Independent Contractor (“1099”) v. Employee (“W2”)…are you sure you got it right?

Understanding what work you can contract out to an independent contractor versus what work must legally be done by an employee is one of the most important and nagging question for business owners. To make things more difficult, the rules regarding who is an independent contractor and who is an employee are set to change…again. In this ever changing landscape it is crucial to stay on top of the latest developments to avoid what too often results in catastrophic consequences for unsuspecting business owners. Let’s delve into this issue.

1. What are the General Differences between an Independent Contractor and an Employee?

The difference between an independent contractor and an employee mainly revolves around the level of control an employer has over the work being done, the financial arrangements, and the relationship’s nature.

Control over Work

• Independent Contractor: Typically has a high degree of control over how to complete their work. They can often set their own hours and decide on the method of work. Contractors are often hired for specific projects or tasks and have the freedom to work for multiple clients.
• Employee: An employer controls when, where, and how an employee performs their job. Employees usually follow a set schedule determined by the employer and are subject to closer supervision.

Wages and Taxes

• Independent Contractor: Pays for their own business expenses, taxes, and benefits. Contractors invoice for their services and are not typically paid through the employer’s payroll. At the end of the year, a business will generally issue IRS Form 1099 to an independent contractor showing how much money was paid out to the independent contractor for that tax year. A major benefit to workers of this status is that there is no income or payroll tax withholding, such that they receive the full amount earned; they are however responsible for paying such taxes at year end. Independent contractors can also reap enormous tax benefits by taking advantage of business deductions. However, independent contractors are not eligible for unemployment insurance and workers’ compensation benefits.
• Employee: Employees are paid through the employer’s payroll and must be paid within legally prescribed times (payroll periods). The employer also must withhold income tax, Social Security, and Medicare (as well as state equivalents such as unemployment insurance and workers’ compensation) from wages paid. Employers must also contribute employer side payments to these same payroll taxes. At the end of the year, a business will issue an employee IRS Form W2, showing how much that employee earned during the year, as well as the income and payroll tax deductions made by the employer. Employees may also be eligible for benefits like health insurance, paid time off, and retirement plans. The employer must also cover all business related expenses incurred by the employee.

Working and Legal Relationship

• Independent Contractor: The relationship is often temporary, based on the duration of a specific project or task. There is usually a contract specifying the work’s scope, payment, and deadlines. Contractors do not receive employee benefits and are not protected by employment and labor laws in the same way employees are.
• Employee: The relationship is typically ongoing and can be full-time or part-time. Employees have a more integrated role within the company and may receive training to perform their job. They are protected by employment and labor laws, which cover minimum wage, overtime, workplace safety, and discrimination.

2. Is it better to hire an Independent Contractor or an Employee?

Deciding whether to hire an employee or an independent contractor depends on the specific needs, circumstances, and goals of your business. Each option has its advantages and considerations.

Caveat: regardless of the pros and cons, the first question should always be whether the work in question can even be done by an independent contractor, or whether the law requires that it be an employee. Any worker can legally be categorized as an employee. However, if you want to classify a worker as an independent contractor, it is crucial to assess the legality of doing so on a case-by-case basis.

Hiring an Independent Contractor

Pros:

• Flexibility: Contractors can be hired on a project-by-project basis, offering flexibility to scale workforce up or down as needed.
• Cost Savings: Typically, there’s no need to provide benefits like health insurance, paid leave, or retirement plans. You also save on employment taxes and payroll administration.
• Specialized Skills: Contractors often bring specialized skills for specific projects, reducing the need for training and development.
• Reduced Legal Obligations: Fewer regulations concerning hiring, managing, and terminating contractors compared to employees.

Cons:

• Less Control: You have less control over the work schedule and the method of work of contractors.
• Dependency Risks: Relying on contractors might pose risks if they leave abruptly or prioritize other clients’ projects.
• Intellectual Property Concerns: May need explicit agreements to ensure your business retains rights to the work produced.

Hiring an Employee

Pros:

• Control: Greater control over work processes, schedules, and adherence to company policies.
• Loyalty and Culture: Employees are more likely to be invested in your company’s success, contributing to a cohesive team and company culture.
• Long-term Investment: Training and developing employees can enhance their productivity and value to the company over time.
• Regulatory Clarity: Clear legal frameworks govern the employment relationship, providing structure and protection for both parties.

Cons:

• Higher Costs: Beyond salaries, you’re responsible for benefits, taxes, and compliance with labor laws, which can add significant costs.
• Less Flexibility: Hiring and terminating employees is more complex and subject to more regulations, making it harder to scale the workforce quickly.
• Administrative Overhead: Managing payroll, benefits, and compliance with employment laws requires significant administrative work.

Ultimately, assuming it is legal to classify a worker as an independent contractor, the decision whether or not to do so should align with your business strategy, operational needs, and financial considerations.

3. How do I Determine if a Worker Can be an Independent Contractor, or if they Must be an Employee?

Any worker can legally be categorized as an employee. However, if you want to classify a worker as an independent contractor, it is crucial to assess the legality of doing so on a case by case basis. Unfortunately, the guidelines for determining who can be an independent contractor and who must be an employee change…sometimes frequently. The U.S. Department of Labor just unveiled a significant revision to the criteria for distinguishing between independent contractors and employees with its final rule issued on January 9, 2024, set to take effect on March 11, 2024. This new regulation marks a shift from the Trump Administration’s more employer-friendly stance to a system that revisits the multi-faceted “economic realities” test. Unlike the Trump administration’s emphasis on two primary factors—the degree of control by the employer and the worker’s potential for profit or loss—the new test evaluates six factors without prioritizing any single one as decisive.

The Six Factors:

1. Opportunity for Profit or Loss: This factor examines if a worker can influence their earnings through “managerial skill,” such as setting prices, choosing jobs, and marketing their services. A lack of such opportunities suggests employee status, while the ability to affect profit or loss points to independent contractor status.

2. Investments: This factor evaluates if a worker’s investments are entrepreneurial in nature, which would suggest independent contractor status. Investments that enhance a worker’s business capabilities, reduce costs, or expand market reach are indicative of an independent contractor. In contrast, basic costs, or costs imposed by the employer, point towards employee status.

3. Permanence of Relationship: This factor supports an employee classification if the work relationship lacks a fixed end date, is ongoing, or prevents working for other employers. Conversely, it leans towards independent contractor status if the relationship is for a specific period, allows working for multiple clients, and involves self-marketed, project-based, or intermittent work.

4. Degree of Control: Greater control by the employer over work performance and economic conditions suggests employee status. Independent contractors typically enjoy more freedom in how and when work is done, including the ability to work for multiple clients.

5. Integral Part of Business: If the work is essential to the business’s core operations, it likely indicates an employee relationship. Work that’s peripheral to the main business activities suggests an independent contractor role.

6. Skill and Initiative: This factor evaluates if a worker’s specialized skills and business initiative contribute to their role, impacting their classification. Employee status is suggested when the worker lacks specialized skills or relies on the employer for necessary training.

This change back to relying on these six factors is particularly relevant for businesses operating under the federal Fair Labor Standards Act (FLSA), including those in states adhering to FLSA standards or those engaged in federal contracts. However, it does NOT supplant more stringent state requirements, such as California’s notorious “ABC Test.”

4. Can an individual be an employee for FLSA purposes even if they are an independent contractor for tax purposes?

Yes. The IRS applies its own test (a version of the common law control test) to analyze if a worker is an employee or independent contractor for tax purposes. While the Department of Labor considers many of the same factors as the IRS, the economic reality test for FLSA purposes is based on a specific definition of “employ” in the FLSA, which provides that employers “employ” workers if they “suffer or permit” them to work. Courts have interpreted this language to be broader than the common law control test. This means that some workers who may be classified as independent contractors for tax purposes may be employees for FLSA purposes because, as a matter of economic reality, they are economically dependent on an employer for work.

5. Some States have More Stringent Rules Regarding Who Can be an Independent Contractor

If the law were not complicated enough, it is important to note that some (many) states have more stringent laws regarding who can be classified as an independent contractor. The most notorious is the “ABC test,” variations of which have been adopted by a large number of states. By way of example, the California iteration of the ABC Test is codified (in relevant part) into California Labor Code § 2750.3 as follows:

“…a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all of the following conditions are satisfied:

(A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

(B) The person performs work that is outside the usual course of the hiring entity’s business.

(C) The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.”

Cal. Lab. Code § 2750.3(a)(1).

The ABC Test and Department of Labor (DOL) guidelines may seem similar due to their overlapping criteria, yet they diverge significantly in application. The ABC Test requires the worker to meet ALL the criteria for independent contractor classification, while the DOL allows for a more holistic approach where stronger indications of independent contractor status on some factors can outweigh weaker indications on other factors.

To complicate matters even further, there are also certain jobs that are specifically excluded from the ABC test, such that they can be analyzed under the more lenient framework (even in states that default to the ABC test). These exemptions are themselves complicated to apply, and differ from state to state. They are an absolute minefield for unsuspecting businesses.

6. Can a Worker Voluntarily Waive Employee Status and Choose to be Classified as an Independent Contractor?

No. The worker has no discretion to voluntarily waive the employee classification if it is required. The same consequences and penalties would apply regardless of the intent of the worker.

7. What if I Misclassify a Worker as an Independent Contractor?

Misclassifying employees as independent contractors can lead to significant legal and financial consequences for employers under various federal and state laws. Key areas of liability include:

1. Wage Law Violations: Employers may face penalties for not paying overtime and minimum wage as required by the Fair Labor Standards Act (FLSA) and state laws. Violations can lead to criminal penalties, back wages, liquidated damages, and attorney’s fees.
2. Unpaid Employment Taxes: Failure to withhold and remit payroll taxes for misclassified workers can result in penalties, including those for unmade social security and Medicare tax payments.
3. I-9 Violations: Misclassification may breach employer verification requirements, leading to civil fines, criminal penalties, and other sanctions following an audit of Form I-9 records by the Department of Homeland Security and the Department of Labor.
4. Unemployment Insurance Shortfalls: Employers might be penalized for not paying state unemployment insurance due to misclassification.
5. Unpaid Workers’ Compensation Premiums: Misclassification can lead to penalties under state workers’ compensation laws and liability for unpaid premiums.
6. Improper Exclusion from Benefits: Misclassified workers may miss out on employer benefits like pension plans, health insurance, paid leave, and severance pay, posing a risk of enforcement actions and lawsuits.
7. Failure to Provide Job-Protected Leave: Employers may breach obligations under laws like the FMLA and state equivalents by failing to offer protected leave to misclassified employees.
8. Failure to Provide Required Notice: Incorrect classification may affect compliance with notice obligations resulting in significant fines and penalties for non-compliance.

Overall, the risks of misclassifying employees as independent contractors include substantial legal liabilities and financial penalties across a broad spectrum of employment laws. It’s essential for all employers to conduct classification audits to ensure compliance with both the new DOL regulations, as well as the stricter state standards.