Classifying Employees and Independent Contractors

You have hired someone to do work for you. Is that person an employee or an independent contractor?

The answer is important because misclassifying an employee as an independent contractor, whether intentionally or through ignorance, can land you in court and in debt for payroll taxes.

There are several tests from a variety of regulatory agencies that are used to try to determine employment status and occasionally changes are made to the standards. Even if you classified certain of your workers correctly before, you might need to revisit the question to ensure you remain in compliance.

Definitions

An employee is a worker for whom the employer must withhold payroll taxes and comply with employment law.

An independent contractor must pay his or her own taxes. There are fewer employment laws for the employer or the independent contractor to comply with. It must be noted that the status of independent contractor is defined by the law and not by any agreement you and the worker make.

To be very clear: a signed contract between an employer and a worker does not bestow the classification of independent contractor (or employee) on an individual. Only the law can do so.

How Does Misclassification Occur?

Most often, ignorance or misapplication of the legal standards results in misclassifying a worker. The employer does not understand how to apply the standards or is misapplying them with the intent to save money by avoiding the payment of payroll taxes for workers by classifying them as independent contractors.

Just because you issue an IRS Form 1099 does not make someone an independent contractor any more than a signed employment contract does.

Misclassification also occurs when employment arrangements change, but employment classification is not revisited with the altered position in mind. Other times, an individual within an organization fails to follow company policies or directives when hiring and classifying workers.

The Impact and Consequences of Misclassification

Misclassifying a worker as an independent contractor can cause your organization to be out of compliance with the Federal Labor Standards Act, especially regarding workers in positions that would normally be categorized as non-exempt.

An example of this is as follows.

An employer hires an individual and classifies him or her as an independent contractor. The employer then assumes there is no requirement to determine exempt status or worry about wage rates or overtime pay.

The individual eventually becomes dissatisfied with the perception (or reality) of long hours, menial duties, and low pay. The worker then claims the position has been misclassified.

In fact, the most common reasons for litigation in employee misclassification are failure to pay minimum wage and failure to pay overtime. Both claims are often made at simultaneously.

Determining Employment Classification

When classifying workers as employees or independent contractors, you must take into consideration a raft of relevant factors from multiple agencies. What you are trying to determine is the degree of control and independence the individual has in performing the work.

A list of tests for employment determination includes:

• IRS “Right to Control” Test
• Fair Labor Standards Act “Economic Realities” Test
• National Labor Relations Act “Common Law Agency” Test
• Title VII of the Civil Rights Act of 1964 “Combined” Test
• Employment Retirement Income Security Act “Common Law Agency” Test

The Employment Development Department of the State of California has its own test, and there are multiple state laws governing classification.

New Guidelines from the Department of Labor

Last year new guidelines were issued by the US Department of Labor to define independent contractors. As of July 2015 the scope of “employment” was broadened, a “Suffer or Permit to Work” standard was implemented, and an “Economic Realities” test added.

The Economic Realities Test asks if workers are economically dependent on the employer or are in business for themselves. Several factors come into consideration to answer this question:

• Whether the work is an integral part of the employee’s business
• Whether the worker’s managerial skill impacts his opportunity for profit
• How the worker’s relative investment compares to the employer’s investment
• Whether the work performed requires special skills or initiative
• Whether the relationship between the worker and employer is permanent or not
• The nature and degree of the employer’s control over the work

The broadened definition of employee will likely cover most workers, more than before. Be aware that with this new definition, the Department of Labor will probably become more aggressive in enforcing employee classification.

IRS Guidance

The IRS has simplified its classification test. It is down from 20 separate factors to three groups with a total of 11 factors, but the test boils down to this:

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. (Internal Revenue Service)

The IRS looks at behavioral, financial, and relationship factors when determining if an individual is an employee or an independent contractor. There is no set number of factors nor a single factor that can be used to make the determination. Factors that are relevant in one circumstance may not be relevant in another situation.

Agencies Concerned with Employee Classification

Multiple agencies within the state of California have direct involvement with the results of employee classification.

The EDD administers payroll and other employment related taxes including tax filings, audits, and assessments. The Division of Labor Standards Enforcement (DLSE) is responsible for the application of the wage, hour, and worker’s compensation insurance laws. The Franchise Tax Board (FTB), the Division of Worker’s Compensation (DWC), and the Contractor’s State Licensing Board (CLSB) are also concerned with employee classification.

It is difficult to overstate the critical nature of employment classification, primarily when determining if a worker is an independent contractor. If an individual is an employee that has been labeled an independent contractor, the employer will be faced with fines and penalties as well as back payroll taxes owed to the state and federal government.

If you have concerns about how you have classified your employees, particularly if you have many independent contractors, there is help available through the California EDD, the IRS, and certainly from an experienced tax attorney. Do not hesitate to contact any of these agencies to ensure your compliance and to stay out of court.