Nationally, it is estimated that 10 to 30 percent of employers misclassify their employees as independent contractors.[1] Misclassification occurs when an employer improperly classifies a worker as an independent contractor instead of an employee. Employers should take care when classifying workers as independent contractors as opposed to employees, as the consequences can be severe. While some employers intentionally misclassify workers because they believe they will save on taxes or they are trying to avoid other costs associated with employees, many employers misclassify workers unintentionally as independent contractors.
Distinguishing between an employee and an independent contractor, although complicated, is important and there are multiple factors employers should evaluate before classifying a worker. When determining a worker’s classification, keep this Internal Revenue Service (IRS) quote in mind: “There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors that are relevant in one situation may not be relevant in another.”[2]
The simplest standard may be evaluating the level of control the employer has over the worker. If the employer has the right to control the work, i.e., how, where, or when the work is completed, and provides the worker with tools and equipment to complete the work, the worker should probably be classified as an employee, not an independent contractor. On the other hand, if the employer determines the task to be performed but the worker controls when, where, or how the work is done, the worker may properly be classified as an independent contractor. Why? Because independent contractors are just that—independent. The employer partners with the independent contractor to define the scope of the work, but the employer does not control how the work is completed. An independent contractor generally sets their own schedule, can work offsite, and uses their own tools and equipment.
The independent contractor tests employed by the IRS and the Department of Labor (DOL) provide useful guidelines for employers.
The IRS considers three categories when classifying independent contractors:
- Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial Control: Are the business aspects of the worker’s job controlled by the payer? (These include factors such as how the worker is paid, whether expenses are reimbursed, who provides tools or supplies, etc.)
- Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the business?[3]
Similarly, the Department of Labor (DOL) uses an “economic reality test” to determine who is an employee: “[A]n employee, as distinguished from a person who is engaged in a business of his or her own, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves.”[4] The economic reality test considers seven characteristics:
- 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[5]
The IRS and Department of Labor (DOL) tests for an independent contractor, although different, both attempt to determine the extent to which a worker is truly independent, versus independent in name only.
Penalties for worker misclassification can be severe. Ramifications vary depending on the IRS’s or DOL’s determination of whether the misclassification was unintentional, intentional (willful), or fraudulent. Consequences can include costly financial penalties, violations of federal and state labor laws and criminal penalties.
It is important that workers are properly classified, and employers must have a clear understanding of the business relationship between themselves and their workers. As every situation is different, a qualified attorney can help you analyze your individual circumstances and ensure you are properly following the law.
To discuss this or other related issues, contact Gregory Gunn by calling (801) 532-1234 or send an email to ggunn@parsonsbehle.com.
[1] National Employment Law Project, Policy Brief: Independent Contractor Misclassification Imposes Huge Costs on Workers and Federal and State Treasuries, Oct. 2020, at 2, available at https://s27147.pcdn.co/wp-content/uploads/Independent-Contractor-Misclassification-Imposes-Huge-Costs-Workers-Federal-State-Treasuries-Update-October-2020.pdf.
[2] Internal Revenue Service, Independent Contractor (Self-Employed) or Employee?, Nov. 9, 2020, available at https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee.
[3] See id.
[4] U.S. Dep’t. of Labor, Wage and Hour Division, Fact Sheet 13: Employment Relationship Under the Fair Labor Standards Act (FLSA), available at https://www.dol.gov/agencies/whd/fact-sheets/13-flsa-employment-relationship.
[5] See id.
