Employee or Contractor: Did you do the Research?
By: Anne Yancey, Director, State Credits & Incentives
There is no single test for determining whether a worker is an employee or an independent contractor and for employers, the lines are often blurred in making the distinction. In the eyes of the Internal Revenue Service (“IRS”), proper worker classification is mainly determined by the degree of control a company has over the employee. In contrast, the Department of Labor utilizes an economic reality test. Given the changing dynamic of today’s workforce, employers must singly carefully consider the facts of each situation in making the determination. An incorrect determination could have severe consequences to a business.
There are several factors to consider when determining whether you should hire employees versus independent contractors, including the type of work to be performed and how long you expect the work to last. For federal tax purposes, the IRS applies what they refer to as “common law rules” to determine whether a worker is an employee or an independent contractor. According to these rules, you must examine the relationship between the worker and the business, and consider all the evidence of the degree of control and independence in the relationship. The facts that provide this evidence fall into the following three categories:
- Behavioral Control relates to whether the business has a right to direct what work is accomplished and how the work is done, through instructions, training or other means. So generally, anyone who performs services for you is your employee if you have the right to control what will be done and how it will be done.
- Financial Control covers whether you are providing the materials, equipment and facilities the worker requires. How does the worker get paid? By project, commission, etc.? Do you reimburse for expenses? Does the worker receive a regular guaranteed salary or wage and have the ability to raise fees? Does the worker perform similar services or duties for other businesses?
- Relationship of the Parties involves whether the worker was hired for a specific project or a limited period of time. Are contracts signed explaining the intention of both worker and employer? Are employee-type benefits, such as insurance, a pension plan, parking, and vacation pay or sick pay, provided to the worker? Is the worker an integral part of your business?
In recent years, the common law test has taken a backseat to the “economic realities” test imposed by the Fair Labor Standards Act. In the California case against Uber, the Department of Labor relied more heavily upon the economic realities test which looks at whether the worker is economically dependent on the employer or whether the worker is in business for him/herself. The economic realities test generally includes consideration of the following six factors:
- The extent to which the work performed is an integral part of the employer’s business.
- The worker’s opportunity for profit or loss depending on his or her managerial skill.
- The extent of the relative investments of the employer and the worker.
- Whether the work performed requires special skills and initiative.
- The permanency of the relationship.
- The degree of control exercised or retained by the employer.
The consequences of improperly characterizing an employee as an independent contractor can be severe. In addition to the IRS imposing the employer and employee payroll taxes, penalties and interest, and hefty fines, you may be at risk of jeopardizing your retirement plan status as well as many other unforeseen problems.
Employers should do their research before classifying workers as an employee or an independent contractor. Both the common law rules and the economic realities test should be considered. Be sure to document each of the factors used in coming up with the determination in the event that there is a dispute. It is always a good idea to consult with an attorney and your CPA to ensure you have correctly classified your workers and properly documented your agreements with them.