Independent Contractor or Employee? Varying Tests

By Michael D. Koppel, CPA, PFS, CITP, MBA
Retired Partner
December 1, 2019

Editor: Marcy Lantz, CPA

It is not unusual to read news stories about companies being sued for classifying workers as independent contractors when they claim to be employees. Being designated an employee can have a profound effect on everything from overtime pay to fringe benefits to, of course, taxes. Numerous articles have been written about the advantages and disadvantages for both the worker and the business of how an individual is classified. The present focus is what criteria are to be used in the determination.

There is no uniform test to distinguish employees from independent contractors. Government agencies such as the IRS, the U.S. Department of Labor (DOL), and the National Labor Relations Board (NLRB) each look at their own set of factors. The same is often true of the state where the business is located.

While the tests for determining a worker’s classification differ, there is a common thread: Definitive answers can be difficult to find.

IRS’s test: The IRS identifies 20 common-law factors for deciding whether someone is an employee rather than an independent contractor in Rev. Rul. 87-41. The general focus is whether a business has the right to direct and control the worker’s actions. The revenue ruling is still valid. However, recently the IRS has grouped the more relevant factors into three main areas:

• Behavioral control;
• Financial control; and
• The type of relationship of the parties.

IRS Publication 15-A, Employer’s Supplemental Tax Guide, provides details of each area.

One of the important things to remember regarding the IRS factors is there is no definitive way of determining whether a worker has been properly classified. However, the IRS does provide potential relief from possible payroll tax exposure based on Section 530 of the Revenue Act of 1978, P.L. 95-600. In order to have this protection, a business must meet all of the following tests:

• Reporting consistency;
• Substantive consistency; and
• Reasonable basis.

The IRS has provided detailed information regarding this relief in Publication 1976, Do You Qualify for Relief Under Section 530?

The IRS recently announced that beginning in 2020, instead of reporting compensation for independent contractors on Form 1099-MISC, Miscellaneous Income, employers should expect to use a new form, 1099-NEC, Nonemployee Compensation. This will provide the IRS an easier way to track independent contractors.

Department of Labor’s test: Because the minimum wage and overtime protections of the Fair Labor Standards Act (FLSA) do not extend to independent contractors, the DOL needs to be able to determine whether someone is an employee or an independent contractor. The DOL website provides some interesting information in this regard starting with the following: “Even if you are an independent contractor under another law (for example, tax law or state law), you may still be an employee under the FLSA” (see DOL, “Get the Facts on Misclassification Under the Fair Labor Standards Act,” available at www.dol.gov. According to the DOL’s interpretation of U.S. Supreme Court decisions, the significant factors in determining worker classification under the FLSA include:

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; and
7. The degree of independent business organization and operation.

However, a worker’s classification ultimately depends on the total activity or situation, not any single rule or test (see DOL Fact Sheet 13: Employment Relationship Under the Fair Labor Standards Act, available at www.dol.gov.)

National Labor Relations Board’s test: Because independent contractors do not have a protected right under the National Labor Relations Act to form labor unions, the NLRB sometimes must decide whether workers are independent contractors or employees. After having modified its classification test in 2014, the NLRB recently revised it again in SuperShuttle DFW, Inc., 367 NLRB No. 75 (2019), this time underlining the importance of evaluating whether a worker has “entrepreneurial opportunity” for gain or loss; if so, this suggests independent-contractor status. A basic principle, however, remains that the more control the business exerts on a worker, the more likely the worker should be treated as an employee. The SuperShuttle decision was not unanimous.

State tests: Some states have sought to make it more difficult for employers to classify workers as independent contractors by adopting a rigorous three-part test. The details vary, but broadly  speaking, the so-called ABC test presumes that workers are employees unless:

1. 1. A. They are free from the control of the hiring entity;
   2. B. They perform work that is outside the usual course of the hiring entity’s business; and
   3. C. They are customarily engaged in an independent trade, occupation, or business.

Unless all three criteria are met, the worker is considered an employee.

The second criterion is perhaps the most stringent. Consider the following: During tax season a CPA firm hires a person to assist in tax return preparation. Based on the second criterion, there is now no question that the worker is an employee. Only a few states have adopted the ABC rules, but more are expected to follow. (In September 2019, California adopted the ABC methodology by enacting Assembly Bill 5, which goes into effect in 2020. The legislation contains a list of exemptions.)

While historically challenges to worker classification have been between a worker or workers and a business, a new type of lawsuit has emerged. In Diva Limousine, Ltd. v. Uber Technologies, Inc., No. 18-CV-05546 (N.D. Cal. 6/20/19), a business contested a competitor’s classification of workers, arguing that it was unfair competition to lower costs by treating employees as independent contractors.

The classification of workers has been an issue for a long time and will likely continue to be so. Businesses need to be aware of the varying rules.

This item provides only a brief overview of the issue of classification.

This article was originally published in the AICPA “Tax Adviser” on December 1, 2019.