Employee vs. Independent Contractor Status
The IRS, Dept. of Labor, and States Look at Worker Status - So Should Employers
How do you tell an employee from an independent contractor? It's often a difficult question, but it's one that has many serious implications. The IRS and some state regulators watch closely to make sure workers are classified correctly.
New Dept. of Labor Rules for Independent Contractor Status
The U.S. Department of Labor (DOL) has announced new guidelines on independent contractor status in a changing job market, including gig workers. Only employees are covered by the DOL's wage and hour law for minimum wage, overtime, child labor, and benefit protections.
The DOL's final rule clarifies the process of differentiating between independent contractors and employees, with several tests, effective March 8, 2021:
An economic reality test that looks at whether the worker is in an independent business or is dependent on an employer
An additional test of independence using two core factors: nature and degree of control over the work and opportunity for profit or loss
Three other factors to be used as guidelines when the two core factors disagree:
- The amount of skill required for the wowk
- The permanence of the working relationship
- Whether the work is integral to the business products or services
The DOL also noted that actual practice is more important than a contract or theoretical possibilities.
The Department of Labor rules, IRS rules, and your state's rules for classifying workers are all different. A worker may be classified as an employee under one rule and an independent contractor under another rule. Get help from an employment attorney to help you sort this out.
An Example: Classifying Ride-Sharing Drivers
Here's an example (from 2015) that explains the difficulty in classifying workers: California's Labor Commission said that an Uber driver should be classified as an employee, not an independent contractor, as Uber claimed. This ruling affected only one driver, and several other states have ruled that Uber drivers are contractors. Uber appealed the ruling and another similar one in Florida.
More of these lawsuits, including some of the class action variety, are or will be headed to the courts soon. Note that it's not just the IRS, but states, that can make this determination.
Are Your Workers Classified Correctly?
The IRS considers a worker to be an employee unless independent contractor status is clearly indicated by the relationship. The IRS evaluates every situation on a case-by-case basis.
This article looks at the definitions of employee and independent contractor, explains the benefits and disadvantages of employee and independent contractor status for employers, and discusses how the IRS evaluates individual cases,
An employee (sometimes called a common-law employee) is a worker who performs services at the direction of an employer; the employer controls the work of the employee. In general, anyone who performs services for an organization is an employee if the organization can control what will be done and how it will be done.
Some factors that might make a worker an employee:
- The employer assigns the person to work specific days and hours.
- The employee must go to the employer for approval and must make periodic reports.
- Customers are the property of the employer, not the employee.
- The employee is paid a specific salary or hourly wage.
What is an Independent Contractor?
Independent contractors are business owners who are in a trade, business, or profession, offering their services to the general public. The general rule is that someone is an independent contractor if the person paying them can control or direct only the result of the work, not what will be done or how it will be done.
For example, if you hire a cleaning service to clean your offices, you are paying them for their expertise in cleaning. You can tell them when you want the work done and what areas you want to be cleaned, but not how to clean, what tools and supplies to use, or how the cleaning should be done.
The IRS previously used a "20-factor test" to makes its determinations on worker status. The IRS used these factors as a guideline, not a checklist, and cases, as now, were decided on a case-by-case basis.
Currently the IRS now uses three common law rules to review specific cases to determine independent contractor or employee status.
- Behavioral. Does the company control or have the right to control what the worker does and how the work is done?
- Financial. Does the company control the worker's pay? Does the company reimburse the person for expenses? (Independent contractors typically pay their own expenses.) Who provides the tools and supplies?
- Type of Relationship. Is there a contract that specifies the relationship? Does the worker receive benefits? Is the work a key aspect of the business? (Cleaning offices isn't a key aspect of a software company.)
See this IRS article on Understanding Employee vs. Independent Contractor Designation for more details on the three factors.
The existence of a contract and its wording isn't proof of worker status. The IRS considers a contract as just one factor in its decision about a worker's status.
State Tests for Independent Contractor Status
Some states have their own requirements for classifying workers as independent contractors vs. employees, usually for the purpose of unemployment insurance and workers' compensation. These requirements are usually more restrictive than the IRS test (described above).
California and some other states use a three-factor ABC test that requires all three factors that must be met for the worker to be considered as an independent contractor:
A. The worker is not under the control of the employer for work performance.
B. The work is NOT within the usual course of the employer's business (the cleaning service doing work for a software company, for example).
C. The worker is engaged in an independent trade, occupation, profession, or business.
Generally, employees and independent contractors are paid for their work in different ways.
Employees are paid on an hourly or salaried basis, and they receive a W-2 showing their total earnings for the year. Employees also may receive benefits, including health coverage, and paid time off for holidays or vacations.
Independent contractors are paid by the job or by the hour, and they receive a 1099-NEC (beginning in 2020) showing their total payments for the year.
One key factor that separates employees from independent contractors is that employees have federal income taxes and FICA taxes (Social Security/Medicare) withheld from their pay. In most cases, you don't withhold these taxes from payments you make to an independent contractor unless the worker is subject to backup withholding.
Another Example: Salespeople as Independent Contractors vs. Employees
Disputes about worker status (employee or independent contractor) between the IRS or states sometimes end up in court. This case shows how a court looks at the issue, taking each point separately.
Salespeople fall into the same categories of employees vs. independent contractors. These situations are handled on a case-by-case basis, but one case stands out for its detail.
In a 2008 case in district appeals court, the Court (U.S. v. Porter) used the IRS 20-factor test and had some specific findings:
- The salesmen (all men in this case) had no set territory, no set hours of work, and no one else had control over when they worked. All three of these factors indicate an independent contractor situation.
- All of the salesmen had training, which consisted of riding along, providing advice, or seminars, but much of the training had to do with the specifics of the products being sold, rather than details of how to sell. The Court decided that this factor was only "minimally" decisive.
- There was no requirement that the salesmen submit written reports, although some submitted these reports voluntarily.
- Expenses were paid by the company and the salesmen were provided a vehicle to use to make sales calls and deliver products. Both of these factors indicate an employment relationship.
- The salesmen did not invest in facilities to use in performing duties; they were reimbursed for these expenses, indicate an employer-employee relationship.
- Either the salesman or the company could terminate the relationship at any time - this indicates an employment situation.
- Finally, the salesmen said they were not provided with health benefits or other employee benefits.
The Court's decision said that there were a number of factors indicating an independent contractor relationship, but they were not compelling enough to change the status of these salesmen from employees to independent contractors.
You can request a determination letter from the IRS on the status of a worker, using Form SS-8. Getting a determination voluntarily can help you avoid fines and penalties for misclassification of a worker. The penalties come from failure to properly classify the person as an employee and for failing to withhold income taxes and FICA taxes from the person's pay.
The form asks a series of questions about behavioral control, financial control, and the relationship between your business and the worker, and you can include an explanation of why you believe the worker is an independent contractor or an employee.
Other IRS Programs Dealing with Worker Classification
The IRS has two other programs dealing with misclassification of workers:
Section 530 relief is a process of applying for an exemption from paying back employment taxes.
The Voluntary Classification Settlement Program gives businesses an opportunity to reclassify workers as employees with partial relief from federal employment taxes.
Employees vs. Independent Contractors Compared
Here is a quick comparison between employees and independent contractors:
|Control by Employer||Controls both what will be done and how||Only controls the result of work|
|Pay and Benefits||Paid salary or hourly wages, may receive benefits||Paid by the hour or the job, with no benefits|
|Withholding from Payments||Federal/state income taxes and FICA taxes withheld||No withholding|
|Annual report||Form W-2||Form 1099-NEC (2020 and beyond)|
|Eligible for unemployment benefits, workers' compensation||Yes||Not usually|
|Receives a contract||Not usually, except for executives||Should have a contract|