The Question of Independent Contractors

March 2001

There is an increasing trend for agencies to classify producers as independent contractors rather than employees. State and federal laws do not look favorably on these arrangements. This article explains the various tests used to determine the difference.

by Edgar H. Lion, JD
Alpine Risk Management Corporation, LLC

There is an increasing trend for agencies to classify producers or other persons performing services for them as independent contractors rather than employees. State and federal laws are very strict on this and do not look favorably on these arrangements. A true independent contractor must operate free of direct control from the contractor and will generally operate under an express written contract.

The test of whether a person is an independent contractor or an employee is the amount of control the principal has over the independent contractor. This test is used whenever an independent contractor is injured in the course of duty. Was the independent contractor under the direction and control of the principal? If it can be determined there was any specific degree of control, the individual will be deemed an employee and subject to workers compensation (WC) and other state and federal regulations. Most states are extremely strict on their interpretation of who is an employee and who is an independent contractor.

Federal law uses the doctrine of "any reasonable basis" for determining the status of an individual. Many states will not apply this doctrine, but will require the "independent" to operate as a separate independent business in order to qualify as an independent contractor.

U.S. Supreme Court Decision

In Nationwide Insurance v Darden, 112 S Ct 1344, 117 L Ed 2d 581 (1992), the U.S. Supreme Court ruled that the generally accepted common-law factors determining whether an individual is an employee or an independent contractor were the relevant factors. These factors are cited below. (Note: The comments under each of the following factors are Alpine's and are submitted for the reader's consideration. In no way are they intended to interpret the rulings, nor do they constitute a legal opinion.)

What is the nature and degree of control retained by the employer?

Does the employer set production quotas or direct the "independent contractor" to make specific calls or show up in the office at a specified time or work a minimum numbers of hours each week? What control and direction does the employer exercise over the independent's activities or work? Is the independent told where to go and on whom to call? Or are all of these activities at the sole discretion of the individual?

What is the degree of supervision retained by the employer over the details of the work?

What direction does the employer provide or give to the individual on how their work is to be performed? Is the method of submitting business and preparing applications specifically spelled out in the contract in accordance with the employer's established written procedures? How much direction is given by the employer over the type of business the independent must produce? If direction is given, what is the difference in the supervision of an "independent" compared to the supervision of a regular employee?

To what extent are services an integral part of the employers business or a distinct business?

How important to the overall agency revenues is the business produced by the independent contractor? Is the business produced by the individual a major part of the agency's premium volume? Does the employer have any interest or ownership of that business? Or does the independent contractor have a 100-percent ownership of renewals with no vesting on the employer's part? Does the contract spell out the relationship that the independent is only using the employer's marketing facilities to place all business developed by the independent?

What is the duration of the relationship?

Is it solely within the employer's authority to dismiss the individual, or does the contract give either party the right to terminate the relationship based on a mutually agreed upon termination clause? Are there buyout provisions whereby the employer can buy any or all of the business in the event of retirement, termination, etc.?

Who supplies the place or instrumentalities of work?

What facilities does the employer provide and pay for? Do the independents pay rent for their office space, buy their own stationary, pay for their telephone bills, and reimburse the employer for all other services provided?

What is the method of payment?

How are independent contractors reimbursed? Do they receive any other reimbursement other than commission income? What kind of commission arrangement does the employer have with its independents? Do they receive the same amount of commission for renewal business as for new business?

What is the hired party's opportunity for loss or profit?

This is self-explanatory. If the individuals are truly independent contractors, they will operate as independent businesses and have the ability to make a profit or incur a loss if business is lost. There should be no backup from the agency.

What is the amount of initiative, skill, judgment, or foresight required of the hired party for the success of the enterprise?

If the individuals are truly independent, they must operate in the same manner as though they were separate independent agents. They must exercise their own initiative, insurance skills, and judgment in producing and developing business.

Although independents can solicit advice and information from the agency principal and staff, it must be at the independents' initiative and not originate from the agency principal or staff members.

What right does the employer have to discharge the hired party?

What are the terms of the written contract between the parties regarding termination of the relationship? Does the agency principal have the same option to terminate the independent for justifiable cause, as he can a regular employee?

Is the hired party engaged in a business apart from the business of the employer?

Are the independents exclusive independent producers for the agency, or can they place business directly through other brokers or companies? Many contracts call for exclusivity. As long as there is a written contract clearly spelling out the terms and conditions of the exclusive arrangement instead of an oral agreement, independents can be exclusive contractors for the principal without being considered employees. Independents should also have their own Employers Identification Number (EIN) and have their own company names, such as John Smith and Associates, etc., not just John Smith. When the employer issues a 1099 to report the gross earnings, it should be issued in the name of the independent's company and EIN rather than the name of the individual and the social security number.

Can the hired party control and hire its own employees?

Can the independents hire their own employees for their own operations, or are the people who perform the work for them considered to be employees of the agency? If the latter, do the independents reimburse the agency for their work through a formalized written agreement between the two parties?

Does the employer withhold taxes or pays Social Security for the hired party?

If the agency principal withholds taxes or pays Social Security for independents out of the commission checks received by the independents, there is a strong likelihood that both the state and federal authorities will rule the independents are in fact employees. An adverse ruling, such as this, can result in severe penalties levied against the agency.

These above-listed factors should be carefully reviewed by the agency principal prior to entering into any arrangement with an individual or group of individuals as independent contractors. After an agreement has been reached, a contract must be drawn by the parties specifically detailing the duties and responsibilities of each party to the contract.

Federal law will allow the employer to meet the "any reasonable basis" standard if more than 25 percent of workers in similar positions with other companies within that type of business are treated as independent contractors. But, to do so, the employer must have filed all required tax returns and have consistently treated its employees doing the same type of work as independent contractors.

Contract between Parties

There must be a written contract between the parties specifically spelling out the independent contractor's duties and compensation, with an absolute minimum of control and direction from the principal. Note: Even though there may be a written contract between a principal and an independent contractor, the state and federal authorities may still rule the individual to be an employee. (See the Internal Revenue Service Rule of 20 below.)

The courts will construe the absence of a written contract to mean these persons were employees. If construed to be employees, they are covered under the agency's WC policy. The state will want unemployment insurance taxes reported, and the federal government will require that Social Security and Medicare tax be withheld and reported.

It is recommended the contract contain the following provisions or information:

1. Deductible Payment: Independent contractor shall be responsible for payment of the deductible in the event of an errors and omissions claim arising out of an incident that is the direct fault of the independent. In the event the fault is that of both the independent and an employee of the agency, the deductible payment can then be apportioned.

2. Premium Payments: The independent contractor shall be responsible to the agency for all overdue, returned, and/or uncollectible premiums on the business they produce.

3. Insurance: The independent contractors shall carry their own automobile and liability insurance and shall be liable for damages arising out of their negligence in the performance of their contract. They can be added to the agency's group health plan as long as they pay the full premium, with no contribution on the part of the agency.

4. Procedural Observance: The independent contractor shall agree to abide by and follow all established written agency procedures. In the event of an errors and omissions or general liability claim arising out of the independent contractors' negligence or failure to follow the established written procedures, the independent contractor shall assume full responsibility for the payment of the deductible plus any other expenses incurred in excess of the policy limits and defense cost limits. (See Paragraph A. above.)

5. Automated Systems: The independent contractors should have a computer that can access the agency's system. However, they should purchase it separately or lease one from the agency.

6. Confidentiality: The contract should contain a clause whereby the independents agree that any information or knowledge they have about any of the risks written by the agency is confidential and cannot be disclosed to any other party and, in the event the contract is terminated, cannot use that information for their personal gain.

7. Exclusivity: The contract should also contain a paragraph that prevents independents from shopping their accounts through other agents or brokers, directly with a company, or through surplus lines brokers unless specifically authorized by the agency principal.

   However, if the independent contractor should produce an account for which the agency has no market—admitted or otherwise—the contract then should permit the independent to market the account through another agent or broker who might have an available market, subject to the express approval of the agency principal. In cases such as this, it must be clearly spelled out in the contract that any errors and omissions (E&O) claim arising out of the particular risk or risks are the sole and exclusive responsibility of the independent contractor and are not covered by the agency's E&O policy.

8. Production Goals: The agency should not set production goals per se for its independents. To do so might be interpreted as exercising a degree of control over the independents and removing them from the "independent" category and classifying them as employees. The contract should spell out what the agency expects the independents to produce each year in commission revenue in order for the agency to pay for the services it provides the independents and realize an expected profit.

9. Remuneration: The contract must clearly specify how the commission paid will be apportioned between the agency and the independent contractor. The agency needs to be paid for its services and make a profit. At the same time, the independent must have an equitable share of the commission, plus a possible incentive to produce larger premium accounts.

   Example: Some agencies will pay the producer 50 percent on all new and renewal commercial lines business, 50 percent on new personal lines business, and 25 percent on renewal. Some agencies offer an incentive to produce large risk business; they will pay the producer 65percent of the first year's premium.

10. Tax Audit Cooperation: There should be a provision in the contract requiring that independents cooperate with the agency in the event of any type of employment tax audit, which would include the independents making available any tax forms that show their income was reported as independent contractors rather than as employees.

11. Non-Compete Agreements: In most states, non-compete agreements are unenforceable. We have reviewed many contracts between the agency and the producer, and found the majority of them contain a non-compete covenant. Since these may be unenforceable, if the agency terminates a producer because he or she will not sign the non-compete agreement, the agency is asking for trouble. Labor attorneys have said that agencies should definitely think twice about including such an agreement in any contract.

Withholding Taxes and Social Security

If there is any type of withholding, the individual will automatically be construed to be an employee by the state, Internal Revenue Service (IRS), and the Department of Labor.

Ownership of the Business

Independent contractors should have full ownership of the business they produce. If they only have a partial vested interest, they could be considered employees. The contracts should contain buyout provisions in the event independent contractors leave the agency or retire. The terms of this provision should clearly define how the buyout will be handled and over what period of time.

Monitoring the Quality of Business

All business produced by the independent contractors should, prior to submission to the company, be reviewed for quality control, agency underwriting acceptability, and completeness of the application, including the signing and dating of the application, by both the insured and the producer. This pre-submission review should be accomplished by a qualified employee of the agency as a quality-control check.

Marketing the Accounts

Independents should not be permitted to make direct submissions to a company or surplus line broker without having the risk and application reviewed by a qualified agency employee prior to submission. If this practice is not followed consistently, the agency is exposing itself to a serious potential E&O claim.

Under no circumstances should the independent be permitted to have a separate agreement with one of the companies in the agent's office. To permit this could expose the agency to a potential E&O claim.

Services and Facilities

Providing services in itself does not necessarily break down the contractor-independent contractor relationship. However, if telephone, mail, desk space, auto parking, or any type of monetary reimbursement is furnished, the IRS and Department of Labor may determine the "independent" is in fact an employee. The contract should clearly spell out the services provided and the costs to the independent contractor. For example, if telephone, desk space, and mail services are provided, the contract should state the percentage of commission to be paid, less a specified percentage for the services and facilities provided by the agency.

Binding Authority

Under no circumstances should an independent contractor be granted any type of binding authority. If an agency allows an independent to bind risks, the agency is running the risk of having the independent classified as an employee. Also, the agency is again exposing its E&O policy to a potential loss.

Errors and Omissions and General Liability Insurance

Do the independent contractors carry their own E&O and general liability (GL) insurance? If they do in addition to having written contracts with the agency, this reduces the agency's exposure to and also strengthens the case that they are independents rather than employees.

If the independents do carry their own insurance, is the agency named as an additional insured? The agency should be named as an additional insured on the independent contractors' policies as respects the business placed by the independents through the agency. It provides additional protection to the agency against a claim that is the fault of the independent contractor.

Independent contractors should also be named on the agency's policies. However, they must be specifically named and identified as independent contractors. And, they are to be covered solely as respects any business placed through the agency facilities. Both the general liability and the errors and omissions underwriters will want to know the classes of business they write, the total premium volume. A separate charge will be made for them, which must be paid by the independent contractor.

Workers Compensation

Do the independent contractors carry their own WC insurance? If the independents have people working for them, then the law requires that they carry WC insurance. If the independent is a single individual, then he or she would not necessarily be required to carry WC. If the independent is named as a covered individual in the agency's WC policy, the IRS and the majority of states will classify the independent as an employee.

Internal Revenue Service Rule of 20

The IRS has established its own criteria for determining whether an individual is an employee or an independent contractor. The amount of weight given each of the rules listed below depends on each individual case being audited. Listed below are the 20 rules used in the determination:

As a general rule an individual will be considered an employee when they:

1. Must comply with the employer's work instructions.
2. Receive training from, or at the direction of, the employer.
3. Provide services that are an integral part of the employers business.
4. Provide services that must be rendered personally.
5. Hire, supervise and pay workers for the employer.
6. Have an ongoing working relationship with the employer.
7. Must follow set hours of work.
8. Work full time for the employer.
9. Do their work on the employer's premises.
10. Must do their work in a sequence set by the employer.
11. Must submit regular reports to the employer.
12. Receive payments of regular amounts at set intervals.
13. Receive payments for business and/or business expense.
14. Rely on the employer to provide tools and materials.
15. Lack a major investment in resources for providing services.
16. Cannot make a profit or suffer a loss from their services.
17. Work for one employer at a time.
18. Do not offer their services to the general public.
19. Can be fired by the employer.
20. May quit work at any time without incurring liability.

As can be seen, the IRS has expanded the generally accepted common-law factors that were reaffirmed by the U.S. Supreme Court. Some other governmental agencies feel the rules as established by the IRS are too vague and unclear. Clear rules are needed to determine how an individual is to be classified. Unfortunately, Congress repealed Section 1706 of the Internal Revenue Code, so the IRS is now forbidden by law from publishing any type of clear guidelines for employers. Any former "safe haven" provisions that would protect small business are now obsolete.

An employer can request a "private ruling" from the IRS to determine whether the individual is an employee or independent contractor. The findings cannot be used against the employer in future IRS audits. However, a tax attorney should be consulted prior to taking any such action.

The IRS has ruled in PUB 15-A—"Employers Supplemental Tax Guide" that:

Anyone who performs services for you is your employee if you can control what can be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

General Liability Insurance Policies

Under a GL policy there is an obligation to provide a defense to the "named insured" for any suit, whether groundless or not. Included under the definition of "insured" are employees of the named insured while acting in the course of their employment. However, independent contractors do not come under the definition of an "employee."

In a recent California case, the sales manager of the insured firm was an independent contractor and not an employee. The court held the independent was not entitled to be provided a defense under the insured firm's liability policy as an "employee". [Fireman's Fund Ins. Co. v Davis, 37 Cal App 4th 1432, 1443, 44 Cal Rptr 2d 546 (1995).]

Make certain any persons who are classified as "independent contractors" in your office are added as named insureds under both your E&O and your commercial general liability policies. Also, review all of your commercial insureds to determine if any of their personnel are classified as independent contractors, and review their policies to make certain they would be covered and provided defense in the event of a claim. Be sure to advise your commercial insureds of this new case and the potential consequences. Otherwise, you might be calling on your E&O insurer to defend you for failure to provide coverage.