Employee vs Independent Contractor: What You Don't Know Could Cost You

When a worker qualifies as an independent contractor, the employer is generally relieved of obligations related to payroll taxes, minimum wage  in addition to overtime requirements, benefits, workers' compensation, and unemployment costs for that individual. However, only a small fraction of workers qualify for independent contractor status.

Independent contractors are generally in an independent trade or business and offer their services to the general public under a contract or agreement. Typically, they provide their own equipment and determine how and when they work. The more control that the business has over the individual, the more likely they will be considered an employee and not an independent contractor.

Many employers refer to independent contractors as "1099" workers and employees as "W-2" workers after the IRS forms used for federal reporting purposes. However, simply providing a worker a 1099 Form doesn't make them an independent contractor. The classification must always be made on the basis of whether the worker meets federal and state tests for independent contractor status. Different tests are used to determine whether a worker is covered by a particular law or benefit. The following is an overview of some of these tests.

Federal tests

Taxes

The Internal Revenue Service uses the Common Law Test for federal tax purposes. The test has three broad categories to determine the appropriate classification of a worker:

• "Behavioral control" examines whether the company has the authority to direct and control the work of the service provider and looks at whether the worker receives training and instruction.
  
  
• "Financial control" looks at factors such as whether the worker realizes a profit or loss, makes investments in tools and facilities, and has unreimbursed expenses.
  
  
• "Type of relationship" examines the nature of the relationship. This includes whether there is a written contract between the parties, the permanency of the relationship, and whether the worker is entitled to employee-type benefits.
  
  

Under this test, no one factor stands alone in making a classification determination. You need to weigh all factors (and take into account any other applicable tests) when determining whether an individual is an employee or an independent contractor. Look at the entire relationship, consider the degree of control, and document each of the factors used in making a determination.

When in doubt, it is a best practice to classify the worker as an employee. You may also request an official determination from the IRS using Form SS-8. However, it can take at least six months to get an IRS determination.

Wage and hour

The U.S. Department of Labor (DOL) uses an "economic realities" test to determine whether workers are considered employees and therefore covered by the FLSA[BR1]  and entitled to minimum wage, overtime, and other wage and hour protections.

Since March 11, 2024, the DOL’s economic realities test has looked at the following six factors. Additional factors that look closely at investments by the worker, the employer’s control, and whether the work performed is integral to the business may also be considered if the worker is in business for themself.

1. Opportunity for profit or loss depending on managerial skill

This factor considers whether the worker has opportunities for profit or loss based on managerial skill (including initiative or business acumen or judgment) that affect the worker's economic success or failure in performing the work. If a worker has no opportunity for a profit or loss, then this factor suggests that the worker is an employee. 

2. Investments by the worker and the employer

This factor considers whether any investments by a worker are capital or entrepreneurial in nature. Such investments generally support an independent business and serve a business-like function, such as increasing the worker's ability to do different types of or more work, reducing costs, or extending market reach. Additionally, the worker's investments should be considered on a relative basis with the potential employer's investments in its overall business.

3. Degree of permanence of the work relationship

This factor weighs in favor of the worker being an employee when the work relationship is indefinite in duration, continuous, or exclusive of work for other employers.

This factor weighs in favor of the worker being an independent contractor when the work relationship is definite in duration, non-exclusive, project-based, or sporadic based on the worker being in business for themself and marketing their services or labor to multiple entities.

4. Nature and degree of control

This factor considers the potential employer's control, including reserved control, over the performance of the work and the economic aspects of the working relationship.

Facts relevant to the potential employer's control over the worker include whether the potential employer sets the worker's schedule, supervises the performance of the work, or explicitly limits the worker's ability to work for others. Additionally, facts relevant to the potential employer's control over the worker include whether the potential employer uses technological means to supervise the performance of the work (such as by means of a device or electronically), reserves the right to supervise or discipline workers, or places demands or restrictions on workers that do not allow them to work for others or work when they choose.

5. Extent to which the work performed is an integral part of the employer’s business

This factor considers whether the work performed is an integral part of the potential employer’s business. This factor doesn’t depend on whether any individual worker in particular is an integral part of the business, but rather whether the function they perform is an integral part of the business.

This factor weighs in favor of the worker being an employee when the work they perform is critical,
necessary, or central to the potential employer's principal business. This factor weighs in favor of the worker being an independent contractor when the work they perform isn’t critical, necessary, or central to the potential employer's principal business.

6. Skill and initiative

This factor considers whether the worker uses specialized skills to perform the work and whether those skills contribute to business-like initiative. This factor indicates employee status where the worker does not use specialized skills in performing the work or where the worker is dependent on training from the potential employer to perform the work.

Equal Employment Opportunity (EEO)

Under federal nondiscrimination laws, a worker is presumed to be an employee (and therefore entitled to protection under EEO laws) unless they meet certain tests. The Equal Employment Opportunity Commission (EEOC) looks at factors suggesting a worker is an employee and not an independent contractor, such as whether:

State tests

Some states have their own tests-- some of which are more difficult to satisfy than federal tests. For example, a number of states use the “ABC test” for determining whether an individual is covered under unemployment insurance and/or wage and hour laws or other benefits. Under this test, a worker must be considered an employee unless all three of the following factors are met:

• The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
• The worker performs work that is outside the usual course of the hiring entity's business; and
• The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
  
  

Check your applicable state tests to ensure compliance.

In Conclusion

Before classifying an individual as an independent contractor, make sure they've met all applicable tests. Misclassification of employees as independent contractors can result in significant penalties. If the worker fails to meet these tests, the individual is an employee and is entitled to all the rights and benefits of employees under the applicable law.