Distinguishing between independent contractors and employees has always been challenging for employers. But as the gig economy explodes—and more misclassification-based lawsuits wind their way through the courts—the lines are only getting blurrier.
Frequently, misclassification lawsuits are brought by the independent contractors themselves, who argue that they are employees in all but name only. However, sometimes it’s a state government, or even The Internal Revenue Service (IRS), raising the issue—typically once it’s brought to their attention by contractors applying for unemployment or workers’ compensation benefits.
The stakes can be high. For example, last month, on the eve of its initial public offering, Uber revealed to investors that it was facing up to $170 million in potential misclassification claims from drivers.
What makes this so challenging for employers is that different authorities use different guidelines, or tests, to determine classification. Depending on who you ask—or which court your case is heard in—the verdict may vary.
In short, individuals who are deemed independent contractors under one test may be deemed employees under another. Do you know what these tests entail? And, if you use independent contractors, do you know how you would fare, should each test be applied to your workforce?
The Federal Economic Realities Test
Developed by the Department of Labor, the Economic Realities Test is often used by federal courts—and many state courts—reviewing FLSA claims. The test is based on these factors:
- The extent to which an individual’s services are an integral part of a company’s business.
- The permanency of the relationship between individual and employer.
- How much the individual has invested in facilities and equipment.
- The nature and degree of control exercised by the employer over the individual.
- The individual’s opportunity for profit and loss.
- The amount of skill, initiative, judgment or foresight required in open market competition for the success of the individual.
The IRS 20-Factor “Right-to-Control” Test
The IRS, on the other hand, has developed its own classification test, based around the general idea that “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.”
This test is often applied when evaluating individuals’ unemployment and workers’ compensation claims. Its 20 factors fall under three broad categories:
- Behavioral control – such as the type and degree of instruction an employer can give, how work is evaluated, and what kind of training is offered.
- Financial control – such as whose equipment the individual uses while working, if expenses are reimbursed, whether the individual can seek out additional business, and how he/she is paid.
- The type of relationship - including existing written contracts, if benefits are provided, its perceived permanency, and how integral the individual’s services are to the company’s regular business.
State ABC Tests
Recently, several states—notably California, but also Illinois, Massachusetts and New Jersey—have adopted variations of what’s known as the ABC Test. Generally speaking, this test makes it harder for employers to classify individuals as independent contractors. It assumes workers are employees unless the company can prove that the individual:
- Is free from the control and direction of the company in relation to the performance of the work
- Performs work outside the usual course of the company’s business
- Is engaged in an independent trade, occupation, or business of the same nature as the work performed for the company.
What Does It Mean for Employers?
Penalties for misclassifying workers can result in fines, back taxes, and of course, hefty legal settlements, not to mention headaches. If independent contractors make up part of your labor force, it’s in your interest to work with your legal counsel to ensure you’re operating in accord with these various tests.
In addition, the Society for Human Resource Management (SHRM) recommends that employers:
- Make sure your classification of independent contractors satisfies every test that may apply wherever you operate.
- Adopt a formal policy regarding the company’s use of independent contractors.
- Make it a practice to involve HR when deciding if a staffing need should be filled via independent contractor or employee.
- Use carefully written independent contractor agreements.
- Ask independent contractors to provide ongoing proof that they are paying full employment taxes.
- Do not treat independent contractors like employees.
Employment law is complicated, but EPAY Systems can help. Our advanced HCM software is designed with built-in safeguards to help employers maintain labor compliance, and our customers have access to workplace law updates via our compliance portal. Learn more—give us two minutes.