Worker Classification Tests: DOL, IRS, State Tests for Classifying Workers

Worker classification is a topic of increasing importance as the independent workforce continues to grow in number. Workers can be classified as employees or independent contractors. Understanding the difference between these two types of classifications is very important for enterprises.

Independent Contractors vs. Employees

Independent contractor is a legal term for workers who are not considered to be full-time employees under the law. Independent contractors may refer to themselves as freelancers, consultants, self-employed professionals, side-giggers, etc. The big difference between independent contractors and your typical W-2 employee is that independent contractors are their own business entities. They pay their own taxes, provide their own benefits, and submit invoices for work completed.

Independent contractors provide specialized knowledge or skills to a client project or task. They are responsible for how, when, and where they complete the work outlined in their contract. An employee, on the other hand, is typically guided by a manager and receives some level of training for their job.

Worker Misclassification

The problem arises when a company classifies a worker as an independent contractor when they should be classified as an employee (or vice versa, but the former is much more common). By engaging a worker as an independent contractor, a company is ensuring that the worker is truly qualified to work as an independent contractor according to federal, state, and local laws.

When workers are misclassified, it doesn’t matter whether it was done intentionally (to avoid paying taxes or providing benefits) or unintentionally. Misclassification can lead to decreased tax collection revenue, loss of employee entitlements such as minimum wage and overtime pay, and class action lawsuits from unhappy workers.

Dozens of federal- and state-level tests exist to help businesses determine whether a worker is an independent contractor or an employee, but these tests vary from one another and are open to interpretation. This can be confusing and frustrating as laws and regulations are in constant flux.

To dig deeper into the tests and guidance surrounding worker classification, we’ve outlined some of the basic guidelines from the United States Department of Labor (DOL), the Internal Revenue Service (IRS), and individual states.

Up next: What is Worker Misclassification?

DOL (Department of Labor) and Independent Contractor Classification

In October of 2022, the DOL proposed a new rule for classifying workers as employees or independent contractors. The proposed rule changes the way certain factors are considered in the economic reality test—the test used to determine if a worker is an employee or independent contractor under the Fair Labor Standards Act (FLSA). The economic reality test looks at whether a worker is economically dependent on the employer for work (and is an employee) or is in business for themselves (and is an independent contractor).

The current worker classification rule

Before exploring the proposed rule, it is helpful to understand the current worker classification rule, which was issued in January 2021 with an effective date of March 8, 2021. The current rule adopted a version of the economic realities test that focused on two core factors with three additional factors. The core factors are:

1. The nature and degree of the individual’s control over the work. This factor weighs towards the individual being an independent contractor to the extent the individual, as opposed to the potential employer, exercises substantial control over key aspects of the performance of the work, such as by setting his or her own schedule, by selecting his or her projects, and/or through the ability to work for others, which might include the potential employer’s competitors.
2. The individual’s opportunity for profit or loss. This factor weighs towards the individual being an independent contractor to the extent the individual has an opportunity to earn profits or incur losses based on his or her exercise of initiative (such as managerial skill or business acumen or judgment) or management of his or her investment in or capital expenditure on, for example, helpers or equipment or material to further his or her work.

Three additional factors may be considered if the core factors are not determinative (find detailed information about these factors here). The additional factors are:

1. The amount of skill required for the work.
2. The degree of permanence of the working relationship between the individual and the potential employer.

iii. Whether the work is part of an integrated unit of production.

The proposed worker classification rule

The proposed rule adopts a totality-of-the-circumstances approach that includes six factors:

1. Opportunity for profit or loss depending on managerial skill (part of core factor 2 of the current rule)
2. Investments by the worker and the employer (part of core factor 2 of the current rule)
3. Degree of permanence of the work relationship (additional factor ii of the current rule)
4. Nature and degree of control (core factor 1 of the current rule)
5. Extent to which the work performed is an integral part of the employer’s business (additional factor iii of the current rule)
6. Skill and initiative (additional factor i of the current rule)
7. Additional factors. Additional factors may be relevant in determining whether the worker is an employee or independent contractor for purposes of the FLSA.

The proposed rule removes the emphasis on two core factors in the current rule. By relying on the totality of the circumstances analysis, the classification may be more complex and require additional expertise to properly classify workers.

Both the proposed rule and the current rule adopt the economic realities test that was introduced in several Supreme Court cases in the 1940s. Circuit courts have adopted slightly different versions of the economic realities test with slightly different emphases. Both the current rule and the proposed rule were adopted to try to standardize the economic realities tests.

IRS Common Law Test for Worker Classification

The IRS is involved in independent contractor classification because they must provide guidelines for employers’ tax liability. Depending on the type of business relationship an employer has with their workers, they may or may not be responsible for withholding income taxes, withholding and paying Social Security and Medicare taxes, and paying unemployment tax on wages.

To determine if a worker is an independent contractor or an employee in the eyes of the IRS, businesses must weigh common law rules—facts that provide evidence of the degree of control and independence in the relationship between a worker and a business. These degrees of control fall into three categories:

1. Behavioral Control

Behavioral control looks at how much say a business has over the work being done and how the work is done. Generally, if a worker is told when, where, and how to do a job, they are generally considered to be an employee. On the other hand, if a worker does not require guidance or training, completes the work as they see fit, and works where and when they like, they are generally considered to be an independent contractor.

2. Financial Control

Financial control looks at whether a business has the right to direct or control the financial and business aspects of a worker’s job. For example, it is more likely for independent contractors to incur unreimbursed expenses than employees. Independents will also typically provide their own equipment or tools, whereas employees will rely on their employer to provide anything extra. Payment is another factor. While employees are paid a regular wage in exchange for working a specific period, independents are typically paid a flat fee for the completion of a project. Independents can also incur a profit or loss from a job and are free to market their services to other businesses.

3. Relationship of the Parties

A contract that defines the relationship between parties and describes a project to be completed in a specific time period generally indicates the relationship of a business with an independent contractor. On the other hand, if a worker is engaged for an indefinite period of time, if they are provided with benefits such as health insurance, vacation, or overtime pay, or if they perform services similar to regular business activity, this generally indicates the relationship of a business with an employee.

State Worker Classification Tests

Currently, the majority of states have signed a Memorandum of Understanding with the Wage and Hour Division (WHD) to protect against misclassification. The MOUs affirm the intent to help provide easy access to employees and employers, share information, and coordinate misclassification investigation efforts.

In addition to efforts to combat misclassification, many states use the “ABC Test,” which applies three factors that must be met for a worker to be considered an independent contractor. While the ABC Test is subject to interpretation and clarification state-to-state, it generally consists of the following parts:

1. The worker is free from the employer’s direction or control over their work,
2. The services the worker provides are performed outside of the employer’s usual course and/or place of business, and
3. The worker is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as the service performed.

Individual states may also have different laws regarding independent contractors and unemployment compensation, worker’s compensation, and state tax collection. State-level Departments of Labor may provide additional state-specific information on these topics.

For now, determining worker classification will remain a complex issue. To minimize exposure to misclassification liability, organizations should follow federal and state guidelines as closely as possible, keep documents on file to support their decision to classify a worker as an independent contractor, and use a written contract in all independent contractor engagements. Partnering with a third party such as MBO Partners to manage engagement can minimize or eliminate compliance issues as well.

The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs.  Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.