Independent Contractor or Employee: How Government Agencies Make the Call
Make sure the independent contractor you hire doesn't get reclassified as an employee.
You may think that a worker’s status as an independent contractor or an employee depends on what your company and the worker decide. As long as both parties agree on the terms of the relationship, that’s all that matters, right?
Wrong. The federal and state governments care a lot about how workers are classified. Not surprisingly, the root of their concern is money. Your company doesn’t have to withhold or pay taxes (including expensive payroll taxes such as Social Security and Medicare) for an independent contractor, and it will have fewer legal obligations to an independent contractor than to an employee. Thus, it’s often in a company’s interest to call a worker an independent contractor.
By contrast, it’s in the government’s interest to label the worker as an employee: The more employees there are in this world, the more money flows straight into government coffers through payroll withholding (and the fewer opportunities workers have to hide or underreport their income).
Unfortunately, there are as many tests to determine whether a worker qualifies as an independent contractor as there are government agencies that deal with workers, from your state unemployment office to the federal Internal Revenue Service. Figuring out how to treat a worker so that agencies classify the worker as an independent contractor can be a complicated undertaking.
Employers who don’t learn the rules before they hire an independent contractor can get hopelessly confused—and get into trouble with one agency or another. To avoid problems such as audits, fines, and taxes, you should learn the rules of all of the following agencies before you hire a worker. (For more information on how government agencies classify workers, as well as detailed contracts that will help you define and maintain a worker's independent contractor status, pick up a copy of Nolo's Working With Independent Contractors, by Stephen Fishman.)
The Internal Revenue Service
The Internal Revenue Service (IRS) is probably the most important agency to satisfy when it comes to classifying a worker as an independent contractor. Under the IRS’s test, workers are considered employees if the company they work for has the right to direct and control the way they work, including the details of when, where, and how the job is accomplished. In contrast, the IRS will consider workers independent contractors if the company they work for does not manage how they work, except to accept or reject their final results.
The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor. The agency is more likely to classify as an independent contractor a worker who:
- can earn a profit or suffer a loss from the activity
- furnishes the tools and materials needed to do the work
- is paid by the job
- works for more than one company at a time
- invests in equipment and facilities
- pays his or her own business and traveling expenses
- hires and pays assistants, and
- sets his or her own working hours.
On the other hand, the IRS is more likely to classify as an employee a worker who:
- can be fired at any time
- is paid by the hour
- receives instructions from the company
- receives training from the company
- works full time for the company
- receives employee benefits
- has the right to quit without incurring liability, and
- provides services that are an integral part of the company’s day-to-day operations.
If the IRS would consider the worker an independent contractor, your company does not have to withhold federal payroll taxes as you would for an employee, including Social Security taxes, federal disability taxes, and federal income taxes. If you’re not sure how to classify a worker, you can ask the IRS to determine the worker’s status, but we don’t recommend it. Not surprisingly, the IRS will usually decide that the worker is an employee (and your company will be stuck with that decision). If you’re really confused, you’re better off consulting with an experienced employment lawyer.
To find out more about the IRS independent contractor test, you can refer to the agency’s website at www.irs.gov.
The U.S. Department of Labor
The U.S. Department of Labor also cares about how your company classifies workers: If a worker is an independent contractor, then the worker is not covered by the Fair Labor Standards Act (FLSA), the major federal law regarding wages and hours. This means, among other things, that the worker is not entitled to minimum wage or overtime.
Like the IRS, the Department of Labor has no single rule or test for determining whether someone is an independent contractor under the FLSA. However, the U.S. Supreme Court has said that the following factors are significant when determining whether a worker is an independent contractor under the FLSA:
- whether the worker’s services are an integral part of your company’s business (this points to employee status)
- the permanency of the relationship (the more permanent the relationship, the more likely it is that the worker is an employee)
- whether the worker has invested in facilities and equipment (if so, this points to independent contractor status)
- how much control your company has over the worker (the more control, the more likely it is that the worker is an employee)
- whether the worker has opportunities to make a profit or suffer a loss (as opposed to always earning a set amount of money no matter what happens, like an employee)
- whether the worker competes in the open market (if so, this points to independent contractor status), and
- the extent to which the worker operates a truly independent business (the more independence, the more likely the worker is an independent contractor).
The U.S. Supreme Court has also said that the following things have no bearing on whether a worker is an independent contractor or an employee:
- where the worker performs the work
- the absence of a formal employment contract, and
- whether the worker is licensed by a state or local government.
For more information about the Department of Labor’s test, refer to the Wage and Hour portion of the agency’s website at www.dol.gov.
Your State Unemployment Compensation Board
If the worker meets your state unemployment compensation board’s definition of independent contractor, your company doesn’t need to pay unemployment insurance for the worker. If the worker does not meet this test, your company should provide unemployment coverage for the worker, even if the worker qualifies as an independent contractor under other tests (such as the IRS test).
To learn more about your state unemployment department’s test, contact your state unemployment compensation board or your state department of labor. You can also try your local office of the Small Business Administration (SBA). For a list of local SBA offices, refer to the SBA’s website, at www.sba.gov.
As a manager, it’s a good idea to learn about your state’s unemployment department test for independent contractor status before you hire an independent contractor. That way, you can create an independent contractor relationship from the beginning that satisfies the test.
Your company could get into trouble if a worker who you thought was an independent contractor decides to apply for unemployment compensation, a benefit that is reserved for employees. Should this happen, it will be your company’s word against the worker’s: You say the worker was an independent contractor, but the worker—eager for that unemployment check—claims to have been an employee. In such a situation, you’ll have to be prepared to back up your assertion.
Your State Workers’ Compensation Insurance Agency
As with unemployment insurance, only employees are entitled to receive workers’ compensation. If a worker meets your state workers’ compensation agency definition of independent contractor, your company does not have to pay for workers’ compensation coverage for that worker. Otherwise, your company should pay for workers’ compensation coverage, even if the worker qualifies as an independent contractor under other tests.
To find out more about the workers’ compensation test in your state, contact your state department of industrial relations or workers’ compensation or your state labor department. Your local office of the Small Business Association (SBA) might also have information on the subject. (For a list of SBA offices, refer to the SBA’s website, at www.sba.gov.)
Again, you should find out what test your state’s workers’ compensation board uses before you hire an independent contractor. If an independent contractor is injured on the job and applies for workers’ compensation—a benefit reserved for employees—your company might face an audit.
Your State Tax Department
If your state collects income tax, then you need to know your state tax department’s rules regarding independent contractors. If the worker will qualify as an independent contractor under your state tax department’s test, your company does not need to withhold state income taxes from the worker’s compensation. Otherwise, you must withhold state income taxes (if your state imposes them), even if the worker qualifies as an independent contractor under other tests. Contact your state tax board for details. This is an especially important test to learn, because many independent contractor audits begin with a state tax agency: state tax agencies are often more aggressive about independent contractor audits than the IRS.
Your State Department of Labor
If your state department of labor would consider the worker an independent contractor, then your company does not have to pay the worker minimum wage or overtime according to your state wage and hour laws. (But federal wage and hour laws might apply—see above for more information.) Contact your state labor department for details.