Anaya Nolan
The distinction between an employee and an independent contractor is important for businesses to correctly classify their workers and avoid costly mistakes. The US Department of Labor is working to update federal laws, while some states have already made changes to their independent contractor laws. The common law test, used by the IRS and 18 states, determines whether a worker is a W-2 employee or a 1099 contractor by assessing the type and degree of control exerted by the employer. This includes behavioural control, such as where, when, and how the work is performed. Other factors include the worker's opportunity for profit or loss, their skill level, and their ability to negotiate pay, accept or decline work, and hire their own workers. Misclassification can result in severe penalties, and states use both the common law test and the ABC test to determine worker classification.
| Characteristics | Values |
|---|---|
| Control | Employers have the right to control the work of employees, but not independent contractors. |
| Nature of work | Independent contractors are hired for work outside the usual course of the hiring entity's business. |
| Work relationship | Employees are economically dependent on their employer, whereas independent contractors are in business for themselves. |
| Work schedule | Employees have set schedules, while independent contractors have more freedom to set their own schedules. |
| Work with multiple clients | Independent contractors can work with multiple clients. |
| Benefits | Employees receive benefits such as paid time off and healthcare, while independent contractors do not. |
| Taxes | Independent contractors are subject to self-employment taxes, while employees may be subject to income tax withholding and FICA (social security and Medicare tax). |
| Classification | Misclassification of workers can result in penalties for employers. |
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Tests to determine worker classification
Worker classification is a complex issue, and employers must be careful in distinguishing between employees and independent contractors to avoid penalties and lawsuits. The classification determines the benefits and protections afforded to the worker, as well as the taxes owed by the employer. Misclassification can lead to substantial losses in revenue for the government. The Internal Revenue Service (IRS) and Department of Labor (DOL) are actively working to identify cases of misclassification.
There are two primary tests used to determine worker classification: the Common Law Test and the ABC Test. The Common Law Test, also known as the "Right to Control" test, is used by the IRS and several other agencies. This test focuses on the degree of control the employer has over the work performed, including the financial and behavioural aspects, as well as the type of relationship between the worker and the employer. If the worker has financial control over their income sources and can pursue other business opportunities, they may be an independent contractor. On the other hand, employees typically have their work directed and controlled by the employer and are economically dependent on that employer.
The ABC Test, used by states like California and the Department of Labor, presumes a worker is an employee unless there is evidence of independent contractor status. This evidence includes the absence of control by the hiring organisation and the worker performing “unusual” work off the hiring entity's premises.
Other tests, such as the Hybrid test and the Economic Realities test (also known as the FSLA Economic Reality test), combine factors from the Right to Control and Economic Realities tests, respectively. These tests consider the broader context of the employment relationship, including the worker's opportunity for profit or loss, skill level, and level of risk.
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Differences between employees and independent contractors
It is crucial for business owners to correctly determine whether the individuals providing services are employees or independent contractors. This is because the two types of workers are treated differently in terms of tax obligations, benefits, and legal protections.
Firstly, in terms of tax, businesses must generally withhold and deposit income taxes, Social Security taxes, and Medicare taxes from the wages paid to an employee. Businesses must also pay the employer portion of Social Security and Medicare taxes, as well as unemployment tax on wages paid to an employee. On the other hand, businesses generally do not have to withhold or pay any taxes on payments to independent contractors.
Secondly, employees typically receive benefits such as health insurance, retirement plans, and paid time off. Independent contractors, on the other hand, do not receive these types of benefits.
Thirdly, employees are afforded certain legal protections that independent contractors are not. For example, employees are protected by minimum wage and overtime pay requirements under federal and state laws. Employees also have recourse in labor disputes, which can provide job security.
Another key difference between employees and independent contractors is the degree of control exercised by the employer. Employers typically have more control over employees, including the right to control what the employee does and how they do their job. This includes controlling the work, hours, and location of the employee's work. Independent contractors, on the other hand, have more freedom to set their own schedules and work with multiple clients.
Lastly, independent contractors are typically engaged in an independently established trade, occupation, or business that is similar to the work they are performing for the hiring entity. They are also often in a position to negotiate their pay, decide whether to accept or decline work, hire their own workers, and purchase materials and equipment.
Overall, while there may be nuances and exceptions in the governing laws, tests, and definitions, it is important for businesses to correctly classify their workers to avoid costly legal consequences.
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Tax implications for independent contractors
The distinction between an employee and an independent contractor is critical for tax purposes. The IRS considers someone to be an employee if the person paying them can control what will be done and how it will be done. This is also known as the common law test, which is used by the IRS for employment tax purposes.
If a worker is classified as an independent contractor, the hiring entity does not have to withhold or pay any taxes on payments to them. Independent contractors are generally considered self-employed and are responsible for handling their own taxes, including self-employment tax, estimated quarterly payments, and deductions for business expenses. They must file additional forms, such as Schedule C and Schedule SE, and pay estimated taxes regularly. They also receive a Form 1099-MISC instead of a W-2.
On the other hand, if a worker is classified as an employee, the business must withhold and deposit income taxes, Social Security taxes, and Medicare taxes from their wages. The business must also pay the employer portion of Social Security and Medicare taxes, as well as unemployment tax on those wages.
Incorrectly classifying a worker as an independent contractor can result in severe penalties and tax liabilities for the business. If a worker believes they have been improperly classified as an independent contractor, they can use Form 8919 to report their employer and figure their share of uncollected Social Security and Medicare taxes. To avoid misclassification, businesses can file Form SS-8 with the IRS, which will review the facts and circumstances and officially determine the worker's status.
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The right to control and direct work
The common law test, used by the IRS and several states, focuses on the degree of control an employer has over a worker. If an employer dictates how a worker performs their job, including where, when, and how they work, this indicates an employer-employee relationship. In contrast, independent contractors typically have more freedom to set their schedules and work for multiple clients.
The ABC test, used by the US Department of Labor and many states, also considers control as one of its criteria. Under this test, a worker is presumed to be an employee unless the hiring entity can demonstrate that the worker is free from the entity's control and direction in performing their work.
The economic reality test, considered under the Fair Labor Standards Act (FLSA), examines the economic realities of the worker's relationship with the employer. If a worker is economically dependent on an employer for work, they are likely an employee. Independent contractors, on the other hand, are typically considered to be in business for themselves and are not covered by the FLSA.
It is important to note that there is no single factor that determines whether a worker is an employee or an independent contractor. The entire relationship must be considered, and multiple factors may indicate different classifications. Misclassifying workers can result in severe penalties, so businesses must carefully evaluate their working arrangements to ensure proper classification.
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The consequences of misclassification
Consequences for employers
Employers may face criminal penalties and liability for back wages if they are found in violation of FLSA laws. This includes liability for unpaid overtime costs and minimum wage deficits, as well as liquidated damages equal to unpaid wages and attorney's fees. Employers may also be penalised for failing to withhold and remit state and federal payroll taxes, including social security and Medicare tax payments.
Additionally, misclassification can result in penalties for violating state workers' compensation insurance laws and liability for unpaid workers' compensation premiums. Claims from an individual misclassified as an independent contractor will be the employer's sole responsibility and will not be covered by the employer's workers' compensation insurance policy.
Misclassification may also result in failure to provide required protections under state and federal anti-discrimination laws. With respect to group health insurance plans, worker misclassification can lead to penalties for failure to offer adequate or affordable coverage to workers who should have been classified as full-time employees.
Consequences for workers
Misclassified workers may not receive the minimum wage and overtime pay to which they are entitled under the FLSA or other benefits and protections to which they are entitled under the law, such as workers' compensation benefits, unemployment benefits, and benefits under an employer's ERISA-governed benefit plans (e.g. group health insurance policies and 401(k) plans).
Consequences for the economy
The misclassification of workers can also have a significant impact on the economy at large, as it affects the overall labour market and tax revenue.
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Frequently asked questions
Independent contractors are not considered employees and work on a contractual basis. They have more freedom to set their own schedules and work with multiple clients. Employees, on the other hand, have set schedules, are under the direct control of the employer, and receive benefits such as paid time off and healthcare.
States use two tests to determine worker classification: the common law test and the ABC test. The common law test is used by the IRS for employment tax purposes and looks at different types of control an employer could have over a worker. The ABC test is used by the US Department of Labor and is similar to the common law test, but it also examines whether the worker is customarily engaged in independent contractor work related to the job they are performing.
Misclassifying a worker as an independent contractor can result in severe penalties. For example, in California, entities can be assessed civil penalties of between $5,000 and $25,000 per violation. Additionally, employees are protected by laws such as minimum wage, overtime, meal periods, and workplace safety laws, whereas independent contractors are not.
