HR Administration | 

Independent Contractors: 5 Key Facts You Need to Know

When a worker qualifies as an independent contractor, the employer is generally relieved of obligations related to payroll taxes, minimum wage and overtime requirements, benefits, workers' compensation, and unemployment costs for that individual. However, only a small fraction of workers qualify for independent contractor status.

Here are five key facts you need to know before classifying a worker as an independent contractor:

Fact #1: Workers are presumed to be employees.

The presumption is that a worker is an employee, unless he or she meets certain criteria established by federal and state tests. If an independent contractor classification is ever challenged, you will need to show that the worker meets these criteria.

Fact #2: Several tests assess status.

Employers can use a number of tests to evaluate a worker's status. The most common is the Internal Revenue Service (IRS) Common Law Test, which is used for federal tax purposes. This test generally looks at the extent to which the employer has the right to control the worker. Other tests include:

  • The Department of Labor (DOL) "economic realities" test to determine whether workers are covered by the Fair Labor Standards Act (FLSA). The FLSA regulates minimum wage, overtime, and other wage and hour issues.
  • The Equal Employment Opportunity Commission test to determine whether workers are covered under federal nondiscrimination laws.
  • Several states also have independent contractor tests to determine whether workers are entitled to unemployment compensation and other employee protections.

Under each of these tests, employers must weigh a variety of factors and no one factor stands alone in making a classification determination. Carefully review each test and consult legal counsel if you have specific questions before classifying any individual as an independent contractor.

Fact #3: The DOL recently provided new guidance on its test.

Under the DOL's "economic realities" test, an employee is someone who, as a matter of economic reality, is dependent upon the business to which he or she renders service. An independent contractor is generally not economically dependent upon the services they provide to one particular business.

In July 2015, the DOL issued an interpretation letter to provide further guidance on the test. Here is a summary of the economic realities test and the DOL's guidance:

  • The extent the work is integral to the business. If the work performed is integral to the employer's business, it is more likely that the worker is economically dependent on the employer and therefore an employee. The work can be integral to a business even if the work is just one component of the business and/or is performed by many other workers. Moreover, work can be integral to an employer's business even if it is performed away from the employer's premises.
  • The opportunity for profit and loss. Bona fide independent contractors have a chance to make a profit or to experience a loss. According to the DOL, the worker's decisions to hire others, purchase materials and equipment, negotiate contracts, advertise, rent space, recruit new clients, and manage time tables affect their opportunity for profit or loss. The focus is not on the worker's ability to work fewer or more hours at their own discretion, but rather on whether the worker exercises managerial skills and whether those skills affect their opportunity for profit and loss.
  • The permanency of the relationship. The DOL said that a worker's lack of a permanent or indefinite relationship with an employer is indicative of independent contractor status if it results from the worker's own independent business initiative (e.g. the worker markets his or services to and works for other businesses).
  • The investment in facilities and equipment. Bona fide independent contractors make an investment in tools, equipment, and facilities (and therefore undertake at least some risk for a loss). According to the DOL, the worker's investment must also be compared to the employer's investment.
  • The level of skill and initiative. A worker's business skills, judgment, and initiative, not his or her technical skills, help determine whether the worker is economically independent. Even if workers are highly skilled, they must operate as independent businesses in order to be classified as independent contractors.
  • The nature and degree of control. This factor evaluates who sets the pay and work hours and who determines how the work is performed. It also looks at whether the worker is free to work for others and hire their own workers. The DOL said that this is a complex factor that warrants careful review because both employees and independent contractors can have work situations that include minimal control by the employer.

Review the DOL guidance carefully, as well as all applicable independent contractor tests, before classifying anyone as an independent contractor.

Fact #4: The existence of a contract or Form 1099 does not prove independent contractor status.

The DOL has made clear that an agreement between an employer and a worker designating or labeling the worker as an independent contractor is not indicative of the worker's status. Simply having an agreement in place is not an indicator of the economic realities of the working relationship. Additionally, under the IRS Common Law test, the mere existence of a contract does not in itself prove that the worker is an independent contractor.

Additionally, the fact that Form 1099 was issued to the worker does not prove that he or she is in fact an independent contractor. Again, the worker must satisfy applicable federal and state tests to be classified as an independent contractor.

Fact #5: Misclassification is a major focus of enforcement.

Misclassification can deny workers the rights and protections to which they are entitled and reduce tax revenue collected by the federal government and states. For these reasons, federal and state agencies have identified misclassification of employees as independent contractors as one of their top enforcement priorities. The penalties for misclassification can be significant. In addition to owing back pay, overtime, and benefits to a misclassified worker, the employer may be ordered to pay back taxes, interest, and fines. In some states, employers that intentionally misclassify a worker may also face criminal charges or stop-work orders.

Conclusion:

Before classifying a worker as an independent contractor, make sure you satisfy all applicable federal and state tests. If, after applying the tests, you are still in doubt, it's a best practice to classify the worker as an employee. You may also request an official determination from the IRS using Form SS-8. Keep in mind, however, that it ordinarily takes at least six months to get an IRS determination.

SHARE THIS TIP | |

    Most Popular

    HR{preneur} - A podcast for small business