Employee or Independent Contractor: How to Get it Right

Whether it’s ignorance or willful disregard, court dockets are full of cases of employee misclassification. Many of these show up in district courts as protests under the Federal Fair Labor Standards Act (FLSA), but a few make it to the U.S. Tax Court.

This means a potential double whammy if your clients misclassify employees as independent contractors. For violations of the FLSA, employers may owe back pay and damages to the worker, plus civil penalties to the Department of Labor (DOL). On the IRS side, employers who misclassify employees as independent contractors will be liable for outstanding payroll taxes, plus penalties and interest.

In general, the IRS classifies workers by the level of control the employer exerts over the worker, while the DOL looks at economic dependence. There’s considerable overlap in the analysis of these two agencies, so let’s take a look at the factors you and your clients need to be aware of.

Analysis by the IRS

The IRS looks at three areas of control: behavioral, financial and the type of relationship.

Behavioral Control – When the employer has the right to specify how, when, where, and with what machinery or equipment the work gets done, this indicates an employer-employee relationship. Independent contractors are generally free to use whatever means they judge best to get the work done and tend to be evaluated solely on the quality of the final work product. Employees, on the other hand, may be evaluated on the basis of how the work is done in addition to the quality of their work.

Financial Control – Independent contractors have the opportunity for profit or loss, while employees generally do not. Contractors usually receive reimbursement for any out-of-pocket expenses and generally have a greater burden of investment in equipment, tools or machinery to get the work done. However, some workers, including those in construction, have to make a considerable investment in tools, but this doesn’t mean they are independent contractors. Independent contractors are generally free to offer their services to others in the marketplace, while an employee may be restricted to one employer. 

Type of Relationship – A written contract may indicate that a worker is an independent contractor, but the IRS may ignore it if other factors suggest otherwise. Employees may receive benefits from their employer, while independent contractors generally do not. A permanent or indefinite work relationship generally signals an employee relationship, while an agreement for a specified period of time or a specific project points to independent contractor status. Employees tend to provide the services that constitute the key offering of the employer.

Analysis by the DOL

The DOL, on the other hand, focuses on the economic relationship between the worker and employee. In general, workers who are economically dependent on the business of the employer will be considered employees. Workers who have their own businesses and are not economically dependent on the employer will be treated as independent contractors. Similar to the IRS, the DOL looks beyond the form of any worker-employer agreement to the substance. The existence of a contract does not control the classification.

Here are the main factors that the DOL looks at when applying the FLSA:

1. Is the work an integral part of the employer’s business? Work that’s part of a manufacturing process or the main service offering of the employer generally implies an employee relationship.
2. Does the worker’s managerial skills impact his or her opportunity for profit or loss? Independent contractors bear the risk of loss for their decisions, while employees generally do not.
3. What are the relative investments in equipment or facilities made by the employer and the worker? As above, independent contractors tend to invest more in their trade than employees, but there are exceptions, such as construction workers.
4. The worker’s skill and initiative. A worker who takes the initiative to compete with others in the marketplace and has management skills to operate as an independent business is generally an independent contractor.
5. The permanency of the worker’s relationship with the employer. An indefinite term of employment may imply an employee relationship.
6. The nature and degree of control by the employer. Remote work or flexible hours do not, by themselves, indicate a worker is an independent contractor. Just like the IRS, the DOL considers the degree to which a worker is allowed to exercise independent judgment in getting the work done.

Getting the classification wrong can be expensive for your clients, so help them get it right!

Editor’s note: This article first appeared on the Firm of the Future blog.