Independent Contractor vs Employee Classification: An Overview
Many workers in the United States are classified as independent contractors (IC) instead of as employees. While the IC classification is appropriate for many, many still are — often intentionally — misclassified as ICs in order to save money. This is because ICs are not entitled to the following benefits legally enjoyed by workers classified as employees:
- An employer’s share of Social Security (FICA) and Medicare taxes
- Overtime and minimum wage payments
- Employee health insurance premiums
- Employee retirement benefits, vacation, holiday, and sick pay
- Other employee fringe benefits, such as stock options
- Federal and state unemployment compensation taxes (FUTA and SUTA)
- Workers’ compensation insurance premiums.
Regulators take this issue very seriously. Unreported or underreported employment taxes contribute to the overall federal tax gap, representing nearly 70% of all outstanding revenue to be paid to the IRS. The IRS, therefore, vigorously seeks back taxes and penalties from employers that wrongly classified workers as self-employed contractors.
At the same time, the U.S. Department of Labor and Department of Justice and their state counterparts actively ensure that workers are properly classified. Any worker who thinks he has been misclassified as an IC can file a complaint with either the U.S. Department of Labor (DOL) or the applicable state department of labor or unemployment agency. Most recently, these agencies have been investigating the rapidly growing economy created by various freelance services such as Uber and Lyft.
Federal penalties for worker misclassification can be severe. Ramifications vary depending on the DOL or the IRS’s determination of whether the misclassification was unintentional, intentional, or even fraudulent. If the mis-classification was unintentional, the employer faces penalties based on the fact that all payments to misclassified ICs are reclassified as wages. But, if the IRS suspects intentional misconduct or fraud, it can and likely will impose additional fines and penalties.
Criminal penalties can be assessed and the court can impose a prison sentence as well. Persons responsible for withholding payroll taxes may even be held personally liable for any uncollected or unremitted tax under the responsible person penalty statute and its state counterparts. Each worker who has been misclassified as an IC may be awarded wages, overtime, and additional compensation.
After an employer is charged at the federal level, the matter may still be referred to state tax or labor authorities, who have the ability to impose their own back taxes, interest, fines, and penalties. In addition, employers could also face individual lawsuits from workers claiming they were denied benefits because of an improper classification. The current trend in worker misclassification litigation frequently involves the filing of a class action lawsuit against the employer, especially in the courts of an employee-friendly state such as California.
One of the major challenges for employers is determining whether a worker should be classified as an employee or an IC. Of the tests to determine this, the best known is the standard “common law” 20-factor test; however, many other recent tests have been generated by various agency rulings and court cases. Since both the IRS and the DOL have ramped up their policing of this issue, many new tests have been generated in recent years.
At the federal payroll tax level alone, there are several tests to examine. Two tests in particular require attention:
- Common law 20-factor test
- IRS three-factor test
The common law test, originally developed by the IRS, uses 20 factors to evaluate right of control and the resulting validity of the independent contractor classification:
- Level of instruction.
- Amount of training.
- Degree of business integration.
- Extent of personal services.
- Control of assistants.
- Continuity of relationship.
- Flexibility of schedule.
- Demands for full-time work.
- Need for on-site services.
- Sequence of work.
- Requirements for reports.
- Method of payment.
- Payment of business or travel expenses.
- Provision of tools and materials.
- Investment in facilities.
- Realization of profit or loss.
- Work for multiple companies.
- Availability to public.
- Control over discharge.
- Right of termination.
Although the IRS has long used the 20-factor test to determine the relationship of a worker and employer, it now groups those factors into three broad categories. The 20-factor test may still be used for reference purposes, but the preferred method now is to consider every piece of information in a case that helps to decide the extent to which the putative employer does or does not retain the right to control the worker. The evidence gathered tends to fall into three main categories: behavioral control, financial control, and relationship control (hence, the three factors).
The behavioral control test focuses on whether the company controls or has the right to control what the worker does and how the job is done. Behavioral control factors include types of instruction given, degree of instruction, evaluation systems, and training.
The financial control test looks at who controls the economics of the worker’s job. Being able to work for multiple employers and providing one’s own tools may indicate IC status. Factors pointing to employee status are eligibility for reimbursement of travel costs and payment based on hours worked. The financial control factors are significant investment, unreimbursed expenses, opportunity for profit or loss, availability of the services to the market, and method of payment.
The relationship control test examines how the parties perceive each other. Providing paid vacation and retirement benefits indicates a worker is likely an employee, as does hiring to provide services indefinitely rather than for a specific time period. Written language stating the worker is an IC is not determinative. The factors include the existence of written contracts, offering of employee benefits, permanency of the relationship, and services provided as a key activity of the business.
Employers must weigh all of the above factors when determining whether a worker is an employee or an IC. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an IC; there is no set number of factors that makes the worker an employee or an IC, and no one factor stands alone in making this determination. Also, factors that are relevant in one situation may not be relevant in another. The key is to look at the entire relationship, consider the degree or extent of the right to direct and control, and to document each of the factors used in coming up with the determination.
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