The determination of whether a worker is an employee or an independent contractor has wide-ranging ramifications for both the company for which work is being performed and the person doing it. The matter of worker classification is ongoing because there is no single definition that can be relied upon. What’s more, the determination of worker classification may depend on where your company is located.
Here’s what we know and what we need to know to avoid problems for our businesses.
IRS criteria
For purposes of federal wages withholding, FICA taxes, and federal unemployment tax, the IRS has a general rule. A worker is an independent contractor if the payer has the right to control or direct only the results of the work, and not what will be done and how it will be done. More specifically, the IRS uses a 3-prong test to make this determination:
- Behavioral control
- Financial control
- Relationship of the parties
State-level ABC test
The City of Los Angeles sued Dynamex, a nationwide same-day courier and delivery service with business centers in California, for purposes of California wage orders regarding minimum wages, maximum hours, and certain working conditions. The case involved delivery drivers who claimed they were employees even though the company treated them as independent contractors. Last year, the Supreme Court of California concluded that the standard to be used in determining worker classification is the “ABC test.”
Under this test, a worker is treated as an independent contractor only if:
A. That worker is free from the control and direction of the hirer in connection with the performance of work, both under the contract for the performance of work and in fact,
B. That worker performs work that is outside the usual course of the hiring entity’s business, and
C. That worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
It has been deduced from this test that if a company engages a worker to do just about anything that’s central to the company’s business (e.g., a car repair company hiring a worker to repair brakes), that worker is an employee. In other words, Test B is a killer for companies that would prefer to treat workers (not necessarily this auto mechanic) as independent contractors.
California isn’t the only state using the ABC test. Massachusetts, New Jersey, and more than half a dozen other states use the same ABC test. And more than a dozen other states use similar tests.
New wrinkles
There are a number of recent developments impacting worker classification:
- Gig economy. The advent of more and more individuals taking on gigs through platforms such as Uber and Lyft, Fivvr, and Rover, has led both government entities and workers to challenge the independent contractor model of these arrangements. Governments want their taxes and to protect workers who are being taken advantage of. And workers are seeking to obtain the benefits (e.g., health care, retirement plans, etc.) and legal protections (e.g., unemployment insurance, workers’ compensation) available to employees.
- QBI deduction. The creation of a 20% deduction for qualified business income, which is available to independent contractors but not to employees, has also heightened the discussion on worker classification. Newly finalized regulations have a 3-year look-back rule under which a person who was an employee but becomes an independent contractor for the same company is presumed to be an employee for purposes of this deduction.
Final thoughts
The matter of worker classification is far from over. There continues to be debates on the criteria for making determinations. There are also various proposals that would help independent contractors with their concerns (e.g., access to workers’ compensation, opportunity to have income tax withholding on their payments). Review your company policies to make sure your classification of workers can hold up under scrutiny.
