Independent Contractor Test: Everything You Need to Know
The independent contractor test is used to determine if a business is responsible for certain taxes and protections of the worker. 8 min read
Independent Contractor Test
The independent contractor test is used to determine if a business is responsible for certain taxes and protections of the worker. The most widely spread example is the test used by the Internal Revenue Service for federal tax purposes, but other government entities, including state governments, have their own variations.
In the past, the IRS used a more extensive test involving 20-sections of identifiers. This process has since been simplified to an 11-part test after complaints from business leaders and members of Congress. These 11 sections have been divided up into three separate groups that distinguish between behavioral and financial control as well as the relationship of the worker and the employer.
In a previous ruling made by the Fifth Circuit court, they claimed that the top distinguishing factor between a contractor and an employee is whether or not they are dependent on the business for their economic reality. Termed the “economic reality” test, its purpose is to identify and label the level of independence of the individual to determine whether or not they should actually be considered an independent contractor or an employee of the company. Both the U.S. Department of Labor and the Social Security Administration rely heavily on the economic reality test to determine the status of the worker.
For the SSA, their focus revolves which party is responsible for Social Security tax. The DOL, on the other hand, values the test because they want to make sure that contractors are aware of their status and aren’t taken advantage of by the employer. A few years ago, the entity decided to propose a change to its rules and require that all businesses offer a complete analysis of any contractor position attached to their company. It became the business’ responsibility to prove that the worker is not an employee based on the economic reality test. If the conclusion of the analysis verified such information, the company is then required to notify the worker and explain how it affects their rights under the Fair Labor Standards Act (FLSA).
The ABC test is another set of guidelines used to identify an independent contractor from an employee, and it’s the common approach for many states across the U.S. for deciding unemployment tax. This test is composed of three guidelines that consist of the following:
- The individual’s main source of income typically comes from independent contractor work.
- The worker completes tasks outside of the business’ location and is separate from the typical services of the company.
- The individual maintains control over the services they provide.
- Many states consider all three factors in their process, but some require that only two guidelines be met.
The State of Texas has its set of rules and regulations regarding independent contractors. According to the Texas Workers’ Compensation Act, employees distinguished as workers who complete tasks that coincide with the standard type of work completed by the company. Independent contractors are identified by meeting the following guidelines:
- Furnish their own tools and supplies;
- Offer a specific skill set particular to the job at hand;
- Independently set their own hours to complete the task;
- Complete employer-like tasks, like payroll, if other individuals work under them separate from the business contracting their services.
Meeting such qualifications allows businesses to identify the worker as an independent contractor and avoid the responsibility of certain taxes pertaining to wages.
The behavioral control section of the IRS’ independent contractor test looks at the amount of independence a worker maintains in terms of how the work is conducted. In this instance, they’re focusing on the company’s demand of the worker including:
- Location and specific working hours
- Equipment type
- Hiring of assistance
- Location of supply purchases
- Specified individual tasks
- Micromanaging of steps to complete work
While the employer may provide some specific requirements regarding the task, they can’t maintain the majority of control over the individual or the workers team. Doing so will qualify the worker as an employee and not a contractor. Independent contractors should be able to perform their work without training or detailed guidance from the employer.
Who maintains financial control in the relationship between the business and the worker is another aspect that the IRS focuses on. To decipher who has the majority of the control, they look for specific areas including:
- Unreimbursed Expenses: Independent contractors typically eat the cost of supplies and materials needed to complete the task at hand. On the opposite side of the spectrum, employees that pay for expenses out of pocket are usually reimbursed by the company.
- Investment: The investment level of a worker is another stipulation set forth. A regular employee only typically invests time while an independent contractor may have a substantial investment in the tools and methods used to complete a task.
- Additional Opportunities: Employees are bound to a specific company and often face a noncompete clause when seeking additional work. Such a component of a contract prevents a worker from providing similar services. On the contrary, a contractor can work for multiple companies simultaneously while offering the same services.
- Payment: The IRS also places some importance on how the worker receives payment. Most contractors provide services for a specific agreed-upon fee regardless of the amount of time that the work takes to complete. Employees usually maintain a regular pay schedule with earnings based on hourly work rate or yearly salary.
- Risk Involved: Financial risk is also a determining factor. A contractor is essentially a business owner as they can lose or gain profit after the supplies and equipment purchased for the work. An employee relies on their employer to cover all of those items, so to avoid such financial risks.
Meeting of some of the requirements doesn’t necessarily mean an individual is automatically considered a contractor as the IRS considers the factors as a whole.
Type of Relationship
The third and final aspect of the IRS’ independent contractor test concerns the type of relationship held between a worker and the company. The areas that they focus on for this section include:
- Contracts: The description of the relationship in the contract of the worker can hold some clout when it comes to tax identification. In many instances, the document will specify that the individual is working as a contractor and was hired as so, but if the relationship mimics that of an employer and employee, then the contract doesn’t matter as much.
- Benefits: A standard, full-time employee is usually offered a range of benefits such as retirement and paid vacation days or sick leave. An independent contractor won’t receive anything more from the company than the agreed upon payment.
- Length of Relationship: The length of the partnership is another area of concern. Employees are usually hired indefinitely unless it’s a temporary or seasonal position, and they’ll work for the company until they decide to leave or are terminated by the employer. Contractors with long-term contracts are seen more as employees because of the length of the relationship between the parties.
- Business Importance of Services: The level of importance of the work to the company is another signifier. The more the company requires the work to achieve success, the higher their control will be over the task during the process as well as afterward. Such a situation is used to identify an employer-employee relationship versus an independent contractor providing a service to a company.
The IRS urges businesses to combine the results of the relationship-type tests with that of the financial and behavior control to determine the status of each of their workers. Doing helps limit the risk of potential tax mistakes regarding income and Social Security taxes.
Former IRS 20-Factor Test
While the previous IRS independent contractor test is no longer used by the federal government, it has been reworked and implemented by the Texas Workforce Commission to determine the responsibility of unemployment tax.
One of the differences between the new and old tests is a provision called the “safe harbor” rule. This guideline created a small loophole for businesses to identify a worker as an independent contractor based on industry standards for such positions. This could only be used when the test results were mostly split between the two tax statuses or if an audit had previously found that such individuals fit the role of contractors and not employees.
Since the State of Texas uses these guidelines to address the situation separately from the federal government, workers within the territory can be classified differently for both levels.
Labor Department’s 6-Part Test for Classifying Employees, Independent Contractors
The DOL issued its own six-part test as a suggestion for businesses to make the right identification between employees and independent contractors for the purpose of the FLSA. The organization released these new stipulations because they saw an increase in wrong classifications from businesses.
The main issue with misclassification is the difference in legal protections for the individual. Labeling a worker as an independent contractor when they are, in fact, an employee can allow businesses to get away with unlawful treatment. Such companies also avoid certain taxes when they misclassify their workers, which isn’t fair to other businesses that follow the rules.
In many instances, the federal government is concerned that some “mistakes” are actually intentional in a company’s effort to reduce employee-specific costs and regulations. The DOL’s six-part test is devised to prevent such issues from occurring and mimics many of the points of the IRS’ 11-part test such as the level of financial independence that a worker maintains.
The increased number of questions regarding employee and independent contractor classifications is a result of growing industries that didn’t exist until a few years ago. Businesses like Lyft and Uber are prime examples of this because they deem their drivers as independent contractors because they choose when to work and which jobs they’ll take. However, many of their drivers claim that they fall under the employee category, which provides them protections under the FLSA. If officially identified as employees, these drivers would be able to obtain certain benefits including:
- Minimum wage
- Overtime pay
- Workers’ compensation benefits
- Qualification for unemployment
Workers that are classified as independent contractors are not protected by the FLSA.
To combat companies taking advantage of such situations, the DOL has encouraged courts and legally entities to extend the protections of the FLSA to a broader range of workers that may not completely fit the classification of employee. Their reasoning for this suggestion is that the DOL believes that the economic dependence of a worker is the true signifier of the two categories and not the classification that a company is allowed to give based on their state or IRS tests.
State Views on Independent Contractor vs. Employee Classifications
While the DOL’s point of view is fairly straightforward, states offer a more varied set of identification processes and guidelines. For instance, the California Labor Commission (CLC) recently deemed Uber workers as employees. They made their decision because of the company’s level of involvement within the task completion process. The business, which is currently facing a major lawsuit because of their worker classification, disagreed with the CLC’s decision on the basis that the company only provides the technology and isn’t involved in day-to-day task management.
Across the country, New York’s City Taxi and Limousine Commission, which regulates the taxi industry within the area, came out in support for Uber’s classification of drivers as independent contractors. They claimed that allowing all taxi drivers to operate as contractors provides freedom and more opportunity for the workers.
The issue is a prominent subject of discussion throughout the legal and business world. There may not be complete state and federal consistency on the issue until a case makes it way to the Supreme Court.
If you need help learning more about the independent contractor test, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.