Studies suggest that 10-30 percent of employers may misclassify their employees as independent contractors. To help employers properly classify their worker as either employees or independent contractors, the Department of Labor (DOL), and the IRS have publicized test to examine the workers economic realities and control assessment in effort to determine proper classification.
Since the DOL economic realities test and the IRS control test differ, it is recommended that you use both tests.
There is no one single factor for determining whether a worker is an employee or an independent contractor, but depends upon the circumstances of the whole activity. In general, an employee is one who "follows the usual path of an employee", is economically dependent on the employer, and is not in business for themselves. DOL gives six factors to consider when determining economic dependency:
Is the work an integral part of the employer's business (examples: Does the worker play an integral role in the business by performing the primary type of work that the employer performs for his customers or clients? Does the worker perform a discrete job that is one part of the business' overall process of productions? Does the worker supervise any of the company's employees?):
Does the worker's managerial skill affect his or her opportunity for profit and loss (examples: Did the worker make any investments such as insurance or bonding? Can the worker earn a profit by performing the job more efficiently or exercising managerial skill or suffer a loss of capital investment?) and
Does the work performed require special skill and initiative (examples: Does the worker perform routine tasks requiring little training? Does the worker advertise independently?)
Relative investments of the worker and the employer (examples: Is the worker reimbursed for any purchases or materials, supplies, etc? Does the worker use his or her own tools or equipment?)
The permanency of the worker's relationship with the employer (example: How long has the worker worked for the same company?)
Employer control of employment relationship (examples: Who decides on what hours to be worked? Who is responsible for quality control? Does the worker work for any other company(s)? Who sets the pay rate?)
The factor should not be applied as a checklist or scorecard. What matters is whether the totality of the circumstances indicates the worker is an employee or independent contractor. *FLSA definitions and additional information on DOL factors to determine the Employment Relationship
The IRS Common Law Rules test below maintains the control standard. An affirmative response to any of these questions indicates that the worker is most likely an employee.
Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
Financial: Are the business aspects of the worker's job controlled by the payer? These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Consequences of Treating an Employee as an Independent Contractor
It is critical for business owners to correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold/pay- Social Security, Medicare, and unemployment taxes on wages paid to an employee vs. an independent contractor, these withholding are not required. The government has stated it will be aggressively pursuing businesses for misclassification of workers. if you classify an employee as an independent contractor and have no reasonable basis for doing so, you may be held liable for up to three years of employment taxes on the misclassified employee's wages; up to 41.5% of their total income, plus employers could face fines, interest charges, and criminal penalties.
When classifying workers as independent contractors instead of employees, it would be good practice to examine the reasons you have for classifying them as such. Make sure to use both the IRS and DOL tests. If you find anyone as being misclassified, your safest course of action will be to reclassify them and compensate them accordingly.
"Independent Contractor or Employee?" The HR Pros: October 2015
"Independent Contractor (Self-Employed) or Employee?" www.irs.gov
"Fact Sheet 13: Am I an Employee?: Employement Relationship Under the Fair Labor Standards Act (FLSA) www.dol.gov