Six-Factor Test Guides the Determination 

The labor market is tight, and you may be looking for someone to come in as an independent contractor once a week and clean your office for less cost than you would pay a commercial cleaning company. One of your full-time employees offers to do the cleaning after hours for some extra cash.  

It seems like the perfect solution. You can help your employees earn some extra money by paying them for the cleaning services as an independent contractor. Everyone’s happy. 

Except the IRS. And the Department of Labor (DOL). And, possibly, your benefit providers. 

Running afoul of worker classification rules can subject an employer to significant penalties, including payment of back payroll taxes. The bottom line in the example above is that it is very difficult for a worker to be an employee and an independent contractor at the same time. An employee may be willing to come in on the weekend to earn extra money, but since that employee already is on the company payroll, the employer must pay them as an employee, and that may mean paying an overtime rate for the weekend work — time and a half. 

What is ‘Worker Classification?’ 

Worker classification rules are protocols determined by the IRS and DOL that govern the distinction between employees, who are on a company’s payroll, and independent contractors, who are not on payroll but are paid to perform specific functions that companies often need. 

An example: 

  • Meredith is a dental technician at a small dental practice who performs x-rays and teeth cleanings. She is required to work from 8 a.m. to 4 p.m. on weekdays, and her compensation includes salary, health benefits, a 401(k) and three weeks of vacation. 
  • Joe is a janitor who provides cleaning services to the dental practice. He comes in three times during the week, and once on the weekend for a deep cleaning. Joe provides services to several dental practices, so his schedule varies from week to week, but he typically devotes seven hours a week to cleaning this practice’s office. He brings his own cleaning equipment and supplies to complete the job. Joe sends a bill to the dental practice every month. 

Under the regulations set by the IRS and DOL, as well as the intentions of the dental practice owner, Meredith is legally considered an employee and Joe is an independent contractor. Specific guidelines set forth by DOL spell out the differences between the two worker classifications. 

DOL’s Six-Factor Test 

The DOL created a list known as the “six-factor test” to determine whether a worker is legally considered an employee, as opposed to an independent contractor: 

  • Degree of control — Who controls the worker’s work schedule and responsibilities? If the employer sets work hours and defines the job responsibilities, as well as how tasks are done, these are the hallmarks of employment. 
  • Terms of the relationship — If the employer and the worker understand the relationship to be permanent, it is likely considered legal employment. If you hire an independent contractor, but the contract calls for a long-term or open-ended time commitment, that’s a red flag to the regulatory agencies. Moreover, the contract must list specific duties and terms of payment, and the employer cannot limit the contractor from working for other clients. 
  • Nature of the work — Is the work integral to the company’s business, or is it a support function or ancillary activity? The more integral it is to the business, the more likely it is to be determined legal employment. 
  • Skill and independence — This test evaluates the level of skill involved in a worker’s activities and the level of independence the worker has in executing their functions.  
  • Investment in tools and/or equipment — Does the worker use their own tools or equipment on the job, or does the employer provide them? To be sure, employees in certain industries often use their own tools, but this test, taken in combination with the other tests, can be critical in determining a worker’s classification. 
  • Opportunity for profit or loss — This test determines whether a worker has the latitude to determine their own business risks and profits.  

As of 2024, DOL adopted a more stringent approach to worker classification, emphasizing an analysis of the totality of circumstances, meaning all factors are considered collectively. No single factor makes the determination of classification.  

Expense Ramifications of Worker Classification 

Often, employers prefer that workers be classified as contractors because it saves the business a significant amount of money. Independent contractors are responsible for paying their own taxes (rather than having them withheld from paychecks), and they pay their full FICA taxes, saving the employer the cost of half the FICA. Moreover, the employer saves costs related to employee benefits, since independent contractors don’t qualify for benefits. 

But shifting these costs to the contract worker can be fraught with risk if you don’t ask the right questions at the hiring stage. 

Consider the story of one company that underwent a workers’ compensation audit. The company employed significantly more contract workers than payroll workers. However, upon hiring the independent contractors, the company failed to obtain certificates of insurance from them. Subsequently, the company failed to include coverage for the contractors in their calculations for workers’ compensation insurance.  

When the audit showed the discrepancy and determined that the company’s premiums would double to cover all the contractors, the company quickly had to contact all the contractors and ask for proof that they had independent workers’ comp insurance. 

It is critical to obtain not only certificates of insurance but also Form W-9 from all contractors at the point of hire. You don’t want to be scrambling for W-9s the following January when it’s time to send out Form 1099-NEC. 

In cases where the IRS or DOL reclassifies independent contractors to employees, the employer will need to cover any under withheld taxes, including the full 15% of FICA taxes. There would also be additional penalties and interest charged for misclassifying workers.  

Reclassification does not happen often. Usually, employers know they have a classification problem with their workforce, and they seek help from their accountants to straighten it out.  

At the state level, most states Departments of Labor suspended worker classification audits during the Covid-19 pandemic and have resumed them in recent years. These audits are random, so a company may be notified that an audit is coming even if it has no worker classification issues. 

Industry Characteristics 

The federal rules governing worker classification can be vexing to employers in certain industries, such as agriculture, construction and janitorial services. 

People who work on farms generally know how to do many different things, and they’re willing to multi-task and work extra hours. Janitorial employees often moonlight as handymen and are willing to provide those services to their employers.  

But it’s important to remember that, once a worker is on your payroll as an employee, they’re an employee. If they put in extra hours to perform a function that either is or is not related to their normal work, they must be paid according to FLSA rules, which in most cases, includes overtime. 

Ramifications for Employee Benefits 

Occasionally, an employer will deliberately pay a worker as an independent contractor to avoid having to pay for their health benefits. When the worker is reclassified by the IRS, the reclassification can lead to issues with discrimination rules that govern employee benefit programs. If the employer has kept a certain class of employees off the books, and the IRS finds they should have been paid as employees, the company may be in violation of its benefit plans. More financial penalties ensue. 

Conclusion  

Worker classification rules are more complex than they may seem on the surface, and penalties for violating them are severe. If you would like to discuss worker classification in your company, or if you have been notified by the state your company has been selected for a worker classification audit, contact an Adams Brown advisor.