Employee or Contractor?
In the past few months, there have been calls for heightened enforcement of current law against employers that misclassify employees as independent contractors, including federal legislation that would make worker misclassification a violation of federal labor law with new penalties in addition to any other labor law penalties currently existing. Reference has been made to a California law that established a new test for independent contractor status. Recall that many self-employed individuals received unemployment benefits during the pandemic even though they had not paid anything into federal unemployment funds. There may be attempts to recover some of that cost by reclassifying those self-employed contractors as employees. Because contractor status may become a major focus, this article will cover the some of the basics for determining independent contractor status.
Employee vs Independent Contractor
This issue is especially important for industries which rely on of temporary workers. It is critical that businesses correctly determine whether the individuals providing services are employees or independent contractors for each service provided. If someone is deemed to be an employee, the business must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. Businesses generally do not have to withhold or pay any taxes on payments to independent contractors unless they are subject to backup withholding. The independent contractor must pay the Social Security/Medicare taxes as self-employment taxes on the payments they receive. They do not pay state of federal unemployment taxes. Businesses must send each independent contractor an annual 1099-NEC form (beginning in 2020) if the contractor was paid cumulatively $600 or more during the year. A form W-2 is issued to employees.
Worker status is also important for pay and benefits status. Only employees are protected by the U.S. Department of Labor’s (“DOL”) wage and hour law, the Fair Labor Standards Act. This act sets rules for minimum wages, overtime, child labor, OSHA, and other protections.
Because Internal Revenue Service (“IRS”) and DOL rules are different, a worker may be classified as an employee under one rule and as an independent contractor under another. Note that both employee and independent contractor may result in liability for workmen’s compensation in case of injury. Your tax advisor should be of help to figure out a worker’s status.
How the IRS Determines Worker Status
The IRS uses three basic rules to determine the type of relationship between the worker and employer, based on the degree of control and independence of the worker. The IRS looks at employee vs. independent contractor designations on a case-by-case basis. They assume the person is an employee unless the facts indicate otherwise. The IRS had a list of 20 questions to determine a worker’s status. They now have been categorized into 3 areas.
Behavioral Control
Behavioral control looks at the degree of control the employer has over workers. Does the employer give many detailed directions, including where and when to do the work? Does the employer train (implying that the worker may not be skilled already)? Does the employer have evaluation systems built in to monitor worker performance? Does the worker bring their own tools and supplies, or does the employer provide them?
Financial Control
This factor includes how the worker is paid, whether the worker may work for others at the same time, and whether the worker can incur a profit or loss. A worker who is paid a salary is restricted from working for others, and who does not participate in company profits or losses, is probably an employee.
Type of Relationship
The presence of a specific contract may indicate an independent contractor, but this factor alone is not controlling. If the worker is entitled to benefits, this would indicate an employment relationship. Another factor would be the type of work the person does; if it is directly related to the company's core work, they are probably an employee.
Determining Worker Status by the DOL
The DOL has announced new rules to make it easier to determine whether a worker is an independent contractor vs. an employee. However, the new DOL regulation has been put on hold, along with other proposed regulations, until all have been reviewed. As alluded to earlier, the enforcement of current rules might be changing.
Currently the DOL looks at an economic reality test to determine whether the worker is in an independent business or, is an employee dependent on an employer for work. They look at two "core factors" to help clarify whether the worker is economically independent:
the nature and degree of control over the work, and
the worker's opportunity for profit or loss based on initiative and/or investment
There are several additional factors for further clarification:
The amount of skill required for the work
The degree of permanence of the working relationship
Whether the work is an essential part of the business product
The DOL also noted that the reality of the situation is more important than having a contract.
It is sometimes difficult to determine the status of a worker for different projects. If you are unsure, you can file a Form SS-8 to request a determination from the IRS.
Also note that whether a worker is properly categorized an employee or a contractor, both classifications may result in workmen’s compensation liability in case of injury. Consider insurance coverage for this exposure.
Summary
The distinction between employees and independent contractors is important. Getting this wrong can be a costly mistake. Determining whether a worker is an independent contractor or an employee on each engagement is important because it affects things like tax and withholding requirements, legal requirements of the compensation, and applicable worker laws. Because IRS and DOL rules are different, a worker may be classified as an employee under one rule and as an independent contractor under another. Certain industries like agriculture may have special rules that limit many of these exposures from DOL.
Because contractor status may begin to be a major focus, analyze and document the status of each individual treated as an independent contractor for each project. Your tax advisor should be of help in the establishing a process to determine a worker’s status as an employee or a contractor.