The Classification Conundrum: Employee or Independent Contractor?

Many employers, from large enterprises to small startups, don’t understand the distinction between an employee and an independent contractor as defined in the Fair Labor Standards Act. In some cases, workers are intentionally misclassified as independent contractors to save the employer money.

When a worker is classified as an independent contractor instead of an employee, the employer is not responsible for Social Security and Medicare taxes, overtime pay, unemployment compensation, workers’ compensation, health benefits, retirement benefits, or paid time off for vacation or sick days. However, an independent contractor without workers’ compensation could sue the employer if injured on the job.

Misclassification has far-reaching consequences. For the employer, misclassification could result in penalties and liability related to labor laws and tax laws, in addition to paying back taxes, overtime, retirement benefits, etc. If misclassification is intentional, additional fines and criminal penalties could be enforced.

A worker misclassified as an independent contractor misses out on important monetary, health and safety benefits and could end up paying double the Social Security tax. Federal and state governments lose billions of dollars in tax revenue each year due to misclassification.

The Distinction Between an Employee and an Independent Contractor

There are a number of misconceptions about what does and does not make someone an independent contractor under the FLSA. As an employer, you can’t just classify someone as an independent contractor because you give the worker a 1099 form, they sign an independent contractor agreement, they have the ability to work remotely, or they’re paid in cash.

The key factor when classifying a worker as an employee or independent contractor is control. If the employer can control what work will be done and how it will be done, the worker is an employee. The employee may still have freedom of action with minimal supervision, but the employer can still control the details of how tasks are performed. Most workers are employees who are economically dependent on the employer

With an independent contractor, the employer has the right to control or direct the result of the work, not what will be done or how it will be done. Independent contractors work for themselves and are not economically dependent on the employer.

3 Categories of Control

According to the IRS, employers must weigh three factors when classifying a worker as an employee or independent contractor. These factors involve the level of control an employer has over a worker, compensation structure, and the relationship between the employer and the worker.

  • Does the employer control or have the right to control the worker’s behavior (what they do and how they do it)?
  • Are compensation, reimbursement and other financial aspects of the job controlled by the employer?
  • Are there agreements or benefits, such as health insurance or vacation pay, that indicate an employee relationship? Is the work performed essential to the business?

New Jersey’s “ABC” Test

New Jersey Unemployment Compensation Law includes a three-part test for determining a worker’s proper classification. The New Jersey Supreme Court has ruled that the “ABC” test meets the requirements of the state’s Wage Payment Law and Wage and Hour Law.

The ABC test assumes at the outset that a worker is an employee, and the burden is on the employer to prove otherwise. According to the New Jersey Department of Labor, the following provisions must be met if a worker is to be classified as an independent contractor:

“(A) Such individual has been and will continue to be free from control or direction over the performance of such service, both under his contract of service and in fact; and (B) such service is either outside the usual course of the business for which such service is performed, or that such service is performed outside of all the places of business of the enterprise for which such service is performed; and (C) such individual is customarily engaged in an independently established trade, occupation, profession or business.”

One important note… even if you’re classified as an independent contractor according to a state or tax law, you still may be an employee in the eyes of the FLSA.

Getting It Right

This information is not intended to scare anyone into classifying all workers as employees. Independent contractors play an extremely valuable role in the American workforce. The goal should be to first analyze business needs and goals, determine if these needs and goals will be best supported by independent contractors, employees or a combination, and classify workers accordingly.

If you’re unsure about how your workers are classified, consult your attorney, and speak with your accountant so you understand your tax obligations in all scenarios.

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