Posted on: April 12, 2023                                                                                                  

When a worker qualifies as an independent contractor, their 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.

Misclassification of employees as independent contractors can result in significant penalties, and this is an enforcement priority for federal and state authorities. The following are answers to some common questions about determining whether workers are bona fide independent contractors.

Q: What are independent contractors?

A: In general, independent contractors are service providers in an independent trade, business or profession who offer their services to the general public under a contract or agreement. While this classification depends on the facts in each case, the determination is based largely on the degree of control the business has over a worker. The more control the business has, the more likely that individual will be considered an employee.

Q: How do I determine if a worker is an employee or independent contractor?

A: The classification must always be made on the basis of whether the worker meets federal and state tests for independent contractor status. Different tests are used to determine whether a worker is covered by a particular law or benefit. You should carefully review each applicable test and consult legal counsel if you have specific questions before classifying any individual as an independent contractor.

Q: What test is used to determine whether a worker is an independent contractor for federal tax purposes?

A: The Internal Revenue Service uses the Common Law Test for federal tax purposes. The test has three broad categories to determine the appropriate classification of a worker:

• "Behavioral control" examines whether the company has the authority to direct and control the work of the service provider, and looks at whether the worker receives training and instruction.
• "Financial control" looks at factors such as whether the worker realizes a profit or loss, makes investments in tools and facilities, and has unreimbursed expenses.
• "Type of relationship" examines the nature of the relationship. This includes whether there is a written contract between the parties, the permanency of the relationship, and whether the worker is entitled to employee-type benefits.

Under this test, no one factor stands alone in making a classification determination. You need to weigh all factors (and take into account other applicable tests) when determining whether an individual is an employee or an independent contractor. Look at the entire relationship, consider the degree of control, and document each of the factors used in making a determination.

When in doubt, classify the worker as an employee. You may also request an official determination from the IRS using Form SS-8. However, it can take at least six months to get an IRS determination.

Q: What test is used to determine if workers are covered by the FLSA and entitled to minimum wage, overtime, and other wage and hour protections?

A: The Department of Labor (DOL) uses an "economic realities" test to determine whether workers are covered by the Fair Labor Standards Act (FLSA) and entitled to minimum wage, overtime, and other wage and hour protections. In recent years, the test has gone through changes.

Prior to 2021:

Before 2021, this test looked at the following factors, each carrying equal weight:

1. The alleged contractor's opportunities for profit and loss
2. The amount of the alleged contractor's investment in facilities and equipment
3. The permanency of the relationship
4. The nature and degree of control by the principal
5. The amount of initiative, judgment, or foresight in open market competition with others required for the contractor's success
6. The extent to which the services rendered are an integral part of the principal's business
7. The degree of independent business organization and operation

2021 Rule:

Toward the end of the Trump Administration, the DOL published a final rule (the 2021 rule) that sharpened the economic realities test into five distinct factors, including:

• Two "core factors" that carry more weight in the analysis. These two factors are the nature and degree of the worker's control over the work, and the worker's opportunity for profit or loss based on initiative and/or investment.
• Three other factors serve as additional guideposts in the analysis: the amount of skill required for the work; the degree of permanence of the working relationship between the worker and the potential employer; and whether the work is part of an integrated unit of production.

The Biden Administration tried to withdraw the 2021 rule, but a federal judge ultimately decided that the 2021 rule went into effect on March 8, 2021, as planned by the Trump Administration.

2022 Proposed Rule:

In October 2022, the DOL proposed revising the test. If finalized, the proposed rule would:

• Eliminate the use of “core factors” in the economic realities test.
• Restore the multifactor, totality-of-the-circumstances analysis to determine whether a worker is an employee or an independent contractor under the FLSA.
• Require the analysis be performed without assigning a predetermined weight to a particular set of factors.
• Return the consideration of investment to a stand-alone factor, focusing on whether the worker’s investment is capital or entrepreneurial in nature, and considering the worker’s investments on a relative basis with the employer’s investment.
• Provide additional analysis of the control factor, including detailed discussions of how scheduling, supervision, price-setting, and the ability to work for others should be considered when analyzing the degree of control over a worker — not just the control that is actually exerted.
• Return to an earlier interpretation of the integral factor, which considers whether the work is integral to the employer’s business — rather than whether it is exclusively part of an “integrated unit of production.”
• Rescind the 2021 rule.

If the changes are finalized, the economic realities test would look at the following factors as a result:

1. Opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the employer
3. Degree of permanence of the work relationship
4. Nature and degree of the business’s control over the worker
5. Extent to which the work performed is an integral part of the employer’s business
6. Skill and initiative

See the text of the proposed rule for details on these factors.

Q: What test is used for the purposes of federal nondiscrimination laws?

A: The Equal Employment Opportunity Commission (EEOC), which enforces federal nondiscrimination laws, looks at factors suggesting a worker is an employee and not an independent contractor, such as whether:

• The employer has the right to control when, where and how the worker performs the job.
• The work doesn't require a high level of skill or expertise.
• The employer furnishes the tools, materials and equipment.
• The work is performed on the employer's premises.
• There is a continuing relationship between the worker and the employer.
• The employer has the right to assign additional projects to the worker.
• The employer sets the hours of work and the duration of the job.
• The worker is paid by the hour, week or month, rather than the agreed cost of performing a particular job.
• The worker does not hire and pay assistants.
• The work performed by the worker is part of the regular business of the employer.
• The worker is not engaged in their own distinct occupation or business.
•  The employer provides the worker with benefits such as insurance, leave or workers' compensation.
• The worker is considered an employee of the employer for tax purposes (i.e., the employer withholds federal, state and Social Security taxes).
• The employer can discharge the worker.
• The worker and the employer believe they are creating an employer-employee relationship.

Q: How do state tests for independent contractors differ from federal tests?

A: Some states have their own tests, some of which are more difficult to satisfy than federal tests. For example, a number of states use the ABC test for determining whether an individual is covered under unemployment insurance and/or wage and hour laws or other benefits. Under this test, a worker must be considered an employee, unless all three of the following factors are met:

• The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
• The worker performs work that is outside the usual course of the hiring entity's business; and
• The worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed for the hiring entity.

Check your applicable state tests to ensure compliance.

Q: I have a written contract with several of my workers. Does this mean they are independent contractors?

A: The contract is one of many factors to consider, but the contract alone is not sufficient to determine the worker’s status.

Q: To lower costs, my boss wants to lay off a few employees and bring them back as independent contractors. Is that possible?

A: Unless the nature of the relationship changes to meet the requirements of independent contractor status, reinstating laid off employees and simply calling them independent contractors does not change their status.

Q: A candidate to whom we offered a job as an employee asked that we classify them as an independent contractor. Can we do this?

A: A worker cannot waive their employee status upon request. Rather, independent contractor tests must be satisfied to classify a worker as an independent contractor.

Conclusion

Before classifying a worker as an independent contractor, make sure all applicable federal and state tests are satisfied.