Classify workers correctly to avoid financial penalties and HR headachesWill the next person you hire be an employee or an independent contractor? In the U.S., your answer has four major consequences.
Start with taxes. For employees, you're required to:
- Withhold income taxes
- Withhold Social Security and Medicare taxes
- Pay employer Social Security and Medicare taxes
- Pay employer unemployment taxes (unless you opt to reimburse the state for any unemployment claims or pay into a trust that can be accessed in the event of an unemployment claim)
For independent contractors, none of these requirements apply.
Second, employees who are mistakenly classified as independent contractors have a lot to lose, including:
- Overtime pay
- Disability compensation
- Unemployment insurance
- The right to join a union and other workplace protections
Third, federal and state governments at all levels lose revenue when taxes aren't withheld properly.
Finally, organizations that mistakenly treat employees as independent contractors can be held liable for unpaid taxes.
Avoid financial penalties and HR headaches with the following guidelines.
Begin with basic definitions
The Fair Labor Standards Act defines employees as people who work for a single business or other organization. Such people are economically dependent on that organization, which controls what employees do during the work day.
In contrast, independent contractors can work for many customers or clients. This means that independent contractors are self-employed — not economically dependent on a single organization.
In addition, independent contractors stay in control of what they do. They sign written agreements to deliver certain goods or services, but their daily work activities aren't supervised by a customer or client.
Apply the IRS tests
Sometimes the line between employee and independent contractor gets blurred. When this happens, the IRS goes beyond basic definitions by applying three tests. These include:
- Behavioral. Does the organization control or have the right to control what the worker does and how the worker does his or her job?
- Financial. Does the organization control the monetary aspects of the worker's job — for instance, how the worker is paid and whether expenses are reimbursed?
- Relationship. Is the relationship between organization and worker defined by a single contract or by a set of benefits typically offered to employees (such as pension, health insurance and vacation pay)?
When applying these tests, the IRS considers several factors to be irrelevant:
- The presence of a signed contract. The fact that people sign an independent contractor agreement is not enough to classify them in this way. The controlling factor is the precise, day-to-day nature of the working relationship — not the label given to that relationship.
- Incorporation. Some workers can be classified as employees even if they're incorporated as a business or licensed by a government agency.
- Payment method. The timing of payments from organization to worker and method of payment are not enough to separate employees from independent contractors.
Apply the Department of Labor tests
More guidance comes from the U.S. Department of Labor in the form of "economic realities" that define a worker's degree of independence:
- The extent to which the work is an integral part of the business. If a worker's activities regularly and directly affect an organization's operations, then the worker is likely to be an employee.
- Whether workers' managerial skills affect the opportunity for profit and loss. Examples of managerial skills are hiring and supervising workers and investing in equipment.
- The worker's degree of risk. Independent contractors are more likely to bear a risk of financial loss.
- The worker's skill and initiative. Independent contractors generally exercise more independent judgment than employees. Contractors also compete with other workers for customers and clients.
- The permanency of the worker's relationship with the employer. A longer-term relationship with an organization suggests that a worker is an employee, not an independent contractor.
- The nature and degree of control by the employer. Independent contractors set their own work hours and choose how to spend those hours. However, this calls for careful review in light of the other tests. Some employees are allowed to work at home with minimal control by an employer.
Ask for help
After applying these tests, you might still feel unsure about whether to treat a worker as an employee or independent contractor. If so:
- File IRS Form SS-8, noting that it can take at least six months to get a reply
- Check out IRS Publication 1976 for details on relief from federal employment tax obligations
- Consider the Voluntary Classification Settlement Program, which allows organizations to reclassify workers as employees for future tax periods
The bottom line: When in doubt, seek guidance directly from the IRS.
This article draws on the expertise of Grace Davies, a Minneapolis-based attorney with special interest in product liability, medical malpractice and employment discrimination.
Department for Professional Employees, AFL-CIO: Misclassification of employees as independent contractors (2016)
U.S. Department of Labor: Fact Sheet 13: Am I an employee? (2014)