When running a business, one of the most critical decisions you'll face is determining whether a worker should be classified as an employee or an independent contractor. Misclassifying workers can lead to significant legal and financial repercussions, including fines, penalties, and back taxes. While it may seem straightforward, the rules governing worker classification vary depending on the agency—whether it’s the IRS, the U.S. Department of Labor (DOL), or your state. Understanding these differences is essential for making informed decisions.
Why Classification Matters
Proper classification affects how a business withholds taxes, pays overtime, offers benefits, and complies with labor laws. Employees are typically entitled to protections like minimum wage, overtime pay, and access to unemployment benefits, while independent contractors are not. Misclassifying an employee as a contractor could mean back-paying wages and benefits, not to mention potential audits.
Companies are technically required to file unemployment reports, including independent contractors that meet the DOL standards for employees. There are almost no independent contractors, except for those with their own formal entities, who could be considered truly independent contractors by the DOL definition.
The IRS Perspective
The IRS focuses on the degree of control a business has over the worker. It evaluates three key factors:
Behavioral Control: Does the business dictate how, when, and where the worker performs tasks? Employees are closely supervised, while contractors have autonomy over how they complete their work.
Financial Control: Does the business control the financial aspects of the worker’s role, such as reimbursement for expenses? Independent contractors often invest in their tools or equipment and may face a profit or loss.
Relationship of the Parties: Is there a written contract or employee benefits, such as health insurance and paid leave? Employees are generally part of the business’s day-to-day operations, whereas contractors provide specific services for a defined period or project.
The IRS takes a holistic approach, considering the totality of circumstances. If there’s ambiguity, you can submit Form SS-8 to the IRS for a determination.
U.S. Department of Labor Rules
The DOL applies a different standard under the Fair Labor Standards Act (FLSA). Their primary focus is on economic dependence—whether the worker is economically dependent on the employer (indicative of an employee) or operates as a true business entity (indicative of an independent contractor). This assessment includes:
The nature of the work: Is the worker performing tasks central to the business?
Control and investment: Does the worker have an independent business with investments in equipment or employees?
State Rules Add Complexity
State rules often align with federal guidelines but can have additional nuances. For example, Vermont uses the ABC Test, which presumes workers are employees unless the hiring business can prove:
The worker operates free from company control.
The work falls outside the company’s usual course of business.
The worker has an independent business providing similar services.
Other states may have similar or completely different standards, making compliance a challenge for businesses operating across multiple jurisdictions.
Practical Tips for Business Owners
Consult Experts: An accountant or legal professional can help navigate the complexities of classification rules.
Document Agreements: Whether hiring employees or contractors, maintain written contracts detailing the scope of work and the nature of the relationship.
Stay Informed: Laws change frequently, so keep abreast of IRS updates, DOL regulations, and state-specific rules. We can help you!
Correctly classifying your workers not only protects your business, but also fosters a fair and transparent relationship with your team. When in doubt, seek professional guidance to avoid costly mistakes.