Independent Contractor or Employee? Take Care in Classifications

In balancing the need for talent with flexibility and cost, organizations may look to hire workers as independent contractors rather than as employees. Over time, however, the lines between independent contractors and employees can get blurred and get companies into trouble.

This area is extremely complex; the advice of competent counsel is definitely recommended. Below is information that can help determine the proper classification of employees.

Test the waters

There is no single test to determine if a worker is classified properly as an independent contractor (also referred to as 1099 status) versus an employee.¹ In addition, the tests tend to be more principles-based than bright line rules, making it a murky area.

Crossing the line from independent contractor/1099 status to employee can happen unintentionally if companies do not pay careful attention. In particular, the title or classification of the worker (that is, what the company calls the worker) is not the most relevant or the determining factor but rather based more on the substance of the relationship.

Furthermore, different tests may lead to different results. A worker may be an independent contractor under one test, such as the Internal Revenue Service (IRS) for tax purposes, but that same worker may be deemed an employee under a different test, such as the U.S. Department of Labor (DOL) or applicable state law. All tests must be considered in the determination.

For example, according to the IRS, “[t]he general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”

The IRS uses three broad categories, emphasizing the degree of control the company exercises over the way the work is performed by the independent contractor.² This is sometimes called the “common law” test.

However, the DOL, which enforces the Fair Labor Standards Act (FLSA), looks to the “economic realities” of the worker’s relationship with the company. The “economic realities test” focuses on whether the worker is economically dependent upon the company.

Factors that signal employee status

The test used and the resulting classification of a worker is critical because independent contractors are not covered by employment, labor and related tax laws that apply to employees. Therefore, companies must ensure that they do not treat independent contractors similarly to employees.

Factors (among others) that suggest the worker is an employee are:

• Offering them employee benefits, especially 401(k) or other retirement benefits.
• Providing workers’ compensation coverage to the worker.
• The method, frequency and basis of the worker’s payment (paid via regular payroll) versus as an account payable in response to invoices provided by the independent contractor).
• Reimbursing the worker’s expenses such as travel and equipment.
• Providing the worker with a computer and other workplace equipment.
• Providing the worker with a company email address that is indistinguishable from other employee email addresses.
• Providing the worker with business cards.
• The company’s control over the manner and means in which the worker performs the work.
• The worker performs general duties as opposed to being hired for a specific project or purpose.
• The freedom of the worker to accept or deny work.
• The worker’s discretion over his/her work schedule and location.
• The existence of a current and accurate independent contractor agreement.

Different factors carry different weight. For example, offering employee benefits to a worker almost certainly means that worker is an employee. By contrast, providing a special email address or company equipment to a worker may be justified for independent contractors to make sure they are accessing the company’s IT environment using equipment that complies with security policies.

However, the more a company treats an independent contractor like an employee, the less likely the 1099 status will survive scrutiny. While no one factor is entirely dispositive, some will carry more weight than others.

Consequences of missing the mark

The misclassification of an employee as an independent contractor can be costly. For example, under the FLSA, the company may face up to three years of back wages, liquidated damages, and attorneys’ fees. Additionally, businesses will be on the hook for unpaid payroll taxes, penalties, and fines.

Moreover, in many cases, companies have been required to make the employees “whole” with respect to employee benefits. Companies likewise face additional potential penalties under ERISA for both the health and welfare plan and the 401(k)/retirement programs for failure to provide required disclosures. It can also result in costly lawsuits which bring reputational damage to the company and sour relationships with valuable workers on both sides of the employee and independent contractor/1099 divide.

As a result, companies should proceed with caution when engaging independent contractors. They should work closely with outside counsel any time they engage independent contractors and most especially if they consider offering any workplace program, policy, or process to an independent contractor. Missing the mark can be costly.

HUB International’s team is available to work with you on a diverse range of HR needs, from risk management and regulatory compliance to benefits strategy, program design and workplace culture.

Neither Hub International Limited nor any of its affiliated companies is a law or accounting firm, and therefore they cannot provide legal or tax advice. The information herein is provided for general information only, and is not intended to constitute legal or tax advice as to an organization’s or individual's specific circumstances. It is based on Hub International's understanding of the law as it exists on the date of this publication. Subsequent developments may result in this information becoming outdated or incorrect and Hub International does not have an obligation to update this information. You should consult an attorney, accountant, or other legal or tax professional regarding the application of the general information provided here to your organization’s specific situation in light of your or your organization’s particular needs.

¹ There is no such thing as a “1099 employee,” which is a contradiction.

² Internal Revenue Service, “Independent Contractor (Self-Employed) or Employee?” November 5, 2021.