Employee or Independent Contractor: Pass the Test or Pay the Penalty; though which test do you take?

As an employer, knowing the difference between an employee and an independent contractor can help avoid the legal and financial penalties of worker misclassification. In my last article, I discussed what those penalties were and the effect misclassification has on employers and employees. In this article, I’ll discuss the various tests for determining whether an individual is an employee or an independent contractor. Which test to use depends on what law is being applied.

The primary distinction between an employee and an independent contractor lies in the nature of their working relationship and the level of control exercised by the employer:

1. Control:
   
   • Employee: Employers have significant control over how, when, and where employees perform their work. Employers can dictate the details of the work and provide specific instructions.
   • Independent contractor: Independent contractors typically have more control over how they perform their work. They may negotiate the terms of the project, set their own schedules, and use their own methods to complete tasks.

1. Taxes:

1. • Employee: Employers withhold income taxes, Social Security, and Medicare from an employee's wages. Employers are also responsible for paying unemployment and workers' compensation taxes.
   • Independent Contractor: Independent contractors are responsible for handling their own taxes, including income taxes and self-employment taxes. Employers do not withhold taxes from their payments.

1. Benefits and Protections:

1. • Employee: Employees are often eligible for various benefits, such as health insurance, retirement plans, and paid time off. They are also protected by labor laws governing minimum wage, overtime, and working conditions.
   • Independent Contractor: Independent contractors do not receive employee benefits and are not covered by the same labor laws. They are considered self-employed and must manage their own benefits.

1. Duration of Relationship:

1. • Employee: Employment relationships are typically ongoing, with no predetermined end date. Employees may have long-term job security.
   • Independent Contractor: The relationship with an independent contractor is often project-based or for a specific duration. It may not be a continuous, long-term arrangement.

THE ABC TEST

The Department of Labor has a three-factor test, the ABC Test. The ABC Test presumes that a worker is an employee. The worker will be classified as an independent contractor only if the hiring entity can satisfy the test’s three elements:

1. The worker is free from the entity’s control or direction in performing his work, both under a contract for the performance of such work and in fact. The hiring entity must establish that the worker is free of such control. A worker who is subject to the type and degree of control a business typically exercises over employees would be considered an employee. Depending on the nature of the work and overall arrangement between the parties, a business need not control the precise manner or details of the work to find that necessary amount of control.
2. The worker performs work that is outside the usual course of the hiring entity’s business. The hiring entity must establish that the worker performs work that is outside the course of its business. Contracted workers who provide services in a role comparable to that of an existing employee will likely be viewed as working in the usual course of the hiring entity’s business.
3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed. The hiring entity must prove that the worker is customarily and currently engaged in an independently established trade, occupation, or business. The hiring entity cannot unilaterally determine a worker’s status simply by labeling the worker an independent contractor or having a contract designating the worker as an independent contractor.

THE COMMON LAW AGENCY TEST

The National Labor Relations Board uses the common law agency test to determine employee status for purposes of the National Labor Relations Act (NLRA). The NLRA recognizes a right to engage in collective bargaining for most private sector employees. Independent contractors are specifically excluded from the NLRA’s definition for the term “employee.” The factors in this test include:

1. The extent of control exercised by a hiring entity over the worker;
2. Whether the worker is engaged in a distinct occupation or business; and
3. The level of skill required by the worker to provide services.

THE ECONOMIC REALITY TEST

The economic reality test is currently used to determine employee status for purposes of the Fair Labor Standards Act (FLSA), the federal law that requires employers to pay a minimum wage and overtime compensation for hours worked in excess of a 40-hour workweek. Federal appellate courts have identified six factors for determining the economic reality of a working relationship:

1. The nature and degree of the alleged employer’s control as to the manner in which the work is to be performed;
2. The alleged employee’s opportunity for profit or loss depending upon his managerial skill;
3. The alleged employee’s investment in equipment or materials required for his task, or his employment of workers;
4. Whether the service rendered requires a special skill;
5. The degree of permanency and duration of the working relationship; and
6. The extent to which the service rendered is an integral part of the alleged employer’s business.

Although courts have indicated that all of the factors should be considered, the U.S. Department of Labor recently promulgated a rule that emphasized two factors—a worker’s entrepreneurial opportunity for profit or loss and the hiring entity’s control over the worker—as more determinative of employee status.

THE IRS THREE-FACTOR TEST - https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee

The Internal Revenue Service developed a three-factor test to help determine whether a worker should be classified as an employee or an independent contractor. Under this test, whether a worker is an independent contractor or an employee depends on the relationship between the worker and the business. Generally, there are three categories to examine:

Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does the job?

Financial Control: Does the business direct or control the financial and business aspects of the worker's job? Are the business aspects of the worker's job controlled by the payer? This level of control looks at aspects like how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies, among others.

Relationship of the Parties: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue? Is the work performed a key aspect of the business?

THE IRS TWENTY-FACTOR TEST - https://www.irs.gov/pub/irs-utl/x-26-07.pdf

The Internal Revenue Service previously used a 20-factor test to help determine whether a worker should be classified as an employee or an independent contractor. This test is not exhaustive, and no single factor is decisive. Instead, the totality of the circumstances should be considered. Here are the 20 factors:

1. Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
2. Training: Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
3. Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
4. Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
5. Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
6. Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
7. Set hours of work: The establishment of set hours for the worker indicates employee status.
8. Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
9. Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
10. Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
11. Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
12. Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
13. Payment of business and/or traveling expenses: If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
14. Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
15. Significant investment: Investment in facilities used by the worker indicates independent contractor status.
16. Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
17. Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
18. Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
19. Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
20. Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.

Again, it's crucial to note that no single factor is decisive, and the entire working relationship must be considered. Employers and workers should carefully evaluate these factors and consult with legal or tax professionals to ensure accurate classification. Misclassification can lead to tax liabilities, penalties, and legal consequences.

THE TESTS ARE NOT ALL THAT EXIST

As if these tests aren’t enough, federal regulations provide even more considerations. For example, 26 C.F.R. § 31.3121(d)-1 has specific tests for determining whether an officer of a corporation is an employee of the corporation; whether an individual is an employee under the usual common law rules (there’s those common law rules again); and which individuals in certain occupational groups (namely, agent-drivers or commission-drivers engaged in certain activities; full-time life insurance salesmen; home workers; and traveling or city salesmen) who are not employees under the usual common law rules are included as employees. Generally, an officer of a corporation is an employee and a director is not.

Applying the “usual common law rules” under the regulation, the employer-employee relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to what is to be done but also as to how it must be done. The employer does not have to actually direct or control the manner in which the services are performed but merely have the right to do so. The right to discharge is also an important factor indicating that the relationship is that of employer-employee. Other factors indicating an employer-employee relationship are the furnishing of tools and the furnishing of a place to work. In general, if an individual is subject to the control or direction of another merely as to what must be done and not how it must be done, that individual is an independent contractor. Individuals such as physicians, lawyers, dentists, veterinarians, construction contractors, public stenographers, and auctioneers, engaged in the pursuit of an independent trade, business, or profession, in which they offer their services to the public, are independent contractors and not employees. Whether the relationship of employer and employee exists under the usual common law rules will in doubtful cases be determined upon an examination of the particular facts of each case.

ONE EXAMPLE OF WHAT HAPPENS WHEN THE COURTS DISAGREE WITH YOU

Since I practice in Virginia, I’ll use a current Virginia case as an example of what can go wrong when you misclassify workers. In 2023, the Virginia Court of Appeals upheld a 2020 decision by the Virginia Employment Commission (VEC) in which it found that Amazon Logistics misclassified delivery drivers using its Flex system as independent contractors.

In 2019, a former worker filed an unemployment claim with VEC. The Commission found that Amazon’s Flex drivers were misclassified and ordered the company to pay unemployment insurance taxes for those drivers. Amazon appealed, and the Richmond City Circuit Court agreed with the VEC. Amazon appealed again to the Virginia Court of Appeals. A three-judge panel found that the supports the Commission’s determination that the workers were misclassified.

Using Amazon’s Flex program, workers compete for available delivery routes through an app and then pick up and deliver all of the packages on a designated route using their own vehicles. Drivers signed up for blocks, were required to arrive at the Amazon facility 30 minutes before a delivery block, and were not allowed to leave for their route until released by Amazon. Amazon required drivers to deliver all packages or return undelivered or undeliverable packages to the Fulfillment Center by 9 p.m. They provided a route for the delivery of packages and dictated how the packages were to be delivered. Drivers could not work for anyone else while delivering for Amazon and had to report the mode of transportation. VEC also concluded that drivers were paid an effective rate of $20 per hour.

Amazon argued that drivers were free to conduct the manner and means of the delivery services without instruction from Amazon, have no set hours of work, do not work full time, do not make any regular oral or written reports to Amazon, are free to choose their own routes to deliver packages, and are paid “by the job,” not hourly, weekly, or monthly.

Applying the 20-factor test that Virginia adopted in 2005, the Court stated that these factors determine whether an employer “exercise[s] sufficient control over the individual for the individual to be classified as an employee.” Summing up the factors, the Court said that “[c]ontrol is the core consideration in the 20-factor inquiry.”

An employer-employee relationship generally exists “when the person for whom the services are performed ha[s] the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.” Further, the law establishes a presumption of an employer-employee relationship and places the burden on the employer of defeating that presumption.

The 20-factor inquiry is fact-sensitive. Applying the facts of the case, the VEC determined that nine factors - 2 (training), 3 (integration), 4 (services rendered personally), 5 (hiring, supervising, and paying assistants), 11 (oral or written reports), 12 (payment by hour, week, month), 14 (furnishing of tools and materials), 17 (working for more than one firm at a time), and 18 (making service available to the general public) – indicated an employer-employee relationship; and two factors - 16 (realization of profit or loss) and 13 (payment of business and/or traveling expenses) were indicative of an independent contractor relationship. The Court focused on the remaining nine factors – 1 (instructions), 6 (continuing relationship), 7 (set hours of work), 8 (full time required), 9 (doing work on employer’s premises), 10 (order or sequence test), 15 (significant investment), 19 (right to discharge), and 20 (right to terminate).

Ultimately, the Court agreed with the Commission finding that the relationship between Flex drivers and Amazon “was more akin to the temporary employee, hired to meet a specific business need.” Amazon exerted the level of control consistent with the employer-employee relationship by dictating how drivers were to interact with customers, the routes that they should take, start and stop times, how they were to make deliveries. Amazon maintained the right to discharge drivers for failing a background check, using a vehicle other than the one reported to Amazon, arriving late, forfeiting delivery blocks late, and “for other commercially reasonable cause.” Even though Amazon stated that drivers could deviate from their routes, it was not practical to do so. Drivers, like an employee, could terminate their relationship with Amazon at any time.

Only factor 15 concerning the amount of investment did not lead to a finding of an employer-employee relationship. And that factor was indeterminate because while drivers did not invest in the facilities (suggesting an employer-employee relationship), they did invest in their modes of delivery (suggestive of an independent contractor relationship).

In the end, the Court agreed with the Commission that “a majority of the factors demonstrated that Amazon ha[d] the right to exercise a substantial degree of control over [the} Flex drivers.” Fifteen factors tended to show an employer-employee relationship and one supported an independent contractor status. The four remaining factors were less significant to the Commission’s analysis.

The Court also upheld the Commission’s finding that Amazon had to pay the unemployment insurance taxes for those drivers.

It's important for employers and workers to correctly classify the nature of their working relationship to comply with labor laws and tax regulations. Misclassifying employees as independent contractors (or vice versa) can lead to legal and financial consequences. The determination is based on several factors, and both federal and state laws may apply.

If you need help with a classification issue or have specific questions related to this article, please contact Mitchell Goldstein (mgoldstein@setlifflaw.com) at (804) 377-1269, or Steve Setliff (ssetliff@setlifflaw.com) at (804) 377-1261.