Independent contractor vs. employee

Why classification matters

Employees are covered by minimum wage and overtime rules, payroll tax withholding, unemployment insurance, workers’ compensation and many leave laws. Independent contractors generally are not. Treating an employee as a contractor can lead to back wages, back taxes, penalties and benefits claims, often for several years. It also affects how you track time: employees who are non-exempt need accurate hour records, which contractors usually do not. See our glossary entry on the independent contractor.

See how EZTime works for your industry, from time tracking to shift scheduling.

The federal wage and hour test

Under the FLSA, courts and the Department of Labor use an “economic reality” approach: is the worker in business for themselves, or economically dependent on the employer? Factors commonly considered include:

• The worker’s opportunity for profit or loss based on their own managerial skill.
• Investments by the worker in their own business, such as equipment, staff or marketing.
• How permanent the relationship is. Ongoing, open-ended work points toward employment.
• The nature and degree of control the employer has over the work, such as schedules, prices and the ability to work for others.
• Whether the work is an integral part of the employer’s business.
• Whether the worker uses business-like initiative and skill.

No single factor decides the outcome. The DOL’s formal guidance on this test has changed several times in recent years, so check the current DOL position before relying on any particular version.

The IRS test

For federal tax purposes, the IRS uses common-law rules grouped into three categories:

If the answer is unclear, either party can ask the IRS for a determination using Form SS-8.

State ABC tests

Several states, including California, Massachusetts and New Jersey, use an “ABC” test for some or all purposes. Under a typical ABC test, a worker is an employee unless the business shows all three of the following:

1. A: the worker is free from the business’s control and direction in performing the work, both under the contract and in fact.
2. B: the work is outside the usual course of the business.
3. C: the worker is customarily engaged in an independently established trade, occupation or business of the same kind.

Part B is often the hardest to meet. For example, a cleaning company that hires “contractor” cleaners to clean clients’ offices will usually struggle, because cleaning is its usual business. Exceptions exist for certain professions and situations, so check your state’s rules.

Warning signs of misclassification

• The “contractor” works set shifts that you schedule.
• They wear your uniform, use your tools and follow your procedures.
• They work only for you, and have done so for a long time.
• They are paid by the hour, like your employees, with no real chance of profit or loss.
• They do the same work as employees on your team.
• They were previously an employee doing the same job.

If several of these apply, the worker may well be an employee under one or more tests.

How to make and document the decision

1. List every worker you pay on a 1099 basis and describe the work they actually do.
2. Apply the federal economic reality factors, the IRS categories and any state test that applies.
3. Look at the relationship in practice, not only at the contract.
4. Where the answer points toward employment, or is unclear, get advice and consider reclassifying.
5. For genuine contractors, keep a written agreement, invoices, proof of their own business and insurance, and avoid controlling how they work.
6. Review classifications at least once a year and whenever the relationship changes.

If you reclassify workers as employees

Moving workers onto payroll means setting them up for tax withholding, onboarding them and tracking their hours. Our guide on onboarding hourly employees covers the first steps, and the guide to exempt vs. non-exempt employees explains whether overtime applies. Professional advice is especially important if back pay or taxes may be owed.

Tracking time for a mixed workforce

Many businesses use a blended workforce of employees and contractors. Employees who are non-exempt need full time records. Contractors usually invoice for their work, but some businesses also track contractor time on projects for billing or job costing. With EZTime, you can record hours for your team in one place and export reports for payroll and project costing. Be careful not to use tracking to control how genuine contractors do their work, since control is one of the factors in every test.

What a misclassification can cost, by agency

The IRS runs a Voluntary Classification Settlement Program for businesses that want to start treating workers as employees going forward. Eligible employers pay a reduced amount on the most recent tax year and avoid interest and penalties on it, provided they meet the program’s conditions, including not being under employment tax audit. Ask a tax professional whether it fits your situation before applying.

A worked example: the cost of a missed overtime week

A fictional delivery driver paid $22.00 an hour as a contractor works 50 hours a week for a year and is later found to be an employee. Under the FLSA, each of those weeks carried 10 overtime hours owed at an extra $11.00, or $110 a week. Over 50 weeks that is $5,500, and with an equal amount of liquidated damages, $11,000, before taxes and state penalties. Time records matter in both directions: if you did not keep them, the employee’s reasonable estimate of hours is often accepted.

Frequently asked questions

Where to go next