09/20/22

Independent Contractor or Employee: Misclassifying Employees Can Lead to Fines and Lawsuits

By Janell Stanton, HR & Employment Attorney, Compliance Center

Hiring workers as independent contractors can be an attractive option for many companies, especially during a tight labor market, because it can offer companies considerable savings and flexibility. However, if a worker is improperly classified as an independent contractor, employers can face serious penalties. For that reason, it is imperative that companies fully assess whether an individual the company desires to retain can be properly classified as an independent contractor. This is no easy feat considering there are several different independent contractor tests employers must consider, all with multiple factors to weigh, and no single factor being dispositive.

The IRS, for example, has its own test which looks at three main factors of the worker/employer relationship to determine independent contractor classification: behavioral, financial, and relational. In examining the behavioral component, the IRS test looks at which party has the right to control the way the worker gets their job done. If an employer dictates the worker’s schedule, the way the worker completes their tasks, or if the company enforces its policies against the worker, then the individual is more likely to be an employee than an independent contractor. Regarding the financial component, the test examines how the worker is paid, whether the company provides tools, resources, or reimburses expenses to the worker, and whether the worker can provide their services for other companies. The relational factor analyzes whether the relationship between the employer and the worker is ongoing, and whether the work they perform is a key aspect of the business.

The Department of Labor employs a different test to determine whether a worker is an independent contractor or an employee: the “economic realities test.” This test consists of five main factors, though some reviewing courts have added a sixth, and looks at:

1. The degree of control the company exercises over the worker;
2. The investment the worker has made in facilities and tools;
3. The worker’s opportunity for profit and loss;
4. The permanency of the parties’ relationship;
5. The skills required; and, in some cases,
6. Whether the worker’s services are integral to the company’s business.

There are other tests employers need to be aware of, as well, including the so-called “ABC test.” The ABC test starts with a presumption that all workers are employees unless the company can show that the worker has been, and will continue to be, free from:

1. Control or direction in the performance of their work,
2. the work is either outside the usual course of business for the company requesting the work or performed outside the company’s place of business,
3. And the worker is customarily engaged in an independently established trade, occupation, or business.

Other states and localities have adopted their own independent contractor tests. There are also tests under the National Labor Relations Act, the Employee Retirement Income Security Act (ERISA), and others.

Though there are several different tests with a multitude of factors, there are also several factors that are not relevant in determining whether a worker is an independent contractor. Most crucially is the existence of an independent contractor agreement. The mere existence of an agreement between the employer and the worker does not mean the employer is not at risk for misclassifying the worker.

As mentioned previously, the penalties for misclassifying an employee as an independent contractor can be severe and can include an award of back pay, including for any unpaid overtime, employee benefits including possible penalties under the Affordable Care Act, disability and worker’s compensation payments, tax and insurance obligations, and a variety of fines.

Before entering into an independent contractor agreement, remember that companies must examine the entire relationship on a case-by-case basis, and should consider consulting legal counsel who can aid in determining whether a worker is properly classified before an accidental misclassification leads to undesirable penalties.

Our partner attorneys and HR professionals at the Flores HR Compliance Center can help ensure your policies are up to date, advise on the best practices for conducting thorough investigations, and guide companies through performance management and termination decisions. To learn more about this Flores service offering, reach out to your Flores Account Manager or Business Development Director, or contact us

The information presented in this post is current as of the publication date. The information included does not constitute legal advice.