The United States Internal Revenue Service (IRS) views any person who works for a startup as either an employee or an independent contractor for tax purposes. Correctly classifying workers as one or the other is not easy, and misclassifying an employee as a contactor comes with a hefty price tag. For example, companies may face significant back taxes and penalties from the IRS, or may be required to extend employment benefits to misclassified individuals. A company may also need to pay other damages if a misclassified individual sues.
For more than 25 years, companies relied on the IRS’s 20-factor analysis to determine classifications and avoid lawsuits. In July 2015, this all changed. The United States Department of Labor (DOL) issued an interpretation of the Fair Labor Standards Act, which provided a new “economic realities” test to determine whether someone is a contractor. The DOL went so far as to conclude that most workers classified as independent contractors at that time were actually employees.
Today, companies must evaluate the economic realities of their relationship with a worker to determine if that worker is “economically dependent on the employer, and thus an employee.” In particular, companies should consider the following six factors:
A worker who does integral work — that is, work critical to the success of the company — is most likely an employee rather than a contractor. Even a small part of the business can be integral, as long as that part is necessary for the business to function.
This factor favors contractor status if a worker can realize a personal profit or loss by being able or unable to market their skills, find new business, negotiate and make business decisions. However, if little or no opportunity for profit or loss exists, this factor favors employee status.
A contractor will typically invest in their own business, while a worker is less likely to make significant investments in the company’s business. In addition, the DOL stresses that a worker’s investments must be significant relative to the employer’s in order for the worker to be classified as a contractor.
A worker must also demonstrate special skills and initiative in order to be considered a contractor. A contractor makes decisions that require business skills, judgment, and initiative in addition to technical ability. Therefore, a worker performing routine tasks is unlikely to be classified as a contractor.
A worker who has a more permanent or indefinite relationship with the company is more likely to qualify as an employee. For example, an at-will employee who works continuously and repeatedly for employed company is considered engaged on a permanent and indefinite basis. By contrast, a contractor typically performs discrete, project-based work for a variety of different employers.
A worker can be asked to provide a desired outcome, but must control meaningful aspects of the work performed, in order to be considered a contractor. For instance, a contractor typically determines how to achieve a business objective. A worker whose approach is subject to an employer’s control should be classified as an employee.
Overall, companies must evaluate all of these six factors — rather than a single parameter — to determine whether or not a worker can legitimately be classified as a contractor.