Independent Contractors vs. Employees: What employers need to know

Properly classifying employees is often a complicated task. It has been made even more complex in recent years due to the constantly shifting laws and guidelines regarding independent contractors.

The Department of Labor issued clarification on the matter in 2021, then rescinded it, and then reinstated it. On June 3rd of 2022, the Department of Labor announced that it is developing a new proposed rule on determining employee or independent contractor status under the FLSA. The DOL stated that the proposed rule is in response to the frequent misclassification of employees, which they called “one of the most serious problems facing affected employees, employers, and the U.S. economy”.

Meanwhile, the National Labor Relations Board (NLRB) is in the middle of updating its guidelines on the matter. Many states have also passed stringent laws that outline more specific requirements and tests for determining who may be paid as an independent contractor.

These frequent changes make it difficult for employers to keep up. However, misclassifying employees as independent contractors can have expensive consequences. Here’s what you need to know about the current state of independent contractor laws and federal guidance.

What is the difference between an independent contractor and an employee?

An independent contractor is a person who provides services or work for a business without having an employee relationship. Independent contractors are also sometimes referred to as freelancers. They often have multiple clients that they provide services for. The trade is that they are also meant to have a higher degree of autonomy than a traditional employee would when it comes to when, where, and how they perform work.

This arrangement is a great way for businesses to supplement their workforce. Independent contractors can often fill in in areas where a specialized skillset is required that cannot be found within their current workforce. They are also helpful for short-term or project-based work activities.

There is typically a trade-off for the worker. They get to have a higher degree of independence and control over how and when work is done. However, they forfeit some of the benefits and protections that come with being an employee. Independent contractors do not receive employee benefits such as health insurance from the business that they are performing work for. They are also typically responsible for the payroll taxes that the employer would typically pay including the employer’s share of Medicare taxes and Social Security taxes.

This arrangement can be mutually beneficial if done correctly, but some employers do intentionally misclassify employees as independent contractors to save money and avoid paying for taxes, paid time off, or benefits that they are legally obligated to provide. At other times, employers may make an honest classification mistake. Regardless, of intention, however, such mistakes can lead to a fair bit of trouble.

Independent contractors are often not protected under employment laws such as overtime and work hour laws, requirements for rest breaks, FMLA, FLSA, and more. When independent contractors have proper autonomy such as control over their own hours this is usually not a major problem for either party. However, employees misclassified as independent contractors often do not have that autonomy and may experience negative working conditions due to the lack of labor law protections.

When hiring independent contractors, payroll taxes require different end-of-year tax forms. Employees receive a form W-2 with total compensation and payroll taxes withheld listed. Independent contractors receive a 1099 form and typically do not have any tax withheld from their checks. Instead, they are responsible for filing quarterly estimated tax payments.

Who can be classified as an independent contractor?

Department of Labor guidance

The DOL has published guidance on independent contractor statuses under the Fair Labor Standards Act (FLSA) through a helpful fact sheet for employers. However, it is important to keep in mind that they are currently in the process of refining their rules on the matter.

The DOL considers an employee to be a worker who follows the usual path of an employee. He/she is dependent on the business for work, unlike a person who is engaged in their own business. The employer-employee relationship under the FLSA is tested by “economic reality” rather than “technical concepts”.

The DOL points out that the U.S. Supreme Court has on a number of occasions indicated that there is no single rule or test for determining whether an individual is an independent contractor or an employee for purposes of the FLSA. The Court has held that it is the total employment relationship and all factors pertaining to it that must be weighed.

Some factors that the Court and DOL consider significant when determining independent contractor classifications are:

  • The extent to which the services rendered are an integral part of the principal’s business.

  • The permanency of the relationship.

  • The amount of the alleged contractor’s investment in facilities and equipment.

  • The nature and degree of control by the principal.

  • The alleged contractor’s opportunities for profit and loss.

  • The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.

  • The degree of independent business organization and operation.

Per the DOL and prior court rulings, there are certain factors that are considered immaterial in determining whether there is an employment relationship. These include the place where work is performed, the absence of a formal employment agreement, or whether an alleged independent contractor is licensed by State/local government.

Additionally, the Supreme Court has held that the time or mode of pay does not control the determination of employee status. You will notice that this is not necessarily consistent with some other agency’s guidelines for evaluating independent contractor classifications.

IRS guidance

The IRS advises that employers should consider the degree of control and independence of the worker when distinguishing between independent contractors and employees.

Businesses are advised to analyze the proposed working arrangement to identify the level of independence that will be provided.

Factors that can provide evidence of the degree of control and independence fall into these three categories:

  1. Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job? This can also include whether work hours are set by the business or worker.

  2. Financial. Are the business aspects of the worker’s job controlled by the business? Does the business provide all necessary tools or equipment or does the worker provide their own tools? It can also help to look at whether the worker is reimbursed for expenses incurred while completing the work. Some expenses may be included on independent contractor invoices, but the basic tools or programs required to complete the work are often provided by the contractor. For example, a graphic designer employed as an independent contractor would likely use their own computer and design software whereas employees often have work devices and any necessary software program subscriptions provided.

  3. Type of relationship. Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business? Is the worker treated as a supplemental resource to the business’ internal staff or are they working alongside them during similar hours and on similar projects?

Unfortunately, there is still room for confusion within these guidelines as the IRS does not prescribe a specific test or scoring system. Business owners must weigh all the above factors and do their best to come to a reasonable decision. Some factors may seem to indicate that the worker should be classified as an employee, while others may indicate that an independent contractor classification would be acceptable.

Look at the entire working relationship and agreement and analyze the level of control over the worker that the business would have. Be sure to document each of the factors considered and the final determination. These records can be helpful if the issue ever goes to court or the IRS.

California laws on independent contractors

California has one of the strictest laws regarding independent classification in the country. California employers must use the ABC test to determine whether a worker may be classified as an independent contractor vs an employee.

Under the ABC test, a worker is considered an employee and not an independent contractor, unless the hiring entity satisfies all three of the following conditions:

  1. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;

  2. The worker performs work that is outside the usual course of the hiring entity’s business; and

  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Employers outside of California may also find value in using the ABC test if they are still having difficulty determining the appropriate classification for a worker after reviewing the DOL and IRS guidance. Since the ABC test is more restrictive than any of the federal guidelines, a worker that passes it is likely to be safely classified as an independent contractor in other areas of the country unless covered under other specific state or local laws.

What if I can’t figure out how to classify an employee?

Sometimes a specific working arrangement really toes the line between employee and independent contractor. If you are in one of those situations and can’t determine which one applies, here are some options to explore.

Ask the IRS

If it is still unclear whether a worker is an employee or an independent contractor after reviewing the definitions, IRS guidance, and DOL guidance, you can file Form SS-8 and let the IRS decide.

Form SS-8 is the Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding form. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.

Though be aware that the IRS is not always the most prompt in responding to filings. You’ll also need to consider whether any state laws may be applicable. It is technically possible for a worker to be classed as an independent contractor for federal purposes and an employee for state tax purposes in states like California with more stringent classification guidelines.

Consult an attorney

Since waiting on an IRS decision can take months and many business owners fear that submitting a SS-8 will result in an audit, consulting with an attorney is a popular alternative. Typically tax or employment attorneys are able to advise on employee classification matters concerning independent contractors.

If your business operates with a largely remote workforce this approach can be a bit trickier if some of the employees are in states with laws beyond the federal employee classification laws. Ensure that you are receiving legal guidance from attorneys that are familiar with all of the relevant laws and requirements.

Penalties for misclassifying employees as independent contractors

This all might sound like a lot of work for a fairly unimportant distinction, but there are strict penalties for misclassifying workers so it is worthwhile to invest time into determining the proper classification.

It is worth noting that these penalties apply for misclassifying employees as independent contractors. This is because workers that are treated as employees but classified as workers end up paying higher taxes, receiving no benefits, and having fewer legal protections without being able to reap the benefits of independent contractor work such as greater autonomy and control.

Classifying independent contractor eligible workers as employees does not result in penalties as it’s a process that does not provide a financial benefit for the employer. The employer ends up paying more in taxes and for benefits, leave, unemployment insurance, rest breaks, and PTO. As such, this is typically not considered a misclassification and there are unlikely to be any damages worth pursuing from the worker or the government. As such it would simply be considered a flexible working arrangement within an employment relationship in most cases.

IRS obligations

If a business misclassifies an employee as an independent contractor and cannot demonstrate that they had a reasonable basis for doing so, they may end up owing the IRS. The amount owed will typically be equal to the amount of employment taxes that would have been owed to the IRS for that worker.

Some penalties may be avoided by proactively reclassifying workers. Voluntary Classification Settlement Program (VCSP) is an optional program that provides small business owners with an opportunity to reclassify their workers as employees for future tax periods for employment tax purposes. It provides partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers as employees. To participate in this voluntary program, the business must meet certain eligibility requirements.

Civil penalties

Lawsuits for misclassification of employees as independent contractors have become increasingly common. This is something that you’ll want to take care to avoid as it can be quite costly. If sued, your business may incur costly legal fees, negative PR, fines, and a number of other fees. Employers may be ordered to provide misclassified workers with back pay for overtime and other wages. Repayment for benefits, PTO, leave, and other compensation that employees are eligible for is also common. Workers’ compensation back pay may also be ordered. Punitive damages may be added if the court believes that the misclassification was intentional.

Being sued and losing a case for employee misclassification can also trigger an audit of your business’ tax and employment records. This is something that all businesses want to avoid as it is a tedious and bureaucratic process. The business will also incur additional financial liability if additional instances of employee misclassification are found during the audit.

Keeping up with changing expectations

It is important to keep in mind that these rules are constantly changing and being updated. Both the Department of Labor and the National Labor Relations Board are in the process of updating their independent contractor classification guidelines and proposing updated rules. Keep checking for new updates from those agencies and be sure to review any changes to state and local labor laws annually at a minimum.