The first article I ever wrote for this site, way back in 2011, was about this subject — the seemingly always relevant and never easily decided matter of worker classification. A few things have happened in the intervening four years to warrant an update:
- Despite the agency’s continued budget cuts, worker misclassification remains a priority for the IRS, mostly because having workers classified as employees is an easier and more efficient way to collect taxes.
- The “Gig Economy” undermines the very definition of “employee” in the 21st century, and is a growing focus of lawsuits and politicians.
- New guidance from the U.S. Department of Labor emphasizes using an “economic realities test” to determine a worker’s classification, and appears to signal that many more workers should be classified as employees under the Fair Labor Standards Act (FLSA).
That’s a lot — and this article just gives a broad overview of the current lay of the land. Perhaps the most frustrating aspect of this area of law is its gross inconsistency. What’s true for one industry isn’t necessarily true for a different line of work.
Employee or independent contractor for income tax purposes
First, it’s important to distinguish worker classification for tax purposes and labor law purposes. IRS regulations and state labor laws aren’t always in agreement.
For the IRS, three factors are used to determine if an employee has been misclassified as an independent contractor.
- The behavioral test — If the company controls or has right to control the manner in which the work is performed, the worker is more likely an employee. Typical examples of having the right to control include giving instructions, offering job training, and requiring set hours of work.
- The financial test — Who controls the economics of the worker’s job? Payment based on hours worked, company provision of tools, and reimbursed expenses generally imply employee status. If the worker offers her services to the general public and has the opportunity to experience profit or loss, she’s more likely an independent contractor.
- The type of relationship test — In the most traditional sense, an independent contractor is someone who has a distinct profession or business, and who performs her services at a specified rate for the person or company who “hires” her. The relationship is generally impermanent or indefinite, she supplies her own tools, and doesn’t expect to receive company benefits.
These factors can only be used as a guide, and the IRS specifically states that there are are no degrees of importance between them. No one factor is given more weight than any other. The decision varies depending upon occupation and context.
A simple example to illustrate these tests is a plumber.
Tom comes home from work and sees that his toilet is overflowing, so he Googles a plumber. The plumber comes out, repairs the toilet, and sends Tom a bill. Tom pays the bill and the relationship ends until the next time Tom needs the services of a plumber. In this scenario, no one would describe the plumber as Tom’s “employee.” The plumber drives his own truck to Tom’s house, brings his own tools, uses his professional skill to fix the toilet, and expects Tom to pay the bill.
What’s not so clear is the case of the Uber driver — who drives her own vehicle but relies upon Uber to connect her with folks needing a ride. And that’s what state labor commissions are trying to make clear, followed up last month by the U.S. Dept. of Labor’s new guidance.
Employee or independent contractor: labor’s view
The DoL’s new guidance is significantly broader than the IRS guidelines, and seems much more likely to ensnare unsuspecting companies. It’s based on an “economics realities test, “ for which the key question is whether a worker is economically-dependent on the company (like an employee), or whether the worker is truly in business for herself (like an independent contractor).
The “economic realities test” relies on six factors (some of which overlap with the IRS tests):
- The extent to which the work performed is an integral part of the company’s business;
- The worker’s opportunity for profit or loss depending on her managerial skill;
- The extent of the relative investments of the worker and the company;
- Whether the work performed requires specialized skills or initiative;
- Whether the relationship is temporary;
- The degree of control exercised by the company.
Like the IRS guidelines, no one factor is determinative. Independent contractors can be treated as employees if their work is “integral” to the company’s business, even if done off-premises. Workers who supply their own tools won’t necessarily be classified as contractors, nor will those who perform work for more than one company.
It’s important to note that the new labor rules don’t change the income tax standards for worker classification. The IRS will continue to use its three-factor test, but it’s likely that the Dept. of Labor will continue sharing misclassification referrals with IRS. (If Labor says that a company’s workers are employees for labor law purposes, the company will probably face an uphill battle convincing the IRS otherwise for tax purposes.)
What to do?
What are the solutions to this quagmire? Is industry standard practice good enough? A written agreement between the parties? It depends. But here are three ideas for mitigating risk:
- Reclassify independent contractors as employees. The IRS offers an amnesty program for this purpose.
- Restructure independent contractor relationships so that they’re more compliant with the “economic realities test.”
- Utilize staffing or workforce management firms or other third-party vendors for hiring independent contractors.
There are pros and cons to each possible solution, and different standards for different industries. If you’re genuinely unsure about your company’s situation, the best course of action is to consult your accountant or attorney.