Businesses can be tempted to call a worker who is really an employee an independent contractor, hoping to save money on payroll taxes, employee benefits, minimum wage, and/or overtime pay. Employers need to know the perils of misclassifying an employee as a contractor, and workers need to know their rights.
First, myth-busting: You cannot legally make someone a contractor just because the parties agree to do so. Instead, IRS and US Department of Labor Fair Labor Standards Act (DOL or FLSA) rules govern. Under both tests, in any given situation, some factors may be more relevant than others, and some factors may not apply at all. It is very common for someone to be properly classified as an employee or as a contractor when not all the factors point in that direction.
The DOL and IRS test factors are similar enough to discuss them together for purposes of this article. There is a difference in emphasis. DOL focuses on the “economic reality test,” whether a worker is economically dependent on the business or whether they are really in business for themselves. The IRS focuses on “control,” broken down into who has control in the relationship behaviorally and financially. Here are factors they consider:
1. Is the worker in business for themselves? Can they increase profits by their entrepreneurial decisions? Do they (or can they) work for other clients? Have they set up an LLC or corporation that receives payment from the employer? Does the worker decide what projects or how much work they will take on? If so, this looks entrepreneurial and favors contractor status. If the only way they can make more money is to work more hours, if they only work for this employer, and the employer fully controls assigning work, this leans toward employee status.
2. Who provides materials and equipment for the work? If it is the company, this indicates an employee. If it is the worker, this indicates contractor status.
3. Is the work temporary or project-based, or is it long-term and indefinite? The former looks more like a contractor, and the latter more like an employee.
4. Who controls when and how the work is done? This relates both to scheduling and to the degree of control over how work is completed. More control by the employer leans toward employee status; more control by the worker indicates contractor status.
5. How integral is the work to the employer’s business? A contractor who does the same work the company’s employees do (or could do) raises a question about classification.
6. What degree of skill is required to perform the work? Expertise favors contractor status, whereas less required skill looks more like an employee.
For information about DOL’s classification test, visit: https://www.dol.gov/agencies/whd/flsa/misclassification. To read more about the IRS test, visit https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee. If you (as a company or as a worker) aren’t sure of proper classification, you can submit IRS form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding for a ruling. Here is a link to the form and instructions: https://www.irs.gov/forms-pubs/about-form-ss-8.
The cost of error is high for misclassifying an employee as a contractor. Depending on what the worker would have received as an employee (e.g., overtime), the employer may be liable under the FLSA for up to two to three years of back overtime pay, plus an equivalent amount in liquidated damages.
From a tax standpoint, misclassification can trigger further penalties for the employer. For intentional or fraudulent misclassification, penalties include 20% of the worker’s wages, 100% of both employee and employer FICA taxes, interest and other penalties on under-withheld amounts, criminal fines up to $1,000 per misclassified worker, and imprisonment. Penalties for unintentional misclassification are less, but are still costly.
These financial risks should cause companies to take the classification issue seriously. If in doubt, make use of IRS and DOL resources, contact an experienced professional (attorney or CPA), and, if still in doubt, it may be safer to classify the worker as an employee.
Kim K. Steffan is an attorney with Steffan & Associates, P.C. in Hillsborough. She can be reached at (919) 732-7300 or kim.steffan@steffanlaw.com.