Are you completely confident you're correctly classifying workers as independent contractors?
Misclassifying workers can result in serious fines and penalties that can significantly hurt your business.
At both the federal and state level, you can be required to pay years in back taxes. Also, you can be required to pay back wages and retroactive insurance premiums, as well as additional penalties. And the risk of potential lawsuits is added reason for you to take this issue seriously.
Several tests are used by various government agencies for classifying workers, but before we look at the tests, let’s take a closer look at the definition of an independent contractor.
Defining an Independent Contractor
An independent contractor is any worker you bring onboard to deliver a specific result and determines on his or her own terms how to achieve that result. On the other hand, an employee is a worker who completes the tasks you give to him or her in the timeframe and manner specified by you. The difference here is the level of control you, as the employer, have over the worker.
The tests for independent contractors include several factors, and it’s important to note that there is no single deciding factor – all factors must be considered in the full context of a particular case.
Let’s examine the main tests that can help you use contractors the right way.
“Right to Control” Test
The IRS and several other agencies use the “Right to Control” test, also known as the “Common Law” test, to classify workers. It takes the following three categories into consideration:
- Behavior toward the worker – Are you acting like a “boss” with this worker? Do you determine how, when and where to do the work? Do you set work hours, provide tools and equipment, offer training, monitor performance or take disciplinary action? If you answered yes to any of these questions, you’re treating this worker as an employee.
- Financial arrangement with worker – An independent contractor typically pays for his or her own business expenses, owns his or her equipment, has other clients and is paid by the project.
- Relationship with the worker – A written contract that identifies the worker as an independent contractor is useful, but it doesn’t cover you completely. If you’re providing benefits and the relationship is leaning toward permanent or long-term, the more likely it will be viewed as an employee relationship. If you use a contractor to perform core business functions, that also could be considered an employee relationship.
“Economic Realities” Test
The Department of Labor (DOL) and the Occupational Safety and Health Administration (OSHA) use a six-factor test called the “Economic Realities” test to establish the true business relationship between employers and workers. It does this by looking at the financial dependence a worker has on an employer.
The first three factors, listed below, are virtually the same as the Right to Control test.
- Right to Control – The worker controls how the work is performed.
- Investment – Independent contractors should pay for equipment, tools, etc.
- Length of Relationship – The relationship should be short-term.
The other three factors take a broader look at some of the concepts to determine the extent to which a worker depends on someone else’s business for his or her continued employment.
- Skill – Contractors tend to have advanced or unique skills and are required to exercise judgment and initiative. The more routine the task is, such as answering the phone, the more likely the worker could be classified as an employee.
- Level of Risk – A contractor makes independent, management-level business decisions and has the opportunity to make a profit or incur a loss based on these decisions.
- Integration – This is similar to the relationship factor in the Right to Control test. If a worker provides services that are a part of your regular business, it will most likely be considered an employee relationship. For example, let’s say you have a website-development business, and your contractors are building websites for your customers. That’s a core business function – and there’s a high probability of misclassification.
In addition to these two tests, several courts and administrative bodies apply the “Hybrid” test to determine employment status by combining factors from both the Right to Control and Economic Realities tests. The Hybrid test recognizes that the process of determining whether a worker is an employee or independent contractor may involve examining every aspect of the employment relationship.
Confidently Classify Independent Contractors
The rules surrounding worker classification are complicated, but it’s important to get it right to avoid penalties and lawsuits. If you’re ever in doubt, it’s always best to classify the worker as an employee.
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Funded, in part, through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.