When's a worker an employee vs. contractor

Correctly classifying a worker as an employee vs. contractor affects tax obligations, benefits and compliance with labor laws.
The U.S. Department of Labor recently adopted a new classification rule that uses a multifactor economic reality test to determine worker status, focusing on factors like control, investment and the nature of the work relationship.
Misclassification can lead to significant financial and legal risks, including penalties, back taxes and increased workers’ compensation premiums.

Understanding worker classification and its impact on your clients

How your commercial clients classify a worker — employee vs. contractor — has a significant impact on both the business owner and the worker. This decision affects not only the business’ experience modifier and workers’ compensation premium, but also the worker’s federal income tax. When it comes time to pay taxes, improper classification may result in workers getting shortchanged in their pay, taxes owed and benefits received. Thus, it’s important to emphasize that worker classification is a significant decision that requires careful consideration from your clients.

Related: How you can prevent business fraud at your company

Key differences between employees and independent contractors

Today, many businesses have a combination of employees and independent contractors, with the former receiving W-2s and the latter 1099 forms at year-end. However, beyond that, distinguishing between these two categories isn’t always straightforward. To address this challenge, effective March 11, 2024, the U.S. Department of Labor has released a new rule that provides guidance on determining whether a worker is an employee or an independent contractor under the Fair Labor Standards Act. Please note that this new rule replaces the January 2021 rule with an analysis that aligns more closely with the FLSA as interpreted by longstanding judicial precedent.

The new rule uses a multifactor economic reality test to decide if a worker is economically dependent on the employer (an employee) or in business for themselves (an independent contractor). By considering all relevant factors without assigning predetermined weight to any single factor, the rule provides a more holistic view of the worker’s status. Key factors include:

Opportunity for profit or loss

If a worker can influence their ability to earn profits or suffer losses through independent effort and decision-making, such as negotiating their pay, accepting or declining work, hiring their own workers and purchasing materials, they are likely an independent contractor. If they rely solely on the employer for work and pay, they are likely an employee.

Investments by the worker and employer

This looks at whether the worker makes significant investments in their business, like buying equipment or marketing their services. If a worker’s investments are similar to those made by the employer, they are more likely to be an independent contractor. Minimal personal investment indicates employee status.

Permanence of the work relationship

This factor assesses the nature and length of the work relationship. Work that is sporadic, project-based or has a fixed ending date suggests independent contractor status. On the other hand, continuous work without a fixed end date indicates employee status.

Nature and degree of control

If the employer controls how, when and where work is done, the worker is likely an employee. Independent contractors typically have more freedom in how they perform their work.

Integral part of the employer’s business

If the work performed is central to the business’s core activities, the worker is more likely to be an employee. Work that is not integral suggests an independent contractor.

Skill and initiative

Workers who use specialized skills and business initiative to perform their tasks are more likely to be independent contractors. If the worker relies on the employer for training and job-specific skills, they are more likely to be an employee.

Implications for your clients

Tax and benefit implications

Misclassifying workers can lead to hefty tax bills. Employers withhold income taxes and pay Social Security and Medicare taxes for employees; independent contractors are responsible for paying their own taxes. Get it wrong, and both sides can end up in hot water. Employers might face big fines, while workers could be on the hook for unpaid taxes they didn’t expect. Additionally, for the worker, being classified incorrectly can mean missing out on benefits such as health insurance, retirement plans and unemployment insurance.

Compliance and legal risks

Businesses that misclassify workers may face compliance and legal risks, including fines and lawsuits. Workers who feel they have been misclassified can file complaints, leading to potential legal battles and serious financial consequences for the business. This could also lead the Internal Revenue Service to reclassify workers and collect unpaid employment taxes, again, causing significant financial and reputational damage to a business.

Related: Minimizing small business liability risks

Impact on workers’ compensation

Worker classification also affects workers’ compensation coverage and premiums. Employees are typically covered under workers’ compensation insurance, while independent contractors are not. Thus, misclassification can result in uninsured workers or increased premiums for the business. And in the event of a workplace injury, having misclassified workers can leave a business vulnerable to lawsuits and significant financial liabilities.

Pros and cons of hiring an employee vs. an independent contractor

It’s crucial to weigh the pros and cons of hiring employees vs. contractors. This knowledge helps your clients make smart choices that fit their business needs and keep them on the right side of the law. Here’s a quick look at what you need to consider:

Hiring employees has its perks. They’re usually more reliable and committed to the company’s long-term goals. Plus, employers have more control over their work. But it’s not all rosy — employees come with higher costs, more paperwork and long-term commitment that might not suit every business.

On the flip side, contractors can save you money and offer flexibility. Need a web designer for a one-off project? A contractor might be perfect. They often bring specialized skills to the table, too. But remember, you can’t control their work schedules, and they might not always be available when you need them.

Ensuring proper classification for compliance and protection

Let’s face it: getting worker classification right isn’t just about following rules. It’s about protecting your business and treating workers fairly. Fortunately, the U.S. Department of Labor’s new rule provides a clearer and more consistent framework, ensuring that workers receive the protections they are entitled to while allowing businesses to engage with independent contractors effectively. By understanding the correct classification, you and your clients can make informed decisions and avoid the risks associated with misclassification.

Agents, take a look at our Workers’ Compensation Program to add to your portfolio of insurance solutions.

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