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Independent Contractors vs. Employees: Classification Mystifications

May 29, 2018 - minute read

Should your so-called independent contractors really be classified as employees? It’s a sticky question that has long plagued employers—and as the gig economy grows, it’s getting worse.

For one thing, the population of independent contractors has grown by 40% in just 10 years. For another, in Seyfarth Shaw’s  2017 Workplace Class Action Litigation Report, employee classification errors were sighted as an emerging wage and hour hazard. While the issue isn’t always clear-cut, the penalties can be severe. 

Independent Contractors vs. Self-Employed Workers vs. Employees 

What’s the difference between a self-employed person and an independent contractor? The shorter answer is: there isn’t one. Independent contractors are in fact self-employed.

What’s the difference between independent contractors and employees? Independent contractors work for themselves, not employers, although they’re compensated for performing work on behalf of companies. Employees receive W-2 forms to document their income; self-employed contractors receive 1099-MISC forms.   

Another key difference: employers are required to pay the following expenses for employees (but not independent contractors):

  • Unemployment tax
  • Workers’ Compensation insurance
  • The employer’s share of Social Security and Medicare taxes
  • Overtime

Similarly, companies don’t offer benefits such as paid time off, insurance and 401Ks to independent contractors.      

For this reason, employers are increasingly using independent contractors to cut labor costs. That’s fine. The problem arises when companies misclassify employees as independent contractors without a solid basis for doing so.

Consequences of Employee Misclassification Independent Contractors vs. Employees: Classification Mystifications

When employers are deemed guilty of employee misclassification, they can face a host of fines and penalties, including: a $50 fee for each W-2 Form that wasn’t filed, employee and employer FICA contributions, a percentage of wages paid and even criminal penalties of up to $1,000 per misclassified employee.

In addition, employers can be hit with huge class-action settlements—such as the $228 million FedEx was required to pay its California drivers in 2015.

Gig Economy infographic-1-2

Why is Employee Classification So Complex?

One reason it’s sometimes difficult to distinguish between independent contractors and employees is that there are multiple sets of government guidelines. In a nutshell, these include:

The FLSA Economic Reality Test

The Department of Labor uses a seven-factor economic reality test to define an employment relationship versus a contractual one, including:

  • The extent to which the services rendered are an integral part of the principal’s business.
  • The permanency of the relationship.
  • The amount of the alleged contractor’s investment in facilities and equipment.
  • The nature and degree of control by the principal.
  • The alleged contractor’s opportunities for profit and loss.
  • The amount of initiative, judgment or foresight in open market competition with others required for the success of the claimed independent contractor.

For detail, see the DOL website.

The IRS Right-to-Control Test

Meanwhile, the IRS uses a 20-factor right-to-control test. Generally speaking, these 20 factors fall under three categories:

  • The company’s behavioral control over the worker, including the type and degree of instruction given, evaluation systems and training.
  • The company’s financial control over the worker, including equipment investment, unreimbursed expenses, method of payment and the worker’s opportunity for profit and loss.
  • The type of relationship between parties, including contracts in place, benefits provided and permanency of the relationship.

For detail, see the IRS website.  

State Independent Contractor Tests

In addition, some states have their own independent contractor tests. For example, last month, the California Supreme Court issued a ruling that makes it harder for companies to classify workers as independent contractors. For employers that operate in multiple states, employee classification can be especially challenging.

What’s an Employer to Do?

Because there is no single, definitive set of factors for distinguishing between independent contractors and employees, employers should tread with care. Some legal experts suggest that employers begin by conducting an internal audit of their current “independent contractors,” working with legal counsel to ensure their employee classifications are compliant.

In addition, they recommend creating guidelines for engaging future independent contractors. These guidelines might include:

  • Requiring independent contractors to sign an agreement defining the scope of the work, the agreed-upon compensation arrangement and both parties’ tax obligations.
  • Asking independent contractors to complete IRS Form W-9.
  • Requiring independent contractors to submit invoices for their work, and specifying that that payment be made upon completion of specific tasks as opposed to on a set schedule.
  • Refraining from providing independent contractors with equipment/supplies and from reimbursing them for expenses (that should be built into contract).
  • Refraining from offering employee benefits, providing an employee handbook, or asking self-employed contractors to complete job applications.  

In summary, while employing self-employed contractors can be a very effective strategy for succeeding in our present gig economy, companies need to be mindful of who and how they label independent contractors. When it comes to employee classification, every detail matters.   

At EPAY, we are committed to helping employers control their labor costs and maintain compliance—and our advance HCM software is packed with built-in safeguards to help you do just that. Want to learn more? Take a two-minute tour!  

Filed Under: Compliance Workforce Management