Worker Classification Part 1: Employee versus Independent Contractor

We often get questions about why a business would want to or need to re-classify their workers. In a nutshell, misclassification of workers has serious consequences and can do a lot of damage to your business including financial penalties and possibly even criminal charges for tax evasion.

In fact, according to the National Employment Law Project (NELP) between 10 and 30 percent of audited employers misclassify their employees as independent contractors, meaning several million workers nationally may be misclassified.

So needless to say, it’s important to get it right. 

When we talk about worker classification, there are two ways workers get classified:

1. Employee versus independent contractor

2. Exempt versus non-exempt status  

In this blog, we’ll be covering employee versus independent contractor classification. 

AB5

Worker classification has recently come into the spotlight thanks to AB5 or California’s Assembly Bill 5 which went into effect on January 1, 2020.  Even if your business is not located in California, it’s important to understand and take note of AB5 (and possibly rethink your classification of workers) because it’s likely more states (if they haven’t already) will begin implementing the same standards. 

AB5 sets strict standards in California for classifying workers as independent contractors rather than employees (and the implications are profound). Approximately 400,000 Californians work for traditional gig platforms like Uber, Lyft and Doordash. There are nearly 1.5 million contractors in California who may now be classified as employees and because of this are entitled to benefits including:

• A minimum wage
• Workers’ compensation
• Unemployment insurance
• Employee benefits
• Rest breaks
• Expense reimbursement
• Paid sick leave and paid family leave
• Opportunity to join a union

California’s ABC Test

AB5 requires businesses to apply the ABC test to determine if their workers are employees or independent contractors. Under the test, a worker is considered an employee unless they meet these three conditions according to the State of California:

Part A. The worker 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;

Part B. The worker performs work that is outside the usual course of the hiring entity’s business; and

Contractor example: A retail store hires an outside plumber to repair a leak in a bathroom on its premises.

Employee example: A bakery hires cake decorators to work on a regular basis on its custom-designed cakes. 

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

Not in California? Here is the IRS’ Test

The IRS has a similar test that any business in the US can use to help determine if they’re classifying their workers correctly. (Note: it’s likely your state has its own tests as well. Find out here.):

Behavioral Control

Employees - work performed is directed and controlled by the employer. The employer gives very specific instructions such as when and where to work, tools to use and how to do the work. The employer also evaluates the details of how the work is done.

Contractors - less detailed instructions from the employer, use their own methods rather than be trained by the employer and only the final results of their work is evaluated. 

Financial Control

Employees - employer directs or controls the financial aspect of the employees’  job including reimbursing expenses, heavily investing in equipment and paying the employee a regular wage on a regular basis (hourly, weekly, monthly).

Contractors - most often paid a flat fee for a job, not reimbursed for expenses, control their own profits and loss opportunities and are free to seek out other business opportunities.

The Relationship 

Employees - employer offers benefits like insurance, retirement plans, sick leave, etc. The relationship between the employee and employer is expected to continue indefinitely. The work of the employee aligns with the key offerings of the business.

Contractors - generally not offered benefits from the employer. The relationship typically lasts for the duration of a project or certain time period, and the contractor provides work that isn’t directly related to the key offerings of the business.

Note: Keep in mind that even if you have a written contract that states the relationship of you and the contractor/employee, it won’t be sufficient in determining the worker’s status. 

How You Can Make Sure You’re Classifying Workers Correctly 

Generally speaking, employers have more control over an employee than they do an independent contractor. If you have contractors on your team, you’ll need to weigh all of the factors laid out in the categories above. Weighing a single factor won’t help you determine a worker’s status. You’ll have to look at all of them and the relationship as a whole. How much direction and control do you really have over the worker?

If you’ve weighed all of the factors and you’re still unsure, the Internal Revenue Service has Form SS-8 that you or the worker can fill out and file with the IRS. According to the IRS, they review the facts and circumstances and then provide the worker’s status. But note this can take at least six months for you to get their determination, but in the interim, you can continue to hire the same types of workers to perform the job.

Next Steps 

So you have independent contractors working for you, applied the tests above and are pretty sure they’re actually employees. You don’t want to have to pay back taxes and penalties, etc., so it’s time to make some changes. Have no fear. All it takes is hiring them as W-2 employees and making sure you have payroll set up. The SBA has an informative article that can help you with your hiring plan. Spur is also here to help you determine if you’re classifying your workers correctly. We can also handle your entire hiring and onboarding process so you can focus on growing your business. For more information or help, feel free to reach out to us.