The economic and tax advantages associated
with the independent contractor relationship are significant. Therefore,
the temptation to pursue and establish such agreements instead of
permanent employment arrangements is a practical reality. In order
to minimize intentional or inadvertent abuse that can result in substantial
penalties, there are various guidelines to assist the employer in
correctly identifying and classifying employment relationships.
Recent changes to the law. On October
13, 2022, the U.S. Department of Labor published its Notice of Proposed
Rulemaking (NPRM) revising the department’s guidance on how to determine
who is an employee or independent contractor under the FLSA. The NPRM
would rescind the earlier rule published on January 7, 2021, and replace
it with an analysis for determining employee or independent contractor
status that is more consistent with the FLSA as interpreted by long-standing
judicial precedent. The DOL’s NPRM proposes a return to the “totality-of-the-circumstances”
analysis of the economic reality test in which the factors do not
have a predetermined weight and are considered in view of the economic
reality of the whole activity. This analysis is dependent on whether
each factor shows the worker is economically dependent upon the employer
for work versus being in business for himself or herself. The DOL
further proposes to return the consideration of investment to a standalone
factor, focusing on whether the worker’s investment is capital or
entrepreneurial in nature and considering the worker’s investments
on a relative basis with the employer’s investment. The DOL will also
provide additional analysis of the control factor, including detailed
discussions of how scheduling, supervision, price-setting, and the
ability to work for others should be considered when analyzing the
degree of control over a worker, and not limiting control to that
which is actually exerted. Finally, the DOL proposes returning to
the long-standing interpretation of the integral factor, which considers
whether the work is integral to the employer’s business rather than
whether it is exclusively part of an integrated unit of production.
The DOL believes that once this proposal is finalized, it will provide
more consistent guidance to employers as they determine whether workers
are economically dependent on the employers for work or are in business
for themselves, as well as useful guidance to workers on whether they
are correctly classified as employees or independent contractors.
This proposed rule is a change from the anticipated ABC test, which
the DOL states it had considered codifying but was legally constrained
from doing so because it is inconsistent with Supreme Court precedent.
The Supreme Court has previously held that the economic reality test
is the applicable standard for determining workers’ classification
under the FLSA as an employee or independent contractor. The proposed
rule will have a 45-day notice-and-comment period that will close
at 11:59 p.m. ET on November 28, 2022.
An employment relationship under the FLSA
must be distinguished from a strictly contractual one. Such a relationship
must exist for any provision of the FLSA to apply to any person engaged
in work that may otherwise be subject to the Act. In the application
of the FLSA, an employee, as distinguished from a person who is engaged
in a business of his or her own, is one who, as a matter of economic
reality, follows the usual path of an employee and is dependent on
the business he or she serves. The employer-employee relationship
under the FLSA is tested by "economic reality" rather than technical
concepts. It is not determined by the common-law standards relating
to master and servant.
The U.S. Supreme Court has, on a number
of occasions, indicated that there is no single rule or test for determining
whether an individual is an independent contractor or an employee
for purposes of the FLSA. The Court has held that it is the total
activity or situation that controls. Among the factors the Court has
considered significant are:
• The extent to which the services rendered
are an integral part of the principal's business;
• The permanency of the relationship;
• The amount of the alleged contractor's
investment in facilities and equipment;
• The nature and degree of control by the
principal;
• The alleged contractor's opportunities
for profit and loss;
• The amount of initiative, judgment, or
foresight in open market competition with others required for the
success of the claimed independent contractor; and
• The degree of independent business organization
and operation.
There are certain factors that are immaterial
in determining whether there is an employment relationship. Such facts
as the place where work is performed, the absence of a formal employment
agreement, or whether an alleged independent contractor is licensed
by state or local government are not considered to have a bearing
on determinations as to whether there is an employment relationship.
Additionally, the Supreme Court has held that the time or mode of
pay does not control the determination of employee status.
The economic realities test has been used for the following
laws:
• Title VII of the Civil Rights Act
• Age Discrimination in Employment Act
• Americans with Disabilities Act
• Fair Labor Standards Act
The U.S. Department of Labor (DOL) has said that the
economic realities test should also be applied to the Family and Medical
Leave Act, as well as the Migrant and Seasonal Agricultural Worker
Protection Act.
The IRS utilizes a common-law test to classify workers.
To determine whether an individual is an employee or an independent
contractor under the common law, the relationship of the worker and
the business must be examined. In any employee-independent contractor
determination, all information that provides evidence of the degree
of control and the degree of independence must be considered. Facts
that provide evidence of the degree of control and independence fall
into three categories: behavioral control, financial control, and
the type of relationship of the parties.
1. Behavioral control. Facts that show whether the business has a right to direct and control
how the worker performs his job functions include the type and degree
of:
• Instructions that the business
gives to the worker. An employee is generally subject to
the business's instructions about when and where to do the work, what
tools or equipment to use, what workers to hire or to assist with
the work, where to purchase supplies and services, what work must
be performed by a specified individual, and what order or sequence
to follow. The amount of instruction needed varies among different
jobs. Even if no instructions are given, sufficient behavioral control
may exist if the employer has the right to control how the work results
are achieved. A business may lack the knowledge to instruct some highly
specialized professionals; in other cases, the task may require little
or no instruction. The key consideration is whether the business has
retained the right to control the details of a worker's performance
or instead has given up that right.
• Training that the business gives
to the worker. An employee may be trained to perform services
in a particular manner. Independent contractors normally use their
own methods.
2. Financial control. Facts that show whether the business has a right to control the business
aspects of the worker's job include:
• The extent to which the worker
has unreimbursed business expenses. Independent contractors
are more likely to have unreimbursed expenses than are employees.
Fixed ongoing costs that are incurred regardless of whether work is
currently being performed are especially important. However, employees
may also incur unreimbursed expenses in connection with the services
that they perform with their business.
• The extent of the worker's investment. An independent contractor often has a significant investment in the
facilities he or she uses in performing services for someone else.
However, a significant investment is not necessary for independent
contractor status.
• The extent to which the worker
makes his or her services available to the relevant market. An independent contractor is generally free to seek out business
opportunities. They often advertise, maintain a visible business location,
and are available to work in the relevant market.
• How the business pays the worker. An employee is generally guaranteed a regular wage amount for an
hourly, weekly, or other period of time. This usually indicates that
a worker is an employee, even when the wage or salary is supplemented
by a commission. An independent contractor is usually paid a flat
fee for the job. However, it is common in some professions, such as
law, to pay independent contractors hourly.
• The extent to which the worker
can realize a profit or loss. An independent contractor
can make a profit or loss.
3. Type of relationship. Facts that show the parties' type of relationship include:
• Written contracts describing
the relationship the parties intended to create.
• Whether or not the business
provides the worker with employee-type benefits such as insurance,
a pension plan, vacation pay, or sick pay.
• The permanency of the relationship. If employers engage the worker with the expectation that the relationship
will continue indefinitely, rather than for a specific project or
period, this is generally considered evidence that the employer's
intent was to create an employer-employee relationship.
• The extent to which services
performed by the worker are a key aspect of the regular business of
the company. If a workers provides services that are a
key aspect of the employer's regular business activity, it is more
likely that the employer will have the right to direct and control
his or her activities.
Note: Be careful of the lure
of past practice. Even though similar positions or the
same position may have been classified as an employee or independent
contractor in the past, working arrangements typically change over
time. Therefore, be certain to evaluate the current status of the
position in light of these factors.
The Internal Revenue Service (IRS)/common-law test has
been used for the following laws:
• Federal Insurance Contributions Act (FICA)
• Federal Unemployment Tax Act
• Income tax withholding
• Employee Retirement and Income Security Act
• National Labor Relations Act
• Immigration Reform and Control Act
When in doubt about the status of a particular
worker or class of workers, an employer or a worker may request an
IRS determination preapproval by filing Form SS-8, Determination of
Worker Status for Purposes of Federal Employment Taxes and Income
Tax Withholding. A Form SS-8 determination may be requested only to
resolve federal tax matters. The party requesting a determination
must file an income tax return for the years in question before a
determination can be issued. A determination will not be issued for
a tax year for which the statute of limitations on the tax return
has expired. The statute of limitations expires 3 years from the due
date of the tax return or the date filed, whichever is later. Although
it can take at least 6 months to get a determination, a business that
continually hires the same types of workers to perform particular
services may want to file the Form SS-8.
Hybrid test. A hybrid
test under which an employment relationship is evaluated under both
common-law and economic reality test factors, with a focus on who
has the right to control the means and manner of a worker’s performance,
has been applied by courts to the following laws:
• Title VII of the Civil Rights Act
• Age Discrimination in Employment Act
• Americans with Disabilities Act
The "reasonable basis" test provides a “safe harbor”
to employers based on existing government or court classifications
of workers in a particular business or industry and was mandated by
the Revenue Act of 1978 (P.L. 95-600, Sec.
530), which provides that a worker may be appropriately classified
as an independent contractor exempt from federal employment taxes
if one or more of the following conditions are met:
• Judicial precedent treating workers in similar circumstances
as nonemployees
• A Revenue Ruling issued by the IRS indicating that similar
workers are exempt
• An IRS Technical Advice Memorandum stating that the worker
in question is not an employee
• A long-standing and recognized practice in the industry
of treating similar workers as nonemployees
• A prior IRS audit finding that individuals in substantially
similar positions were not employees
ABC test. Numerous states, such as Massachusetts and California, have adopted
the ABC test to classify workers as independent contractors or employees.
The ABC test significantly toughens the analysis used to determine
whether a worker can be classified as an independent contractor, and
the change has had a big impact on gig economy workers. The test is
putting stress on businesses such as rideshare giants Uber and Lyft
because they and other gig economy entities rely on the independent
contractor model, which is a far less expensive way to staff their
businesses than hiring employees who are eligible to form unions,
collect benefits, and be covered under an array of state and federal
laws.
The ABC test presumes a worker is an employee
unless the hiring entity proves the following:
A. 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 the work and in fact.
B. The worker performs work that is outside
the usual course of the hiring entity’s business.
C. 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.