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That’s the question, and the way in which you arrive at an answer can be very challenging. Much has been made today about the gig economy, with many workers doing freelance or other gig work occasionally or full time. For example, according to Statista, in 2022, there were about 31.9 million occasional independent contractors in the U.S., which is double from the 15.8 million in 2020. These workers may be professionals and consultants, platform workers (e.g., Uber and Lyft drivers; FIVRR freelancers), or informal workers (e.g., child or eldercare workers; handymen). It’s estimated that it costs 50% to 70% more to use an employee compared with an independent contractor because of payroll taxes, benefits, and insurance required for employees but not for independent contractors.
From your company’s perspective, whether you hire employees or engage independent contractors greatly affects your responsibilities…and your budget. Simply slapping on an independent contractor label to a worker won’t cut it. You need to know the rules and apply them correctly to ensure that the worker classification you’re going for will stick.
Minimum wage and overtime rules
Employees who are not “exempt employees” are subject to minimum wage and overtime rules. If you fail to pay required amounts to employees, you may be subject to substantial penalties (e.g., a civil penalty up to $1,000 for each violation, or $10,000 for violating child labor laws, and potentially criminal penalties).
On January 9, 2023, the U.S. Department of Labor announced a final rule in worker classification. It rescinds the 2021 rule and replaces it with a new one that uses 6 factors synthesized from decades of court decisions:
Opportunity for profit or loss a worker might have
Financial stake and nature of any resources a worker has invested in the work
Degree of permanence of the work relationship
Degree of control an employer has over the person’s work
Whether the work the person does is essential to the employer’s business
Worker’s skill and initiative.
The final rule takes effect on March 11, 2024.
Federal employment taxes
Employers must withhold income tax and the employee’s share of FICA, as well as pay the employer’s share of FICA and FUTA (collectively referred to as employment or payroll taxes). None of these obligations apply if the worker is an independent contractor; only a filing of Form 1099-NEC if payments to the worker in the year are $600 or more. Misclassification can result in having to pay employment taxes, plus interest and penalties, although there may be some relief.
In making a determination, the IRS considers 3 categories derived from common law:
Behavioral control. A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.
Financial control. Does the business have a right to direct or control the financial and business aspects of the worker’s job.
Relationship of the parties. The type of relationship depends upon how the worker and business perceive their interaction with one another.
State wage and hour rules
According to one source, an ABC test for applying state wage and hour rules applies in its entirety in Alaska, Arkansas, California, Connecticut, Delaware, Georgia, Hawaii, Illinois, Indiana, Kansas, Louisiana, Maine, Maryland, Massachusetts, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, Ohio, Oregon, Rhode Island, Tennessee, Utah, Vermont, Washington, and West Virginia; there’s partial adoption in Colorado, Idaho, Montana, Oklahoma, Pennsylvania, Virginia, Wisconsin, and Wyoming. The penalties for violating the ABC test can be severe (e.g., in California, up to $15,000 per violation for the first offense).
The ABC test requires the hiring entity to show each of these 3 factors to support independent contractor treatment:
A: The worker is free from the control and direction of the hiring entity in connection with the performance of work, both under the contract for the performance of work and in fact.
B: The worker performs work that is outside the usual course of the hiring entity’s business.
C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
However, many states have created various exemptions, such as for specific categories (e.g., physicians, private investigators, investment advisors) and contractual work for professional services (e.g., graphic designers, freelance writers). For occupations that are exempt, other rules in place of the ABC test are used to make a worker classification.
Other tests
Other federal and state government agencies may use their own tests. For example, the NLRB, in a decision involving shuttle-van driver franchisees reaffirmed its use of a common law test to determine whether they have the right to organize into a union. States use their own tests for purposes of worker compensation and unemployment insurance.
Final thoughts
The rules are complicated and there are no bright-line tests to help you make non-contestable decisions about classifying your workers. Workers may challenge you. The government may challenge you. To protect yourself to the extent possible, get advice from an expert, such as a CPA with respect to employment taxes.
More blogs have been published about the gig economy, find them here.
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