As a business owner, you might be tasked with determining a worker’s status. You could have employees, independent contractors, or both. It’s critical that you correctly classify whether a worker is an employee or independent contractor. Learn why worker status is important, and use the economic realities test to help.
Why does worker status matter?
To comply with the Fair Labor Standards Act (FLSA), IRS, Family and Medical Leave Act (FMLA), and workers’ compensation laws, you need to determine whether your worker is an employee or independent contractor.
When you hire independent contractors, you do not need to offer them the same benefits as employees. As an employer, you must do the following:
- Pay employees minimum wage and overtime depending on whether they are exempt vs. nonexempt (FLSA)
- Withhold payroll and income taxes from employee wages (IRS)
- Offer unpaid leave for qualifying health and family reasons according to FMLA rules
- Provide compensation to employees who are injured on the job (workers’ compensation)
Some studies show that 10-30% of employers misclassify employees as independent contractors, meaning the worker does not get any of the above benefits.
Worker misclassification can be costly. You could face penalties, fees, back taxes, and even lawsuits. Learn how to prevent it by downloading “A Guide to Independent Contractors vs. Employees.”
Economic realities test
Figuring out a worker’s status can be tricky. Employees are economically dependent on their employers. Independent contractors are not dependent on the businesses that hire them. An economic reality test is made up of a number of factors to help you find out whether a worker is dependent on you or not.
Apply the following factors of the FLSA independent contractor test to your worker to determine their status:
- How integral the work is to the business
- The permanency of the worker’s relationship with the company
- The worker’s and employer’s investments in things like equipment
- How much control the worker has
- The worker’s opportunity for profit and loss
- How much skill is required to do the job and the worker’s initiative
You must use all of these factors when deciding a worker’s status. Answering one will not be enough to figure out whether a worker is an independent contractor vs. employee.
How important are the worker’s services to your business? Does their work play a part in production, selling products, or performing services? Do they perform primary work? Understanding whether the worker’s job directly impacts your business is one factor.
If the worker deals with customers, or if your business depends on the kind of work they do, they are most likely an employee.
For example, you own a coffee house. You have a part-time worker who prepares coffee drinks. They are likely an employee. Without them, daily production would come to a halt.
One day, the coffee grinder breaks down. You need to hire someone to fix it. The person repairing the machine is an independent contractor. Though their services are important for getting the machine up and running, they do not perform primary work like the part-time employee.
How long has the worker worked for you? How long did they work for their previous company? Determine the length of time the worker typically spends at each job.
If a worker jumps from project to project at different jobs, it might indicate they are an independent contractor. But, staying at a job for a long period of time doesn’t necessarily mean they are an employee.
You should figure out if the worker chooses to leave each job or if they leave as a result of their industry or business (i.e., seasonal employees). Worker’s choice might indicate they are an independent contractor.
Does the worker use his or her own tools or equipment for the job? Does the worker do expense reporting and get reimbursed when they purchase supplies? Learn how much the worker invests in equipment at your business.
Workers who invest in substantial things like equipment and use them beyond their current position are likely independent contractors.
Employees don’t usually invest in your business’s supplies and equipment. Keep in mind the comparative investments that you and the worker make into your business. For example, you invest in supplies, tools, and equipment for employees. And, they might bring in their own supplies to help them work better.
How much control does the worker have over things like their pay rate, work schedule, and how the work is performed? Can the worker work for other businesses? If the worker sets their pay rate and determines the number of hours they need for the task, they are most likely an independent contractor.
Independent contractors are (typically) not under your control. They have their own business, and they know how to do the work without instruction.
Let’s say you need an accountant to handle your business’s finances. The accountant determines their pay rate and when they do work for your business. The accountant is most likely an independent contractor.
5. Profit and loss
Can the worker earn more by performing their job more efficiently or making business decisions? Independent contractors make business decisions, like making investments and hiring workers.
If the worker can gain or lose money from their business decisions, they are an independent contractor.
For example, you pay a worker $1,000 after they finish a job. They projected it would take 14 days to complete the job, but it only took 10. Because the person worked faster, they were able to take on another project and increase their profits. This indicates the worker is an independent contractor. An employee usually does not earn more when they complete a job ahead of schedule.
6. Skill and initiative
What level of skill is needed for the job? Do the worker’s services require substantial training? Do they advertise independently with things like business cards? Do they have their own business website?
Independent contractors have their own business. They may try to promote their business by passing out business cards.
Different positions require various levels of skill. Employees and independent contractors can both be highly skilled for the job. If the skills show that the worker uses their own independent judgment or initiative, then they might be an independent contractor.
Differentiating between an independent contractor and employee can be difficult. The economic realities test isn’t black and white. That’s why it’s important to use all the factors when deciding.
To help you, take a look at this chart:
Further help: Form SS-8
If you are still having trouble determining your worker’s status, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
You can file Form SS-8 after you have already classified a worker. Your worker can also file the form. The IRS will get back to you and let you know what the worker’s status should be.
When you have independent contractors at your small business, automate payment and record-keeping processes. Patriot’s online accounting makes it easy to pay contractors. And, you can create and print necessary forms. Try it for free today!
This is not intended as legal advice; for more information, please click here.