8723 / How is it determined whether a taxpayer is an independent contractor or a common law employee?

Editor’s Note: January 9, 2024, the Biden Department of Labor (DOL) announced that it had finalized a standard for determining whether a worker is an employee or an independent contractor under the Fair Labor Standards Act. The focus in determining independent contractor status under this rule hinges on the economic realities of the work relationship, including investment, opportunity for profit or risk of loss and whether the work is integral to the employer’s business. Under the rule, a six-factor "economic reality" test will consider: (1) the workers' opportunity for profit or loss depending on managerial skill, (2) investments by the worker and the employer, (3) the permanence of the work relationship, (4) the nature and degree of control exercised by the employer, (5) whether the work performed is integral to the employer’s business, and (6) the worker's skill and initiative. Additional factors may be considered as relevant to determining whether the worker is economically dependent on the employer or in business for themselves. States that use the so-called "ABC" test will not be impacted by the new rule, which is only used for FLSA purposes. The rule rescinded the 2021 standard entirely. In June of 2023, the National Labor Relations Board (NLRB) issued a ruling that follows this totality of the circumstances analysis.

On May 6, 2021, the DOL announced its intent to withdraw the most recent modifications to the independent contractor test. The Trump-era rule was designed to make it easier for employers to classify workers as independent contractors, rather than traditional employees, by focusing on whether workers are economically dependent upon an employer—or in business for themselves. The now-withdrawn rule prioritized two key factors, including (1) the worker’s degree of control over the work performed, and (2) the worker’s opportunity for profit or loss. The DOL’s 2021 announcement stated that prioritizing these factors in determining employment status under the Fair Labor Standards Act (FLSA) would have undermined the longstanding balancing approach of the economic realities test and court decisions requiring a review of the totality of the circumstances related to the employment relationship. The Trump DOL rule would have resulted in many workers’ losing FLSA protections, including minimum wage and overtime benefits. Shortly thereafter, a group of businesses filed a lawsuit in federal court. The Texas Court agreed with the business groups and reinstated the Trump-era test, with an effective date of March 8, 2021. The court found that the DOL's delay of the effective date for the Trump-era rule violated the Administrative Procedure Act by providing only a 19-day period for notice and comments (rather than the 30-day minimum). The court also found that the DOL limited the content of the responses to whether the effective date should be delayed (so unduly limited the scope of the comments received, making the decision to rescind the Trump-era rule "arbitrary and capricious").¹Generally speaking, an individual will be considered an employee under the common law rules if the person or organization for which the individual performs services has the right to control and direct the individual’s work, not only as to the result to be accomplished, but also as to the details and means by which that result is accomplished.² In other words, an individual will be classified as an employee if the employer has the right to control not only what will be done, but also how that work will be accomplished. On the other hand, if the individual performing the work is only under the control of another to the extent of the end result that must be delivered, that individual will be classified as an independent contractor.

It is important to note that the employer does not actually have to direct and control the manner of an individual’s work in order for that individual to be classified as an employee. The individual will be classified as an employee if an employer has the right to direct and control the manner in which that employee’s work is accomplished even if the employer does not actually exercise this right.³

The parties’ classification of the relationship as anything other than an employer-employee relationship is immaterial if the facts and circumstances show that the individual is performing services as an employee.⁴ The IRS has developed three categories of control: behavioral control, financial control, and the type of relationship that exists between the parties.⁵ Additionally, the IRS has developed a 20 factor test that is often applied in determining whether an individual is performing services as an employee or an independent contractor. These 20 factors include the following:

(1) Instructions. If the individual is required to comply with another person’s instructions about when, where and how he or she works, that individual is usually an employee.

(2) Training. If an individual is trained alongside a more experienced employee or is required to attend training meetings, this indicates that the person for whom services are performed wants the individual to perform those services in a certain manner, making it more likely that an employer-employee relationship exists.

(3) Integration. When the success or failure of the business is significantly dependent upon the performance of services by the individual, the individual performing those services must necessarily be subject to a certain degree of control by the business owner, indicating that an employer-employee relationship exists.⁶

(4) Services Rendered Personally. If the services must be rendered personally, it is presumed that the person for whom the services are performed is interested in the methods used to accomplish the work, as well as the end results.

(5) Hiring, Supervising and Paying Assistants. If the person for whom the services are performed hires, supervises, and pays assistants, it can generally be shown that he or she exercises control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status exists.

(6) Continuing Relationship. A continuing relationship between the individual performing the services and the person for whom they are performed indicates an employer-employee relationship.

(7) Set Hours of Work. If the person for whom services are performed sets the individual’s hours of work, this factor indicates an employer-employee relationship.

(8) Full-Time Schedule Required. If the individual must dedicate substantially all of the individual’s time to the work, the person for whom the services are performed has control over the amount of time the worker spends working and impliedly restricts the individual from taking other work. An independent contractor, on the other hand, is free to work when and for whom he or she chooses.

(9) Work on the Employer’s Premises. If work is performed on an employer’s premises, control is suggested, especially if the work could be done elsewhere. Work done off premises indicates freedom from control, but is not sufficient, on its own, to show that the individual is not an employee.

(10) Order or Sequence Set. If the individual must complete the work in a certain order, this factor shows that it is likely that another is controlling his or her pattern of work.

(11) Oral or Written Reports. If oral or written reports must be submitted by the individual completing the work, it is likely that another is controlling his or her work.

(12) Payment by Hour, Week or Month. Payment by the hour, week, or month usually indicates an employer-employee relationship, provided that the payment method is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor.

(13) Payment of Business or Traveling Expenses. If another pays the individual’s business or traveling expenses, an employer-employee relationship is indicated because the employer, in order to control the individual’s expenses, generally must have the right to direct the individual’s business activities.

(14) Furnishing Tools and Materials. If the person for whom services are performed furnishes significant tools and materials, this tends to show an employer-employee relationship.

(15) Significant Investment. If the individual invests in facilities that are usually used by workers in performing services, but are not typically maintained by employees (such as office space), this factor indicates that the individual is an independent contractor. Special scrutiny is applied in the case of home offices.

(16) Realization of Profit and Loss. An individual who can realize profit or loss as a result of the services offered is generally an independent contractor. The IRS uses the example of an individual who has a risk of loss with respect to liability for expenses, such as payment to unrelated employees (indicating independent contractor status), and distinguishes this type of risk from the risk that the individual will not receive payment for services (which is common to both employees and independent contractors).

(17) Working for more than One Firm at a Time. If an individual performs more than de minimis services for more than one firm at a time, this factor indicates that the individual is an independent contractor.

(18) Making Services Available to General Public. If an individual makes services available to the general public on a regular and consistent basis, this factor indicates that the individual is an independent contractor.

(19) Right to Discharge. The right to discharge an individual suggests an employer-employee relationship is present. An independent contractor, on the other hand, cannot be fired so long as the individual produces the end result that meets the contract specifications.

(20) Right to Terminate. If the individual has the right to terminate the relationship without incurring liability, this indicates an employer-employee relationship is present.⁷

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Planning Point: The California Supreme Court has abandoned the traditional multi-faceted test that has typically been used to determine employment status.Instead, the court determined that a three-factor “ABC” test is the correct standard to be employed under California state law.For a worker to be treated as an independent contractor in California, the following three prongs must be satisfied: (a) the worker has freedom from control over how to perform the service, (b) the service is outside the business’ normal variety or workplace and (c) the worker is engaged in an independently established role.⁸

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Planning Point: In 2019, the DOL released an advisory opinion confirming that certain “gig” workers who are connected to consumers (i.e., those who need services) via a virtual marketplace community (VMC) are not employees of the VMC. The VMC at issue here did not provide any training to the workers, nor did it provide equipment, supplies or a workspace, although the VMC did provide information on interacting with consumers, best practices and basic information about the consumer’s needs. The VMC also did not monitor or supervise the worker’s performance, and did not require the worker to accept a certain number of jobs, although the VMC did impose a fee for late or cancelled work. The DOL applied the generally applicable principles in determining worker classification and found that the VMC was essentially a referral service and that they received no services from the worker. Further, the DOL rejected the idea that the workers should be employees because they were “integral” to the VMC’s business.⁹

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All of the facts and circumstances of the relationship must be considered in weighing these factors to determine whether the relationship is an employer-employee relationship or an independent contractor relationship. No one factor will be determinative in making the correct classification.