Independent Contractor: Legal Definition and Status

IRS Classification Factors

The Internal Revenue Service uses a multi-factor test to determine whether a worker qualifies as an independent contractor or should be classified as an employee. This assessment is critical because misclassification can result in substantial tax liabilities and penalties.

Behavioral Control

Behavioral control examines who has the right to direct and control how work is performed:

• Instructions: Employees typically receive detailed instructions about when, where, and how to work. Independent contractors generally determine their own methods and processes
• Training: Companies that provide extensive training to workers usually indicate an employer-employee relationship. ICs rely on their existing expertise
• Work Schedule: Employees often have set schedules determined by the employer. ICs typically control when and how much they work

Financial Control

Financial control evaluates the business aspects of the worker’s relationship with the company:

• Significant Investment: ICs usually have their own equipment, tools, and workspace. Employees typically use employer-provided resources
• Unreimbursed Expenses: ICs typically bear their own business expenses. Employees usually have expenses reimbursed by their employer
• Opportunity for Profit or Loss: ICs can make business decisions that affect their profitability. Employees receive fixed wages regardless of the company’s financial performance
• Services Available to Market: ICs generally offer services to multiple clients simultaneously. Employees typically work for one employer

Relationship Type

The nature of the relationship reflects how the worker and business perceive their arrangement:

• Written Contracts: While not determinative, contracts describing the relationship as independent contractor status support IC classification
• Benefits: Employee benefits such as insurance, pension plans, and paid leave indicate employment. ICs arrange their own benefits
• Permanency: Ongoing, indefinite relationships suggest employment. ICs typically engage in project-based or temporary work
• Services as Key Activity: When a worker’s services are a key aspect of regular business operations, this may indicate employment

IC vs Employee: Legal Tests

Beyond the IRS factors, courts and government agencies apply various legal tests to determine worker classification. Different jurisdictions may emphasize different criteria.

ABC Test

Many states, particularly California under AB5, use the “ABC test” for determining independent contractor status. Under this test, a worker is presumed to be an employee unless the hiring entity proves all three conditions:

A. Autonomy: The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under contract and in fact

B. Business Scope: The worker performs work that is outside the usual course of the hiring entity’s business. For example, a freelance graphic designer hired by a law firm may meet this test, but a driver hired by a rideshare company likely does not

C. Customarily Engaged: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. This means the worker has an independent business serving multiple clients

Economic Reality Test

Federal courts and the Department of Labor have traditionally used the “economic reality test” under the Fair Labor Standards Act (FLSA). This test examines whether the worker is economically dependent on the employer or truly in business for themselves:

• Permanency of Relationship: Temporary or project-based relationships favor IC status
• Degree of Control: The extent to which the hiring party controls the manner and means of work
• Worker’s Investment: Whether the worker has made significant investment in facilities, equipment, or hiring helpers
• Skill and Initiative: Whether the work requires special skills and whether the worker exercises business judgment
• Profit and Loss Opportunity: The degree to which the worker’s managerial skill affects their opportunity for profit or loss
• Integration: How integral the worker’s services are to the employer’s business

Different federal agencies and courts may weigh these factors differently, and the analysis is highly fact-specific to each working relationship.

Risks of Misclassification

Incorrectly classifying employees as independent contractors carries serious legal and financial consequences for both workers and companies.

Consequences for Companies

Organizations that misclassify employees as independent contractors, whether intentionally or inadvertently, face multiple risks:

• Back Taxes and Penalties: Companies may owe back payment of payroll taxes (employer portion of Social Security and Medicare, federal unemployment tax), plus interest and substantial penalties. The IRS can assess penalties of up to 100% of the unpaid tax liability in cases of intentional misclassification
• Wage and Hour Violations: Misclassified workers may be entitled to minimum wage, overtime pay, and meal and rest breaks. Class-action lawsuits for wage violations can cost companies millions
• Benefits Liability: Companies may be required to provide retroactive benefits including health insurance, retirement plan contributions, and paid time off
• State Audits: State agencies frequently audit companies for unemployment insurance and workers’ compensation misclassification, resulting in back premiums and penalties
• Criminal Penalties: Willful misclassification can result in criminal prosecution in some jurisdictions, including potential imprisonment for responsible corporate officers

Consequences for Workers

Workers misclassified as independent contractors also face significant disadvantages:

• Lost Benefits: Misclassified workers miss out on employer-sponsored health insurance, retirement contributions, paid leave, and other benefits
• Higher Tax Burden: Workers pay the full 15.3% self-employment tax instead of splitting the burden with an employer
• No Legal Protections: Misclassified workers lack protection under employment laws including anti-discrimination statutes, minimum wage and overtime requirements, workers’ compensation, and unemployment insurance
• Unpaid Overtime: Workers performing overtime may receive no additional compensation despite being legally entitled to time-and-a-half
• Limited Recourse: While workers can report misclassification to tax authorities and labor agencies, the process can be lengthy and may jeopardize the working relationship

Remedies and Reporting

Workers who believe they have been misclassified can:

• File IRS Form SS-8 to request a determination of worker status
• File Form 8919 to calculate and pay the employee share of Social Security and Medicare taxes
• Report misclassification to their state labor department or unemployment insurance agency
• Consult with an employment attorney about potential wage and hour claims

Companies should conduct regular audits of worker classifications and consult employment law specialists when relationships with workers evolve or become ambiguous.