, for failing to pay the employment taxes that were due on their “misclassified employees.”

Businesses that find themselves in the above scenario have a couple standard options. One option is to concede the independent contractor classification and convert the worker to an employee. Another option is to correct the deficiencies found in order to fully and completely meet the definition of an independent contractor. In pursuing the latter option, however, what many businesses are surprised to find out, particularly after an L&I or ESD audit, is that the very nature of their business model means that their independent contractor can never satisfy key parts of the independent contractor test, and thus can never be exempt from certain employment taxes. For example, a business may find out that it will never satisfy the exempt independent contractor test if the nature of the business is such that the business must instruct and work closely with an independent contractor, thus violating the foundational requirement that an independent contractor be completely free from direction/control. Or a business may find that it will never satisfy the independent contractor test because the independent contractor has no other clients and works solely and exclusively for the business, thus violating the requirement that the independent contractor be truly independent and operating an “independently established business.”

In these cases, where an independent contractor for the most part walks and talks like an independent contractor, but has the above (or similar) fatal compliance deficiencies, what is a business to do? As stated above, one option might be to convert to an employment relationship and be done with it. An alternative that is worth considering, however, is the hybrid independent contractor relationship. The full classification and reasons for the classification are too expansive to discuss in a short blog but key features of the classification contemplate the following:

  1. Keeping the worker classified as an independent contractor on the grounds that that worker is more of an independent contractor than an employee.
  2. Determining which individual state or federal agency independent contractor test your business is likely to flunk. Often a business can satisfy the IRS test (or at least meet the IRS’s Section 530 safe harbor) and meet an ESD exemption (thus being exempt from ESD taxes), while at the same time flunk L&I’s  ultra-strict independent contractor test.
  3. Paying taxes due to the agency whose test would be flunked i.e. rendering to Caesar that which is Caesar’s. In the above example, the business would not pay taxes to the IRS or ESD, but would pay taxes to L&I.

In short, the strategy entails getting into full compliance with most of the applicable enforcement/taxing agencies, while paying taxes to the one or two agencies for which full compliance is impossible or difficult. If you’ve been through an audit and flunked, consider whether you need to convert to employees, or if the hybrid independent contractor relationship could be right for you. The major caveat is that it requires sound legal strategy, careful planning and appropriate documentation. But for the right business, it may be exactly the way to go.


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