What Defines a Contractor vs. an Employee?

Contractor vs. employee status affects tax responsibilities, compliance with the Fair Labor Standards Act, and the nature of the work

On May 6, the Biden Administration reversed a Department of Labor (DOL) rule issued in the waning days of the Trump Administration governing when to classify a worker as a contractor or an employee.

This reversal returned determining contractor status back to what it’s been for many years. But Biden officials also signaled future changes that may define more contractors as employees, aiming to reduce exploitative labor practices. Many businesses avoid classifying individuals as employees because it sidesteps issuing benefits, paying payroll taxes, and compliance with the Fair Standards Labor Act (FLSA), including paying overtime above 40 hours per week.

This struggle over defining contractors has been going on for decades and is exemplified by Microsoft’s troubles about 30 years ago. The tech giant classified numerous workers as contractors despite treating them as employees and had to retroactively cover payroll taxes after IRS audits in 1989 and 1990. Eight improperly classified contractors subsequently filed a lawsuit that sought full benefits and eventually won on appeal in 1999. The decision meant that Microsoft owed “a small fortune to its misclassified workers.”  

In this first installment of a two-part series on freelance work, we look at the previous and current methods of defining contractors. We also explain why it’s vital to get classifications right, even when the rules aren’t always perfectly clear or easily enforceable.

Defining contractors: back to the status quo

The Trump DOL rule

The short-lived Trump Administration Independent Contractor Rule was issued on January 7—just 13 days before the inauguration of President Joe Biden. So, it practically never went into effect. 

The rule proposed a simplified five-part “economic reality” test that made it easier for businesses to classify individuals as contractors. The first two and “main factors” were:

1. The level of control the individual has over his or her own work; and,
2. The opportunity for profit or loss due to their own personal investment.

If those two elements weren’t definitively in favor of a contractor having control and opportunity, there were an additional three “guiding factors:” “the level of skill of the role involved; the permanence of the working relationship; and how the role in question relates to the company’s overall business operation.”

Legal and business analysts agreed that the Trump rule made it easier to classify people as contractors and viewed it as a win for business owners. But Biden’s Department of Labor withdrew the rule because they claimed it contradicted legal precedent, confused assessments rather than simplifying them, and reduced worker protections under the Fair Labor Standards Act (FLSA). Despite its short life, it’s valuable to understand the previous DOL rule because it—or something like it—could return with a future change in administrations.

The current status quo on classifying contractors

The withdrawal of this federal rule puts things back to the way they were—for now—which is essentially a patchwork of guidance informed by state laws, federal tax law, the FSLA, common law principles, and court rulings. In essence, the main factors defining an employee are whether an individual relies on an employer as their primary source of income and whether the employer exercises total control over how a job is done.

It gets more complicated from there, however. Several multi-part tests are designed to figure out who is a contractor, all of which may be impacted by state laws.

The Internal Revenue Service (IRS) has a huge stake in this because the classification of contractors and employees determines who is responsible for paying Social Security and Medicare taxes. The agency’s guidance reflects both influential court rulings and commonly used tests:

1. “Behavioral Control,” sometimes called “The Right to Control Test:” “A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.”

Indicators of this control include how detailed instructions are, whether the worker’s progress is evaluated before a task’s completion, and whether the employer trains the person.

2. “Financial Control” aka “The Economic Realities Test:” “Does the business have a right to direct or control the financial and business aspects of the worker’s job?”

These factors include whether the individual receives a regular paycheck or significant equipment from the employer and whether the employer enforces limitations on the worker’s ability to offer services to other businesses. Again, the more control a company exercises, the more likely a person is an employee.

3. “Relationship:” “The type of relationship depends upon how the worker and business perceive their interaction with one another.”

Factors here are the nature of the contracts defining the work, if a worker receives benefits, whether the relationship is “permanent,” and whether the services are “a key activity of the business.”

The Department of Labor also outlines seven factors used by the US Supreme Court to determine whether a business violates the FSLA. All these items reflect the tests above but simplify things to one list:

1. The extent to which the services rendered are an integral part of the principal’s business.
2. The permanency of the relationship.
3. The amount of the alleged contractor’s investment in facilities and equipment.
4. The nature and degree of control by the principal.
5. The alleged contractor’s opportunities for profit and loss.
6. The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
7. The degree of independent business organization and operation.

The current standard boils down to how much control an employer exercises, along with the financial impact and permanence of the relationship. But the number of factors and their room for interpretation can still make it unclear when to classify someone as a contractor. And this ambiguity has downsides.

The limits of enforcement, potential legal liability, worker abuses, and why it’s essential to classify correctly

Ambiguity makes it harder to enforce classifications, and some employers suffer few consequences—until they are hit with an IRS audit or a labor and employment complaint.

Again, many businesses regard too many workers as contractors to avoid payroll taxes, benefits, and FLSA requirements. An example is a company with two-dozen contractors and only five W-2 employees, even though the freelancers derive most of their income from the employer, work 40 hours per week, and adhere to strict guidelines while completing tasks.

As an employer, it’s important to carefully classify workers according to the tests for two reasons:

1. Any financial gains achieved by improperly defining individuals as contractors can be wiped out (and then some) by lawsuits, fines, or tax audits.

2. It’s the law and the right thing to do. Prioritizing fairness and the dignity of workers pays off in the long run.

Increasing enforcement and protecting workers are priorities for Biden’s Department of Labor. Newly appointed officials have commented on plans for more changes to how contractors are defined, and these revisions may regard more individuals as employees.

Nevertheless, the popularity of independent work has grown because of generational, cultural, and financial shifts. So, smart changes should balance protecting people from exploitation with ensuring they can work how and where they want.

We’ll cover these issues in our next piece on the state of freelance work—stay tuned.

Karp HR solutions can help you evaluate how to classify and structure your workforce while providing customized benefits that attract talent without breaking the bank. Contact us today for a free consultation.