Employee or independent contractor and why it matters


The pandemic has changed who we hire. In some cases it is about hiring contractors vs employees and in other cases it is about from where employees are located. In this article, we will focus on hiring contractors vs employees.

As states look to replenish depleted unemployment funds, I suspect that more audits around worker classification will be coming.

Many Federal and state agencies deal with worker classification and tend to use one of two approaches to determine the correct classification.

Approach 1 – Common Law

Whether a worker is an independent contractor or an employee depends on the relationship between the worker and the business. Generally, there are three categories that make up what is know as the common law approach used by the IRS and some states:

  1. Behavioral Control − does the company control or have the right to control what the worker does and how the worker does the job?
  2. Financial Control − does the business direct or control the financial and business aspects of the worker’s job. Are the business aspects of the worker’s job controlled by the payer? (Things like how the worker is paid, are expenses reimbursed, who provides tools/supplies, etc.)
  3. Relationship of the Parties − are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Approach 2 – ABC Test

The US Department of Labor and 33 states use the ABC test to determine independent contractor status for labor law purposes, including minimum wages, overtime, and workers’ compensation. The burden is on the hiring entity to establish that the worker is not an employee.⁠ A hiring entity can show that a worker is an independent contractor (and thus not an employee) only if all three of the following requirements are met:

  1. Autonomy. The worker must be free from the control and direction of the hiring entity with regard to how the work is performed.⁠
  2. Business Dissimilarity. The worker’s labor or services must fall outside the usual course of the hiring entity’s business.⁠
  3. Custom of the Worker. The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.⁠

Ramifications of Misclassified workers

Misclassifying workers as independent contractors adversely affects employees because the employer’s share of taxes is not paid, and the employee’s share is not withheld. If a business misclassified an employee without a reasonable basis, it could be held liable for employment taxes for that worker. Generally, an employer must withhold and pay income taxes, Social Security and Medicare taxes, as well as unemployment taxes.

One way the IRS and the various states find our about misclassified workers is when a worker who believe they have been improperly classified as independent contractors can files IRS Form 8919, Uncollected Social Security and Medicare Tax on Wages to figure and report their share of uncollected Social Security and Medicare taxes due on their compensation.

Another way to get caught is when a worker files for unemployment. This does not have to be that your company cut back on the contract, it could be that the worker lost their main W2 job and in applying for unemployment has to report all sources of income. In my experience this is the most common way NYS comes calling. And if you lose your case (which under NYS law almost always is the outcome) NYS then opens a second case for unpaid workers compensation and disability insurance. Fines for not having the proper insurance can be as much as $500 a day per misclassified worker. We have helped clients reduce these fines from tens of thousands of dollars to a few hundred dollars by obtaining the insurance and making a case for abatement.

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