Classifying Independent Contractors vs. Employees

Topics: Small Business Advice

Summary: Incorrectly classifying workers as independent contractors when they should be employees can have dire consequences. Learn the IRS rules regarding correctly classifying employees to prevent costly fines and back tax payments. Also, find out the latest updates on California’s independent worker law, AB5 and Prop 22.

Large and small businesses across the country utilize independent contractors or freelancers for various reasons, such as staffing flexibility or reduced office costs. As these workers fuel today’s gig economy, understanding the difference between a company employee and an independent contractor is important for an organization’s tax purposes. Insurance Journal shared that government agencies are auditing companies to see if they are classifying their employees as independent contractors instead of workers to avoid paying workers’ comp, unemployment taxes, social security and Medicare.


New Federal Employee Classification Rule Changes

The U.S. Department of Labor has proposed a rule change for classifying employees versus independent contractors under the Fair Labor Standards Act. The most recent federal independent contractor designation rules went into effect in 2021. These rules made it easier for employers to classify workers as independent contractors by looking at the following:
  • The extent to which services rendered are an integral part of the employer’s business
  • The permanency of the relationship between the employer and the worker
  • The amount of worker’s investment in tools, equipment and facilities
  • The nature and degree of control asserted over the worker by the employer
  • The worker’s opportunity for profit and loss
  • The amount of initiative, judgment or foresight in open-market competition with others required for the worker’s success

In the updated rules, the Department of Labor is proposing that employers include exclusivity as a consideration under the permanency factor. The new changes revert to looking at the totality of circumstances, with no single factor being more important than another. Economic reality factors for employers to consider under the updated rules may include:
  • The amount of skill required for the work
  • The degree of permanence of the working relationship
  • The worker's investment in equipment or materials required for the task
  • The extent to which the service rendered is an integral part of the employer's business

The biggest impact of the new rules will be on ride-hailing companies, delivery services and other industries. These types of gig workers could be considered as performing work that is critical, necessary or central to the employer’s principal business, therefore classifying them as employees of the company and not independent contractors. Employers could have a more challenging time classifying these workers as independent contractors.

The updates were entered into the Federal Register on October 13, 2022. The public can comment on the rule changes until December 13, 2022, with finalization in mid-2023.

California’s AB5 and Prop 22

In addition to the federal rules, a handful of states, such as California, Florida, Illinois, Massachusetts and New York, have specific qualifying tests to determine if a worker can be classified as an independent contractor or an employee. California’s AB5 law has the most stringent definition of an independent contractor.

AB5, California’s gig worker law, went into effect on January 1, 2020. Based on the California Supreme Court Dynamex decision, the legislation uses the ABC test to classify an employee versus an independent contractor. A worker is considered an independent contractor if they meet all three of the following conditions:

  • The person is independent of the hiring organization in connection with the performance of the work
  • The person performs work outside the course of business for the hiring organization
  • The person is routinely doing work in an independently established trade, occupation, or business
Workers who don’t meet all three conditions must be classified as employees for state wage, hour protections and state unemployment provisions.

Proposition 22 (Prop 22), a ballot initiative supported by DoorDash, Uber and Lyft, was passed by California voters in November 2020. The initiative made app-based drivers independent contractors and not employees of the company. Just recently, an Alameda County Superior Court judge ruled that Prop 22 was unconstitutional and unenforceable because it infringes on the power of the California legislature to regulate compensation for workers’ injuries and includes language, which prevents Californians who work for these organizations from unionizing. Ride-hailing and delivery companies who supported Prop 22 plan on appealing the ruling to the California Supreme Court where it is still awaiting a decision. 

Employee vs. Independent Contractor Definition

Most gig economy workers are considered independent contractors and not employees. Independent contractors are paid only for the services that they provide to the company. They do not receive benefits, insurance options, or a retirement plan and payroll taxes are not taken out of their checks. To be classified as an employee, a company would have to provide workers’ compensation insurance, unemployment and health insurance as well as social security and Medicare benefits.

IRS Classification Determination

Employees and independent contractors are taxed differently by the IRS. Independent contractors are not taxed a payroll tax at the time of payment. Companies must look at the IRS classification rules and decide which, if not all, apply to their workers to determine if they are freelancers or employees. Employers need to look at the entire relationship with their worker from beginning to end and keep documentation of their determination.

The IRS rules are based on three factors:
  • Control: The main factor in classifying a worker as an independent worker versus an employee is the amount of control the employer has over the worker. The more control the employer has over the worker, the more likely they would be considered an employee. Employees usually work on-site with set schedules with specific training for their positions, and their work is crucial to the business.
  • Financial: A worker whose employer provides them with tools or supplies and controls other aspects of their business practices would be considered an employee rather than a freelance contractor. Independent contractors are paid hourly or per project, are free to set their own schedule, and their work is not the core of the business.
  •  Relationship: A worker with a written contract with benefits or exclusivity requirements would more than likely be considered an employee and not an independent contractor. Also, the longer the relationship between the small business and the worker, the more it could be considered an employer-employee relationship.

The Department of Labor has also shared its own misclassification fact sheet for further clarification and some states, such as California and New York, have their own enhanced classification factors.

Consequences of Misclassifying Employee as Independent Contractor

There are consequences for misclassifying and employee as an independent contractor. In many cases, employers misclassify their employees as independent contractors so they don’t have to pay taxes or provide benefits. It isn’t just large corporations having this issue, either, as small businesses who do not know the differences could also do this.  The IRS could investigate a company further, if there are red flags about a worker’s paperwork.

The IRS looks at the entire relationship between the employee and employer when determining if a worker has been misclassified. The IRS also states that if a business classifies an employee as an independent contractor and there is no reasoning behind doing so, the employer may be held liable for employment taxes for that worker. However, if it’s determined the individual is an independent contractor, a company will not have to pay employment taxes or other benefits.

Companies must file the correct employee or independent contractor paperwork with the IRS. If a worker is misclassified and the employer doesn’t correctly withhold or pay the required employment taxes, or withhold social security or Medicare amounts, the IRS could audit the business and go after the money that they are owed as well as give additional penalties or fines for the mistake.

Small Business Insurance at AmTrust

Small business owners need to consider a variety of small business insurance solutions for their classified employees. AmTrust Financial is a multinational property and casualty insurer specializing in coverage for small businesses. To learn more about our small business solutions, please contact us today.

This material is for informational purposes only and is not legal or business advice. Neither AmTrust Financial Services, Inc. nor any of its subsidiaries or affiliates represents or warrants that the information contained herein is appropriate or suitable for any specific business or legal purpose. Readers seeking resolution of specific questions should consult their business and/or legal advisors. Coverages may vary by location. Contact your local RSM for more information.

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