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Employee Classification: The Contractor Vs. Employee Dilemma

Posted by Leslie Ruhland on Oct 5, 2017 9:06:00 AM
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The Department of Labor has hired scores of new auditors solely to investigate misclassifications. State investigators are also placing more attention on employers. And more workers are challenging their classifications.


Employee classification has become increasingly risky for businesses in California and across the country. Incorrectly classifying employees as independent contractors is on the rise, but may represent a 'red flag' for many employers.

An article from Forbes pointed out that,

"This fundamental worker status issue has become one of the most consequential legal determinations around. If you’re in business and guess wrong, the liability for past years can be crushing."

The problem is that there has been a massive shift in the corporate hiring strategies of America. The outsourcing push that saw apparel-making jobs move to China and call-center operations to India is now occurring inside companies across the U.S. and in almost every industry.

Along with this trend is an increased focus by government agencies to both regulate and generate revenue from employer classification efforts. Because of the continued lack of clarity among employers, instances of misclassification are on the rise.

According to Business Management Daily,

"The past few years have seen a massive new "Misclassification Initiative" launched by the IRS and U.S. Department of Labor, targeting employers with more audits and closer scrutiny. The IRS estimates that 80% of workers classified as "independent contractors" are actually employees."

They go on to note that the federal government has predicted that its crackdown on employee misclassification will net over $7 billion in additional federal revenue over the next 10 years. This, of course, on the backs of unfortunate employers and businesses found to have misclassified their workers. 

In addition, the increased focus on independent constractor vs employee and overtime has now prompted more independent contractors to challenge their classifications in court. 

It has been noted by staffing executives that at large firms 20% to 50% of the total workforce is often outsourced. Companies such as Bank of America, Verizon, Procter & Gamble and FedEx have thousands of contractors each.

Proper Employee Classification is Critical

Misclassifying employees can result in significant liability. According to a article from HRCalifornia,

"If your company controls the details and the worker does not have meaningful discretion in how he/she completes the work, it has generally been the rule that the worker will be found to be an employee and not an independent contractor."

In addition, state governments and the IRS are concerned about the loss of tax revenue when this occurs. The Treasury Inspector General for Tax Administration, J. Russell George, observed recently that,

“This problem adversely affects employees because the employer’s share of taxes is not paid and the employee’s share is not withheld. If left unchecked, the problem will continue to deprive the Federal Government, and the American people, of millions of dollars in lost revenue every year.”   

For businesses, the biggest benefit of replacing company employees with contract workers is having more control over their costs. Independent contractors help businesses keep their full-time, in-house staff small and flexible enough to adapt to new ideas or changes in their industry.

For workers, however, the changes from employees to contractors often lead to lower pay and creates confusion as to where do they actually work and for whom? Some economists believe that this parallel workforce being created by the rise of contracting is also causing more income inequality between people doing the same jobs.


The Rules for Employee Classification

In the past, the IRS has provided guidelines to direct its agents for determining worker status. The guidelines include a list of 20 factors determined by the IRS which have been used in court decisions regarding worker status.

Commonly referred to as the "20-factor test", and still used as guidelines, some of the factors are less relevant as in the past. Currently, IRS agents are directed to focus on the overall situation rather than specific aspects of the 20 factor test.

According to the IRS rules, employee classification and a worker's status hinges on whether the employer has the right to direct and control the service provider on what is to be done and how it is to be done. Typically, an employer does control how an employee performs work. On the other hand, independent contractors will usually determine how their work is done.

Three Issues for Classification Status

Court cases have established three broad categories of factors for determining employee classification:

1. Behavioral control

Do you, as the employer, have a right to direct and control how the worker does the task that you hired them for? Behavioral control factors include the extent of:

  • Instructions you or your staff gives the worker. Normally, an employee is required to follow instructions regarding how, where, and when, he or she works. (Note that even if there are no explicit instructions provided, it can be deemed that sufficient behavioral control may exist you have the right to control how the worker's results are achieved.)
  • Any training your company provides the worker. While independent contractors normally implement their own methods, employees are often trained to perform their job by the employer.

2. Financial control

Does your business have a right to control the business aspects of the worker’s job? These would include issues such as:

  • The extent of un-reimbursed business expenses incurred. Independent contractors are likely to have un-reimbursed expenses whereas employees do not. Especially important are the fixed, ongoing costs that can be incurred regardless of whether or not the work is being performed.
  • The extent to which a profit can be realized or a loss incurred by the worker. An independent contractor, unlike most employees, can make a profit or loss.
  • The extent to which the worker has an investment in facilities, tools, or equipment. Independent contractors normally have a significant investment in what they need to perform services for someone else.

3. Relationship between parties

Relevant facts regarding the type of relationship between you and the worker include:

  • A written contract defining the relationship intended between your company and the worker.
  • Whether your business provides the worker with any benefits, such as health insurance, vacation pay or sick pay, or even pension plans. These are typically benefits reserved for employees.

Staying In Compliance Requires Diligence and Forethought

With the recent pressure being put on employers by both the IRS and various state agencies, it is critical that HR compliance is a priority and that businesses be fully informed regarding the correct status and proper employee classification of all their workers.

According to the IRS website

"Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.

There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination."

Staying On Top of Employer and Labor Law

One of the informal roles of the HR manager is that of being aware of change. Staying informed and up-to-date not only of regulatory and legislative changes, but of the social and technological shifts that spell opportunity for a business, is essential.

In addition to a growing and demanding role in recruiting, hiring, and continually training employees, the HR staff will still be responsible for every other function they are typically tasked with such as payroll management, tax filings, employee records compliance, and so forth.

If you are looking for reliable help with determining employee classification, we can help. Get your Free Download: Payroll Outsourcing Guide to help you make an informed decision or call Accuchex Payroll Management Services at 877-422-2824.


Topics: independent contractors, overtime pay, employee classification, employee lawsuits, dol fsla, final rule

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