Hiring a worker is an important step in the growth of your business. But, is your worker an employee or independent contractor? Understanding the differences between hiring an employee and an independent contractor is crucial.
Why does this distinction matter? Just ask Uber. Drivers have sued the ride-sharing company, claiming Uber incorrectly classified them as contractors instead of employees. Uber could be on the hook for millions of dollars. In fact, a judge
Finally, you’ll have liability for what your employee does. Your business could be financially responsible in a lawsuit over an employee’s actions. Instead, hiring a contractor protects your business.
Employee or Independent Contractor: Who Decides?
Unfortunately, you can’t label someone an employee or contractor and end the discussion. The title you give to a worker doesn’t matter; only the facts do. Multiple government agencies will weigh in.
At the federal level, the IRS will analyze whether someone is an employee for federal tax purposes, like Social Security and Medicare. The Department of Labor will do the same to determine whether labor laws, like the Fair Labor Standards Act (FLSA), apply.
At the state level, state agencies can include tax, labor, unemployment, and workers compensation. And each of these agencies could decide things differently. A worker might be an independent contractor to the IRS, but an employee to your state’s tax department.
So how do these myriad authorities decide who’s an employee?
Employees, Control, and the IRS
The IRS focuses on the level of control over a worker. Of course, there’s no clear rule – that would be too easy. The IRS looks at the entire relationship, including other similar situations. There are three main factors: control over behavior, control over finances, and control over the relationship.
#1. How much control do you have over the worker’s behavior?
Giving specific instructions, such as when and where to work or what equipment to use, points to an employee relationship.
This factor is one of Uber’s main arguments: drivers can work as much or as little as they want and use whatever car they like. If Uber told its drivers that they must drive a certain route and use a certain model of car, its drivers would be more likely to be considered employees.
#2. What financial control do you have over the worker?
Do you reimburse him for expenses, like meals or transportation costs, or provide equipment? That would indicate employment. If Uber drivers are employees, then Uber will be responsible for their gas and insurance.
#3. What control do you exercise over the relationship with the worker?
Providing benefits such as sick days or vacation makes it more likely your worker is an employee. The same applies if the relationship is permanent (instead of a specific project, like a contractor building a single house), or if you required the worker to sign a noncompetition agreement.
Note there are also “statutory employees” that, by law, are never contractors. These include certain delivery drivers for food and laundry and life insurance agents.
Labor and Economic Reality
The Department of Labor uses an “economic reality” test to decide whether a worker’s an employee. This test applies for labor laws like the FLSA (which governs overtime and minimum wage) and the National Labor Relations Act (which gives employees the right to collective bargaining).
The economic reality test includes six factors, and to the shock of no one, none of the factors is controlling. Some of the factors overlap with the IRS’ test as well:
#1. Is the work an integral part of your business?
For example, someone who packs and ships products in your warehouse may be an employee, because getting the product to customers is integral to your business. But someone who comes in occasionally to clean your warehouse wouldn’t be (though work can be “integral” even if it’s done away from the premises).
This is one of Uber drivers’ main arguments. Drivers are certainly integral to Uber’s business; Uber’s entire business model relies on them. Does this mean that Uber’s drivers are employees?
#2. Does the worker’s managerial skill affect the worker’s opportunity for profit or loss?
If a worker has more opportunity for profit or loss, he’s more likely to be an independent contractor. A contractor independently advertises for new clients, tries to reduce his costs, and schedules his work, so his managerial skill affects his opportunity for profit or loss. In contrast, an employee doesn’t do any of those tasks.
#3. How does the worker’s relative investment compare to your investment?
This is similar to the IRS’ financial control factor. An independent contractor is more likely to invest in her own equipment – like an Uber driver buying her own car.
#4. Does the work performed require special skill and initiative?
The technical skills of a worker don’t determine whether he’s an contractor. A worker may have the skill of installing plumbing, but just because plumbers are usually contractors doesn’t make this particular worker one. Rather, focus on the business skills of a worker. Is the worker marketing his own services and ordering his own materials? That points more toward contractor status.
#5. Is the relationship between the worker and employer permanent or indefinite?
Similar to the IRS’ relationship factor, an indefinite relationship suggests employment, not contracting.
#6. What is the nature and degree of the employer’s control?
Finally, this is similar to the control test used by the IRS. But for the Department of Labor, “control” isn’t the ultimate question – economic reality is.
The ABCs of State Law
The tests used by states vary, but they often follow similar lines of inquiry. About two-thirds of states use the “ABC test.” This test classifies a worker as an independent contractor if all of the following are met:
- A. The worker is free from control or direction in the performance of the work;
- B. The worker is operating an independent trade or business; and
- C. The work is outside the usual course of the company’s business and is done off the premises.
Notice the similarity to the IRS and Department of Labor tests. There’s control, just like the other tests. “Independent trade or business” sounds a lot like the profit/loss factor from the economic reality test, and “outside the usual course of business” seems similar to “integral part of the business.”
But remember that a state can decide who’s an employee separately from the IRS and Department of Labor, and not all states use the ABC test. Check with your state to avoid any surprises.
Walking the Walk
So, knowing what makes someone an employee, how do you ensure you don’t accidentally hire one? If you have an agreement, you can say something like “nothing in this agreement shall be construed to create any employment relationship between the parties hereto.” But those words – while you might as well use them, just to cover your bases – aren’t enough to prevent an employment relationship.
More than your words, your behavior matters. Check the factors above and make sure you come down on the contractor side of the equation. Make sure your instructions aren’t too specific and don’t provide the training you’d provide employees. Don’t provide equipment. Make sure your working relationship has a specific end date, instead of open-ended and indefinite.
Use the IRS’ Form SS-8 as an internal checklist to guide your behavior. This form is a list of questions that the IRS uses to classify workers, and it follows the control analysis set out above.
You can submit Form SS-8 to the IRS for classification of your worker, but it’s not recommended. The IRS is likely to determine the worker is an employee – after all, it wants the tax revenue – and you must abide by that decision. Use it as internal guideline only.
Uber, Uncertainty, and You
Uber’s case is now headed to arbitration. There won’t be a clear answer whether its drivers are employees or contractors for a while, and in fact, arbitration probably won’t answer that question at all. How should workers in the “gig economy” be treated?
Employers and workers still face uncertainty. Frustration is inevitable without a clear legal rule. But keep the above considerations in mind when managing your workers.
Image: choice of working as freelancer versus employee