Independent contractor or employee? It is a question that most business owners face as they grow from being self-reliant to needing help. Initially, many business owners choose to classify individuals as independent contractors.
For some, the need for a regular, part-time employee, much less full-time, isn’t there. For others, the costs involved with hiring an employee — such as worker’s compensation insurance, payroll taxes, and compliance with labor laws — are a limiting factor.
However, as many companies have discovered the hard way, the line between independent contractor and employee is thin, and with the release of the U.S. Department of Labor’s Wage of Hour’s Division’s Administrator’s Interpretation No. 2015-1 two months ago — PDF download here — it has gotten even thinner. The ability to classify someone as an independent contractor is going to be very difficult.
The ability to classify someone as an independent contractor is going to be very difficult.
Who Determines Employee v. Contractor?
The legal decision of an employee versus an independent contractor rests with several entities. The I.R.S., the U.S. Department of Labor, and individual states have different tests to determine whether someone is an independent contractor or an employee. However, until recently almost all agree on the basic test to determine whether someone is an employee or a contractor: If the company has significant control over the individual, then the person is an employee and not a contractor. Interpretation No. 2015-1 changes this and will likely have a ripple effect with other federal and state agencies.
In the recent Interpretation, the Department of Labor stated that the “misclassification of employees as independent contractors is found in an increasing number of workplaces in the United States.” To help ensure that individuals are properly classified, the D.O.L. has entered into agreements with the I.R.S. and 26 states. As part of this initiative, the D.O.L. issued the Interpretation to help companies and other entities determine whether someone is an employee or contractor.
Unfortunately for companies that have sought the help of independent contractors, this Interpretation has determined that “most workers are employees under the FLSA [Fair Labor Standards Act].”
Previous ‘Direction and Control’ Test
Prior to the Interpretation, most entities used the “direction and control” test to determine if someone was an employee or independent contractor. Under the direction and control test, the prevailing factor was whether an employer could tell employees when and how to do their work.
Some of the factors that helped determine this were:
- Did the individual receive training from the company?
- Did the individual receive tools from the company?
- Did the company tell the individual when to do the work, how to do the work, or where to do the work?
- Did the individual work full time for the company for a significant length of time?
Many companies were able to avoid having employees by limiting the length of time a person performed services for the company, the types of services that were performed, and the amount of supervision the company exercised over the individual. This allowed the company to bypass the costs of having an employee. In some cases this was legitimate. In others, however, it was to hire someone at a substantially lower cost than an employee.
New ‘Economic Realities’ Test
With the new Interpretation, the Department of Labor has moved away from only the direction and control test and towards an “economic realities” test, where it looks at the financial independence of the individual from the company to determine if someone is an employee or contractor. Instead of looking at just if there is direction and control, the D.O.L. recommends the use of a 6-factor test.
- Is the work performed by the individual integral to the employer’s business? For instance, if the employer cannot provide services without the individual’s contribution (i.e., a pizza company cannot deliver pizzas without a driver), then it looks like employment.
- Can the individual experience both profit and loss? For instance, if the individual can solicit additional business from the company’s customers on his or her own, then it looks less like employment since the individual can experience profit on his or her own.
- To perform the services, do both the individual and the company have similar financial investment? This is similar to the old factor of receiving tools and training from the company. But it now goes further than just if tools and training are received. The D.O.L. now looks at the financial amount spent by both parties to perform the services, on items such as tools, training, advertisement, and insurance. The closer the financial contributions by both parties, the less it looks like employment; the further apart, the more it does.
- Does the work require special skills and independent thought? With this, it is not only whether skills are required, but also if the individual can use those skills independent of directions from the employer. For example, if a company tells a highly skilled developer how to develop a computer program, it looks like employment. But if the company simply asks the developer to fix a problem in any way that the developer can, it looks less like employment.
- What is the length of time of the relationship? The longer the relationship between the parties, the more it looks like employment. This is similar to the old factor, but now takes a much greater look at whether the individual is financially dependent on the company during the length of time.
- What is the nature and degree of the company’s control? The test still looks at the direction and control factor, but more from a financial aspect. It looks at whether someone can truly turn down jobs and, if she takes a job, set her own rate for jobs that are secured.
For ecommerce and other technology businesses that have used independent contractors — for reasons such as not having enough consistent work or not enough budget to pay for an employee — this new ruling may limit the use independent contractors.
When hiring developers, short-term manual labor to handle large order periods (such as the holiday season), and individuals who are “integral” to the business, businesses owners may be unable to classify such individuals as independent contractors, even if it is only for a season or a few weeks.
With the position of the Department of Labor and many states that most individuals are now employees, classifying those individuals as independent contractors could lead to fines, penalties, and payment of wages and benefits.