In today’s gig economy, more workers are finding themselves classified as independent contractors and fulfilling multiple roles for multiple employers. Freelancers, temporary workers, drivers, and consultants often gain freedom in choosing their own work schedule and how they will complete the work, but often do not enjoy the same benefits as traditional employees.
Independent contractors are not covered by the Fair Labor Standards Act (FLSA); they are treated differently in terms of taxes, benefits, and worker protections and receive a 1099-MISC form instead of a W-2 each year.
For small business owners and human resource specialists, differentiating between employees and contract workers isn’t as simple as it used to be and the risks of worker misclassification are no joke.
FLSA and IRS Guidelines for Employee vs. Contractor Determination
The Department of Labor offers this guidance to help employers determine how they should classify workers under the FLSA.
The worker may be an employee if:
- The work completed by the worker is an integral part of the employer's business;
- The relationship between the worker and employer is relatively permanent;
- The employer has control over the worker's pay, hours, and how the work is performed.
The worker may be an independent contractor if:
- The worker's managerial skills affect their own opportunities for profit and loss. This includes the ability to make independent business decisions such as business investments and hiring.
- The worker invests in facilities or equipment outside a single job and bears some risk of loss.
- The worker exercises skill, initiative, and independent business judgment to create job opportunities and is in open market competition with others.
The IRS guidelines for employee classification comprise three categories:
- Behavioral: Does the company control (or have the right to control) what workers do and how they do their jobs?
- Financial: Are the business aspects of workers' jobs controlled by the business owner, including how workers are paid, whether expenses are reimbursed and who provides tools, supplies, etc.?
- Type of relationship: Are there written contracts or employee-type benefits such as pensions, insurance, or vacation pay? Is the work performed a key aspect of the business? Will the relationship continue?
If the answers to these questions are yes, the worker is likely considered an employee and covered by FLSA minimum wage and overtime protections as well as other benefits.
The Importance of Correctly Classifying Workers
Correctly classifying workers is essential for employers because companies are subject to federal and state fines and back taxes for misclassified employees. When employers are determined to have treated employees as independent contractors, they become liable for past employment taxes for those workers. The employer may be penalized by the same amount of employment taxes due, doubling the cost to the employer. Adding to the expense to the employer is the possible liability for the employee portion of the taxes not withheld and any overtime pay.
Several court cases have also shown the potentially high cost of misclassifying workers. In 2015, FedEx agreed to pay $228 million to settle a class-action suit. Independent contractor truck drivers working for FedEx stated they were employees because they worked 10 hours a day, wore FedEx uniforms, and operated trucks with the FedEx logo.
Even more recently, on-demand food delivery startup DoorDash agreed to pay $5 million to settle a class-action suit related to misclassifying delivery drivers as contract workers. The settlement did not prompt the reclassification of those workers but changed policies related to the rights of those workers. With app-based service businesses like Uber, Lyft, and Instacart growing rapidly -- partly due to hiring thousands to work as independent contractors -- some workers have filed suits alleging these companies are ignoring labor laws. These types of companies couldn’t have grown so quickly if they had hired all these people as employees, the New York Times reported.
How the Rules for Each Worker Classification Differ
There are clear differences in the rules and regulations that currently apply to employees versus independent contractors:
- Employers pay employment taxes on employee wages and also withhold and remit the employee portion of employment taxes, including federal income tax, Medicare, and Social Security. Independent contractors aren’t subject to these withholdings, but are responsible for their own taxes.
- Minimum wage and overtime laws protect employees. No such protections exist for independent contractors.
- Employees usually receive healthcare insurance, vacation pay, pensions, workers' compensation, or other employee benefits, and might be eligible for unemployment compensation in the event of separation from the company. Independent contractors aren’t entitled to any of these benefits.
- Workplace safety and antidiscrimination laws protect employees. Independent contractors are most often not protected by these laws.
- Employees may join or form a union at their employer's place of business. Independent contractors may not.
Other Considerations When Hiring a Contractor
Often, hiring a contractor is a money-saving measure. While Independent contractors can command higher pay than some employees, employers may save money on health insurance, worker’s compensation, and unemployment insurance. In addition, hiring an independent contractor means that normal overtime rules may not apply.
However, despite the lower up-front costs, some situations demand that an employer hire an employee. Independent contractors have a much higher turnover rate, so employers could sacrifice some long-term growth for short-term performance, despite the cheaper initial cost of hiring independent contractors. If an employer decides he or she needs to control the means and manner in which a worker provides a service, that’s a good indication hiring an employee is the best course of action.
Employers must also consider the way contractors get paid. While it’s still the norm for employers to pay contractors through accounts payable, some employers pay contractors through the payroll system. While typical employment taxes will not be applied, this allows the employer to pay a contractor via direct deposit, streamlining the process for everyone involved.
Additional Ways to Determine if a Worker is an Employee or Contractor
There are resources available to help employers gain clarity on the question of employee vs. contractor. It is highly recommended that employers seek the advice of a labor attorney if there is any uncertainty in worker classification. Employers can also seek the assistance of the federal government in determining worker status by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
The Voluntary Classification Settlement Program (VCSP) can offer employers help when an employee has been misclassified as an independent contractor. The VCSP allows eligible employers to voluntarily reclassify workers as employees and may also receive partial relief from federal employment taxes. To participate in the program, an employer must meet certain requirements and file Form 8952, Application for Voluntary Classification Settlement Program, as well as enter into a closing agreement with the IRS.
The Future of Worker Status
One of the federal government’s pending pieces of legislation is related to contract employees and providing portable benefits for people who work multiple gigs.
The proposed law “would make a substantial investment in DOL to actually allow cities, regions, and states to experiment with portable benefits,” Sen. Mark Warner of Virginia told Bloomberg BNA earlier this year.
Contract positions have increased exponentially in recent years and will likely continue to grow in number, prompting additional legal action as well as changes in federal and state regulations and HR best practices.