Employee vs Independent Contractor Classification

Navigating Employee vs. Independent Contractor Classification for Small Businesses

For small businesses, correctly classifying workers as either employees or independent contractors is crucial. Misclassification can lead to significant legal and financial repercussions. This article will help you understand the distinction between the two classifications and navigate compliance with relevant regulations.

Understanding the FLSA and its Applicability

The Fair Labor Standards Act (FLSA) sets minimum wage, overtime pay, recordkeeping, and child labor standards affecting full-time and part-time employees in both the private sector and government. However, the protections of the FLSA do not extend to independent contractors. The primary method for determining classification under the FLSA is through the “economic reality test,” which examines whether a worker is economically dependent on the employer or in business for themselves.

Employee vs. Independent Contractor: Key Differences

Employees are individuals hired by a company to work under its direction and control. They receive wages, have taxes withheld from their paychecks, and often receive benefits such as health insurance and retirement plans (IRS ReferenceSBA Reference).

Independent contractors, on the other hand, provide services to a company but maintain control over how those services are executed. They are responsible for their own taxes and often do not receive employee benefits (IRS ReferenceSBA Reference).

The Economic Reality Test

The FLSA uses the “economic reality test” to assess whether a worker is an employee or an independent contractor. The following six factors are considered, but no single factor is decisive:

  1. Opportunity for profit or loss: Independent contractors can make a profit or incur a loss based on their managerial skill.
  2. Investment: Contractors often invest in their own equipment and resources, whereas employees use resources provided by the employer.
  3. Degree of permanence: Employees generally have an ongoing relationship with the employer, while contractors typically work on specific projects.
  4. Nature and degree of control: Contractors maintain significant control over how they perform their work, unlike employees, who follow the employer’s instructions.
  5. Integral part of the business: Work that is vital to the employer’s business suggests an employment relationship.
  6. Skill and initiative: Independent contractors often bring specialized skills and take initiative in their work.

The IRS 20-Factor Test

The IRS employs a comprehensive 20-Factor Test to provide detailed guidance on distinguishing between employees and independent contractors. This test examines a wide range of behavioral, financial, and relational aspects to determine the level of control and independence of the worker (IRS Reference).

Behavioral Control Factors:

  1. Instructions: If the business has the right to control what, how, and when work is done, the worker is more likely to be an employee.
  2. Training: Providing training to the worker implies an expectation of following company guidelines, indicating employee status.

Financial Control Factors:

  1. Significant Investment: Independent contractors typically invest in their own facilities or tools. A lack of significant investment indicates employee status.
  2. Unreimbursed Expenses: Independent contractors are more likely to have expenses that are not reimbursed, further indicating their independence.
  3. Opportunity for Profit or Loss: A worker’s ability to realize a profit or incur a loss suggests independent contractor status.
  4. Services Available to the Market: Independent contractors often make their services available to the general public and work for multiple clients.

Relationship of the Parties Factors:

  1. Written Contracts: While a contract can signify the parties’ intentions, the actual nature of the relationship holds more weight.
  2. Employee Benefits: Providing employee benefits like insurance and retirement plans signifies an employment relationship.
  3. Permanency of the Relationship: A relationship intended to be ongoing or indefinite generally indicates employee status.
  4. Regular Business Activity: If the services provided are a key part of the company’s regular business, this suggests the worker is an employee.

Other Considerations:

  1. Degree of Instruction: Detailed instructions given by the business indicate control, suggesting employee status.
  2. Order or Sequence Set: If the business mandates the order or sequence in which the work should be done, this indicates control over the worker.
  3. Reports: Regular reports to the business suggest an oversight typical for employees.
  4. Payment Method: Employees typically receive periodic payments such as hourly or weekly, while independent contractors are usually paid per job or project.
  5. Right to Discharge: The right to terminate the worker indicates an employer-employee relationship, while an independent contractor relationship limits termination based on contract terms.
  6. Right to Terminate: If the worker can walk away without liability, it suggests employee status; independent contractors generally cannot terminate without potential liabilities.
  7. Hiring Assistants: Independent contractors often hire, supervise, and pay their own assistants, unlike employees who are usually provided assistance by their employer.
  8. Stationary Facilities: Provision of work facilities by the employer suggests an employment relationship.
  9. Company Instructions: If the worker must comply with the company’s instructions on how to complete the work, this suggests control and an employment relationship.
  10. Continuous Relationship: A continuous working relationship indicates employment, whereas contractors typically have a relationship that ends upon project completion.

Specific Guidelines for New Mexico

In New Mexico, worker classification can vary depending on the regulatory entity involved:

  • Federal Payroll Taxes and the IRS Test: The IRS uses a comprehensive 20-factor test.
  • FLSA Economic Reality Test: A six-factor test focusing on the economic realities of the work relationship.
  • ABC Test under New Mexico Unemployment Compensation Law: This test considers control and direction, the nature of the service provided, and whether the worker is engaged in an independently established trade or business (Base Article Reference).

Consequences of Misclassification

Misclassification occurs when an employer incorrectly labels an employee as an independent contractor. This can be driven by the desire to avoid costs associated with employees, such as payroll taxes, benefits, and compliance with labor laws. However, misclassification can lead to severe penalties, including retroactive tax liabilities, fines, and legal action (Reference Article).

Best Practices for Small Businesses

To ensure compliance and avoid misclassification:

  • Evaluate each worker on a case-by-case basis: Document your analysis based on the factors outlined above.
  • Stay informed: Keep up with the latest federal and state guidelines relating to worker classification.
  • Consult professionals: Seek advice from legal or tax experts to navigate complex classification scenarios.

Proper worker classification is essential for small businesses. Understanding and applying the relevant guidelines can help you avoid legal pitfalls and focus on growing your business. By adhering to best practices and seeking professional advice when needed, you can ensure compliance and make informed business decisions.


References:

  1. Understanding Employee vs. Independent Contractor: IRS Guidelines
  2. Employee vs. Independent Contractor Guide – SBA
  3. DOL: Fair Labor Standards Act Overview

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