Employee vs. independent contractor: What employers need to know

There's more than one test to determine if an independent contractor is actually an employee, and getting it wrong can cost you more than back pay—it can cost you your freedom.

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Diane Faulkner

by Diane Faulkner

Diane is a writer, speaker, and human resource consultant with over 30 years of experience working in and covering em.

Updated on: November 22, 2023 · 8 min read

The three sets of tests to determine status
Common questions
Common problem
Multiplying investigations

Classifying workers as employees or independent contractors is a tricky business. After all, the rules change as often as the administrations in Washington, D.C.

On Jan. 6, 2021, the U.S. Department of Labor (DoL) issued its final rule clarifying who an independent contractor is versus an employee. But by May 5th, the clarification was rescinded. Earlier, the National Labor Relations Board (NLRB) eliminated three of its factors that clarified the definition of an independent contractor. Meanwhile, the IRS held fast to its two key points with nine clarifying aspects.

With all these rules and changes floating around, how are you to know how to classify work without getting into trouble?

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The three sets of tests to determine status

More than one government agency has a test to define what an independent contractor is. Each has its own angle, which means that each has a slightly different focus. That said, many test factors coincide, while others contradict each other. If you make a good faith effort to clear as many factors as possible, you'll be well on your way to classifying workers correctly.

Department of Labor test

The U.S. Supreme Court has repeatedly held there is no single rule or test for determining whether someone is an independent contractor (1099-NEC) or an employee (W-2) for the purposes of the Fair Labor Standards Act (FLSA).

Rather, the Court says, "it's the total activity or situation which controls. Among the factors which the Court has considered significant are:

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

The Court considers immaterial:

The place where work is performed.
The absence of a formal employment agreement.
Whether an alleged independent contractor is licensed by state or local government.
The time or mode of pay does not control the determination of employee status.

Even though there is no one determinative factor, "the biggest factor is going to be the degree of control," says David Miklas, employment attorney with Miklas Employment Law. "The key thing for control that I usually see is if the worker:

Chooses what hours they're going to work
Is not monitored or supervised
Does not receive performance evaluations
Is permitted to work for other businesses
Is not bound by a non-compete agreement

—that looks like an independent contractor."

"On the flip side," Miklas says, "if the worker has to work long hours, maybe 50, 60, 70 hours a week, that makes it almost impossible to work for anyone else, let alone competitors, that looks like an employee. Also, if workers have to:

Work in flexible shifts, e.g., 12- or 15-hour days
Sign a non-compete
Have work inspected
Receive performance evaluations
Receive an employee handbook

–that's what you do with employees."

The IRS test

As you might guess, the IRS is concerned about its tax base. With employees, you must withhold income taxes, pay Social Security, Medicare taxes, and unemployment taxes on all wages paid to employees. None of that happens with independent contractors. Instead, independent contractors must pay their own taxes.

The two key points the IRS says you have to keep in mind when classifying employees are:

Control. If the business controls what work is accomplished and directs how it's done, it exerts behavioral control. If the business directs or controls financial and certain relevant aspects of a worker's job, it exercises financial control. This includes:
- The extent of the worker's investment in the facilities or tools used in performing services
- The extent to which the worker makes services available to the relevant market
- How the business pays the worker
- The extent to which the worker can realize a profit or incur a loss
Relationship. How the employer and worker perceive their relationship is also important for determining worker status. Key topics to think about include:
- Written contracts describing the relationship the parties intended to create
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation, or sick pay
- The permanency of the relationship
- The extent to which services performed by the worker are a key aspect of the regular business of the company
- The extent to which the worker has unreimbursed business expenses."

"If you still cannot determine if a worker is an employee or independent contractor," says Talibah Bayles, founder, and CEO of TMB Tax and Financial Services, "the IRS has a form that business owners can use to let the IRS figure it out for you. It's the Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

National Labor Relations Board (NLRB) test

Since many small business owners do not have unionized employees, they aren't as familiar with this test. Whether or not your employees are unionized, however, these factors still apply.

Miklas describes the 10 factors:

Extent of control the company has over the worker
Whether or not the one who's working is engaged in a distinct occupation or business
Whether the work is usually done under the direction and supervision of an employer
Whether a skill or license or specialized training is required
Who buys the supplies, instrumentalities, or tools
The length of time workers provide services, e.g., two months versus two years
Method of payment, e.g., hourly or by project
Whether or not the work is part of the regular business of the employer
Whether or not the parties engaged in an independent contractor agreement
Whether the principal is or is not a business

"No one factor is decisive," Miklas says. "If you have an independent contractor bucket and an employee bucket, you're never going to get every drop of water into one bucket. You're going to have some go into each bucket. Whichever bucket is the most full, that's most likely where the NLRB will go with its findings."

Common questions

There are two common questions people have when it comes to classification: Can you tell an independent contractor:

When to work?
What to wear?

"The answer is 'sometimes,'" says Aaron Tandy, partner and head of employment law section at Pathman, Lewis. Tandy explains that you could have two painters working in an apartment complex: One on staff, the other as an independent contractor. The staff painter works from 8 a.m. to 5 p.m., Monday through Friday, wears a company shirt, and is paid a wage. The independent contractor is contracted to design and paint a mural. She works on the mural on her own schedule, but the building owner can restrict the days and times she can access the building. The building owner can also give her a company shirt to wear, so residents are not alarmed that this stranger is painting in the building. She gets paid by invoice to turn over the copyright for the image she created to the company. As you can see, things aren't always clear-cut.

Common problem

The most common way companies get into trouble with misclassification is by not paying overtime. To save money, they'll wrongly misclassify employees as independent contractors to specifically not pay overtime. They also save money because they don't have to pay taxes on independent contractors, can't get sued under most of the discrimination laws, and don't have to deal with unions.

"I usually see it where someone wants to save as much money as possible, and [the company] works people 50, 60, 70 hours a week and won't pay overtime because they've misclassified [the people]," says Miklas. Then they get caught. "Now they're on the hook for back pay, which can be extraordinarily high. And most likely, if you've misclassified one person, you've misclassified an entire group. These aren't $2,000 settlements. They could be significant enough to bankrupt a company." Plus, misclassifying employees is a federal offense, so there can also be jail time for the company owner.

Multiplying investigations

Once an employer is caught in an investigation by any one of the three government agencies—usually for not paying overtime—they can expect to be investigated by other agencies, possibly state and local government agencies, too. This is because many agencies have work-sharing agreements with each other. The U.S. Department of Labor, for example, has a work-sharing agreement with the Florida Department of Revenue. If one is investigating you and finds evidence of wrongdoing, they'll notify the other. "As part of that," says Miklas, "they'll make a referral of a complaint, and then they'll coordinate their investigations and even cooperate with criminal investigations."

Investigations can go back two years. If there are willful violations, investigators will go back three years. Then they keep coming back every two years.

"The biggest problem," says Miklas, "is that people don't seek legal advice. They don't want to know they're doing it wrong, and when they get caught, they just want to get out of trouble. At that point, you're just writing a check."

With the new administration's focus on making it difficult to be classified as an independent contractor, "there are going to be more challenges," Miklas warns. "Now's the time companies should be auditing [themselves] and making sure these people really are independent contractors."

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This article is for informational purposes. This content is not legal advice, it is the expression of the author and has not been evaluated by LegalZoom for accuracy or changes in the law.