Employers and employees should be able to ascertain whether a worker is an employee or an independent contractor. This classification determines tax obligations, legal rights, and benefits. Misclassification has severe legal and financial consequences, so it is essential to understand the classification criteria.
Understanding the Common Law Test
The common law test, or the FLSA Economic Reality test, is used to classify workers on a blanket basis. It considers three important factors: financial, behavioral, and relationship criteria.
Financial criteria
- Financial control: Independent contractors tend to have control over their own source of income and can have a large number of clients. They tend to be paid in the form of lump sums or per project and not in the form of regular salary.
- Payment arrangement: Employees are often paid through payroll, while independent contractors are given direct payment for work.
- Expense obligation: Independent contractors often bear business expenses, whereas employees are reimbursed by the employer.
Behavioral criteria
- Control over work: Employers have great control over employees’ schedule, mode, and locations of work. Independent contractors enjoy greater control over doing their job.
- Training offered: Employers offer training to workers that don’t always take place for independent contractors.
Test of relationship
- Contractual arrangements: Independent contractors have written agreements detailing their job responsibilities, while employees have contracts of at-will employment.
- Benefits and length: Workers have benefits such as health insurance and paid leaves, and they have long-term employment. Independent contractors pay their own benefits and work on a project-by-project basis.
The IRS and DOL guidelines
The IRS and Department of Labor (DOL) issue guidelines on the classification of employees.
- IRS guidelines: The IRS is concerned with the common law test of identifying tax liability. The employers need to examine the level of control and independence in the employer-employee relationship.
- DOL guidelines: The DOL uses a six-factor economic reality test to decide who an employee is for purposes of the Fair Labor Standards Act (FLSA). It entails finding out the employee’s opportunity for profit or loss, his or her investment in the work, the permanence of the relationship, the employer’s control over the work, the work’s essentiality to the business, and the skill and initiative of the employee8.
Legal implications of misclassification
Misclassifying workers has severe legal and financial consequences. Businesses can be penalized for failing to offer workers essential benefits and protections such as minimum wage, overtime pay, and workers’ compensation.
Proper classification of workers as employees or independent contractors is crucial to compliance with labor and tax law. Employers are required to thoroughly review the financial, conduct, and relational elements of the worker-employer relationship in making proper classification and avoiding potential legal troubles. Familiarity with these standards enables employers to effectively navigate the complexities of worker classification.
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