How to tell if you're misclassifying your workers as independent contractors

While working with a flexible workforce of independent contractors can provide a myriad of benefits for businesses looking to stay lean and nimble, the consequences of misclassifying your independent contractors can get expensive fast.

To avoid misclassification penalties, companies need to follow federal and state guidelines for determining the appropriate worker classification. Below is a summary of those guidelines and regulations governing the classification of employees and independent contractors.

IRS definitions

The Internal Revenue Service (IRS) distinguishes employees from independent contractors based on three factors: behavioral control, financial control, and the logistics of the worker-employer relationship. 

1. Behavioral control

The behavioral control category refers to employers’ control over how work is done. The more control the employer has, the more likely the worker is a full-time employee. The IRS groups behavioral control factors into four major categories:

• Types of instruction given. Employees receive instructions about when, where, and how to work.
• Degree of instruction. Independent contractors typically work with minimal oversight, making decisions on their own.
• Instructions and training. If the company provides detailed instructions and extensive training, the worker is probably an employee.
• Evaluation system. Independent contractors' work is typically assessed based on project outcomes rather than routine performance reviews.

2. Financial control

This category refers to workers’ control over their work-related expenses and investments. The IRS considers five financial factors to distinguish contractors from employees: 

• Significant investment. Workers who make significant investments in equipment and resources needed to perform their tasks are generally contractors, but there are exceptions. Construction employees, for example, typically buy their own tools.
• Expense reimbursement. Employees typically receive business expense reimbursements from employers. 
• Profit and loss. Because independent contractors often pay for their own resources, they have a greater chance of losing or profiting from their work than employees. The latter is generally paid a consistent salary regardless of varying costs. 
• Services available to the market. Contractors are free to provide their services to multiple clients simultaneously and can advertise their services to a broad audience.
• Method of payment. An employee receives a regular wage, while independent contractors are paid based on project timelines. 

3. Type of relationship

The way the employer and worker perceive and define their relationship is the third definitive criterion for worker classification. The IRS has several considerations, including whether the: 

• Employer-worker agreement is contractual. A written contract may specify several things, including whether a worker is an employee or contractor, but the document alone doesn’t determine their classification. 
• Workers receive benefits. Traditional benefits like insurance, retirement plans, and paid leave are typically associated with full-time employment and aren’t extended to independent contractors. 
• Employer-worker relationship is indefinite. Which suggests the worker is an employee. 
• Services provided are key activities of the business. Independent contractors often provide specialized services that are not core to the hiring party's primary business activities.

All of these factors—broken into more detailed points—make up the 20-point IRS checklist that you’ll find at the end of this guide. 

FLSA definitions

The Fair Labor Standards Act (FLSA) provides an “economic reality” test to gauge whether a worker is an employee or contractor. An employee is economically dependent on the employer, whereas a contractor has a business of their own. 

But, according to the US Supreme Court, the economic reality test isn’t clear-cut, emphasizing that multiple contextual factors are taken into account when determining a worker's classification. The Court holds that there are several relevant FLSA factors to consider, including: 

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

The Supreme Court also states that some factors aren’t relevant to the FLSA economic reality test. The place of work, the presence or absence of a formal employment agreement, whether the worker is licensed, and the time or mode of pay all don’t impact a worker’s status. 

State misclassification guidelines

Along with the federal IRS and FLSA guidelines, many states use one of two primary tests to assess worker-employer relationships: the ABC test and the Common Law test. There are also modified ABC test versions, the A&B and A&C tests. 

The ABC test consists of three criteria that must all be met for a worker to be considered an independent contractor:

• The worker is free from the control and direction of the hiring entity.
• The worker performs services that are outside the usual course of the hiring entity's business.
• The worker is engaged in an independently established trade, occupation, or business that is similar to the services they are providing.

The Common Law test evaluates multiple factors to determine worker classification, with no single factor being decisive. This test is essentially the same as the IRS guidelines. 

Along with considering these tests, check whether your state has unique civil law statutes regarding labor that impact classification. California, for example, has its own labor code, which was the basis of the Lime scooter misclassification fine mentioned earlier. 

States also have varying fines for misclassifying employees. For instance, in Texas, misclassification fines start at $200 per worker, while Michigan employers can expect a fine of around $1,000, imprisonment for up to a year, or both.

How have worker classification laws changed in recent years?

Perhaps the biggest challenge of staying compliant with classification laws is that they change frequently—both on federal and state levels.

Federal changes

The current Independent Contractor Rule, published in January 2021, states that someone is an independent contractor based on two factors: the degree of control a company has over the individual’s work and the person's opportunity for profit or loss. 

The US Department of Labor (DOL) has been repeatedly delaying the finalization of a new independent contractor rule suggested in October 2022. While the 2021 IC Rule is considered more employer-friendly, the new rule should broaden the economic realities test’s scope and offer more detailed guidelines for determining the employee-employer relationship.

State changes

In recent years, different states and cities have also undergone significant changes in their worker classification laws, adding an extra layer of complexity for businesses operating across multiple jurisdictions.

These are just some examples of the most recent updates in contractor classification regulations by state and city:

• California Assembly Bill 5 (AB 5). The bill, which came into effect on January 1, 2020, introduced the ABC test for determining worker classification in California. The new test makes it more challenging for companies to classify workers as independent contractors, particularly in industries like ride-sharing and food delivery.

• The Freelance Worker Protection Act (FWPA) in Illinois. Designed to protect contractors, this law takes effect on July 1, 2024. The FWPA ensures that once a freelance worker starts their contracted services, the hiring party can neither delay payment nor offer less than the agreed-upon compensation.

• Seattle’s new Independent Contractor Protections. The City of Seattle’s Independent Contractor Protections Ordinance (ICPO) took effect on September 1, 2022. It safeguards independent contractors from payment delays or non-payment while also ensuring they possess comprehensive knowledge of their work agreements.

3 frameworks to assess your worker classification protocols

Classifying your workers properly is crucial to avoid legal and financial risks. The following three questions should help you assess your worker classifications and ensure compliance.

1. Do my worker classifications align with the IRS and FLSA definitions?

When assessing worker classification under the IRS rule, pay special attention to the first two degrees of control: behavioral and financial control. While the third degree of control, the relationship between the parties is undoubtedly a consideration in determining worker classification, the first two factors are more important. 

And what about FLSA compliance?

While the IRS rule primarily examines degrees of control, the FLSA introduces the economic reality test.

Let’s take a case involving a worker named Alex, who provides graphic design services to a marketing agency called CreativeEdge. To assess compliance with the FLSA, a lawyer or agency would consider the following factors (as outlined by the Supreme Court):

• Extent of integration: If Alex's work directly contributes to the agency's core marketing activities, it suggests an employee-employer relationship under the FLSA.
• Permanency of the relationship: If Alex consistently works on multiple projects for the agency over an extended period, they have a long-term working arrangement that suggests they’re an employee.
• Investment in equipment: Alex is likely an independent contractor if they use their own computer, software, and design tools.
• Nature and degree of control: If CreativeEdge provides specific instructions on how to complete design projects and maintains significant oversight, Alex is likely an employee. 
• Opportunities for profit and loss: If Alex can earn more by taking on additional projects or securing new clients, that’s a sign they’re an independent contractor.
• Initiative, judgment, or foresight: Alex is likely a contractor if they operate independently and compete with other designers in the open market.
• Degree of independent business operation: Alex is likely a contractor if they have their own client base, market their services, and manage their workload.

Worker classification under IRS and FLSA guidelines depends on evaluating various factors, with no single criterion determining the outcome. Always consider the full scope of circumstances, as the worker classification is based on the interplay of these factors and the unique context of each case.

2. Do my worker classifications align with my state’s regulations?

To check whether your worker classifications align with local rules, consult your state's labor department website or seek legal advice.

For instance, in California, the ABC test applies. To be classified as an independent contractor, the worker must be:

• Free from the control and direction of the hiring entity.
• Performing a job that is outside the usual course of the hiring entity's business.
• Engaged in an independently established trade, occupation, or business.

3. Am I using technology to mitigate compliance risks? 

Many companies relying on independent contractors use slow, laborious processes to manage these workers. But, this manual work is time-consuming and invites errors—two factors that can increase risk and the likelihood of misclassifications. It’s easy to miss IRS deadlines and submit 1099-NEC forms with inaccurate information when administering these critical processes through human touch points—as opposed to implementing automation with specific and algorithmic-driven process adherence. 

Businesses that use AI and automation to manage data-intensive processes significantly reduce compliance risks associated with human error. Find a tool that lets you set up automatic workflows for regular contractor management tasks—like requesting W9 forms and sending payments—all while staying compliant. 

Classify your contractors with confidence

Contractors are a revenue driver for so many businesses today. If that’s true for your company, don’t let regulatory complexities stand in the way of engaging these independent workers and giving your business a competitive edge. 

First and foremost, consult with your in-house counsel or external legal experts to ensure full compliance with the law. Worker classification is a nuanced and context-dependent process that requires detailed legal expertise. 

But as you seek legal advice, you can also build your own knowledge of worker classification rules so you can confidently work with contractors. Use this worker classification checklist as a starting point for your evaluation, and regularly return to this guide for an overview of IRS, FLSA, and state guidelines. 

Our team is also happy to help you evaluate your existing processes and navigate the complexities of 1099 categorization.

Download our brand new ebook: "2024 Edition: The Ultimate Guide To Worker Classification."