By Lindy Spencer
Published July 2021
I’ve lost count of the number of times I’ve heard people claim that they make more money as an independent contractor than as an employee, so it’s better to be an independent contractor, full stop. Similarly, I don’t know how many times I’ve heard people incorrectly state what their rights or protections are. It’s understandable that people get confused by this topic– in fact, there are actually 3 separate entities who dictate what it means to be an independent contractor, and each determines different benefits and responsibilities! Fortunately for you, I’ve simplified much of the actual text of the laws into plainspeak, and included convenient links that will go to the original text. Then, simply tackling each of the entities one at a time will make everything much clearer.
Before getting to each of those sections, let’s clarify some commonly confused terms:
Employee ─ A worker who works for their employer, and who is entitled to certain rights. Examples include: full-time, part-time, temporary, and contracted employees.
Independent Contractor ─ A worker who is not an employee. Generally, they are in business for themselves, and provide their services to businesses. More specific definitions will be in each of the three following sections.
Contract Worker/Contractor ─ A worker who works on a contract, written or otherwise. This includes both contracted employees and independent contractors.
Freelancer ─ This word has no legal definition. Typically, this describes someone who works for multiple hiring entities, based on availability. Examples include: an independent contractor working for multiple businesses, an employee with several on-demand employers, and someone who works as an independent contractor for some jobs and an employee for others.
Gig-Worker ─ A worker who earns income by providing on-demand work, services, or goods, often through a digital app. This can include both independent contractors and employees.
Self-Employed ─ A person who earns a living by working for themselves. This term includes both independent contractors and sole proprietors, but not employees.
If you just want to skip to a specific section, simply click one of the shortcuts to the right to jump ahead. Now, let’s dive into the fun stuff: the 3 entities that define your worker classification, and why you should care!
INTERNAL REVENUE SERVICE (IRS)
Most likely, you’re reading this article because you want to know about how this all affects your money, and that is largely affected by the IRS’s definition. The IRS is the entity that decides how you get taxed and makes you fill out complicated forms every year. This is where many people who are working as an independent contractor don’t realize that they are committing fraud, or that they are being misclassified by their employer and deprived of their benefits.
This section is specific to federal taxes; state income taxes fall under the next section.
The Common Law Test (AKA Control and Direction Test)
The keys for this test are to look at the entire relationship between the worker and the employer, and consider the extent of the right the employer has to direct and control the worker. All information which provides evidence of either control or independence must be considered. No single factor can determine whether a worker is an employee or an independent contractor. The IRS assumes the worker is an employee until it is proven otherwise.
The three factors of this test are:
Behavioral Control: Basically, indicators of who is “in charge” of the job’s details after a worker is hired. Questions answered in the negative weigh toward implying the worker is an employee.
- Does the worker decide when, where, and how the work will be done?
- Can the worker hire their own workers?
- Is the worker given little to no instruction?
- Is the worker assumed to be trained?
- Is there no evaluation of the worker or the work?
Financial Control: Basically, indicators of a worker being in business for themself. Questions answered in the negative weigh toward implying the worker is an employee. Unusual pay might indicate Independent Contractor.
- Does the worker provide the tools and equipment for the job?
- Are expenses not reimbursed?
- Is it possible for the worker to lose money from the job?
- Does the worker advertise their services or seek out business opportunities?
- How is the worker paid?
Type of Relationship: What kind of relationship do the business and the worker have? Questions answered in the positive weigh toward implying the worker is an employee. Contracts might be considered.
- What does the contract say?
- Are there employee-type benefits?
- Will the relationship continue?
- Is the work performed a key aspect of the business? (eg. Performing on stage for a theatre company)
You’re probably now a bit overwhelmed and questioning whether or not you care anymore. Well, before you walk away, let’s look at why knowing your classification will save you money and possibly jail time:
Employee Benefits and Responsibilities under the IRS
- Tax Return: In most cases, you have to file your annual tax return, but the form is one of the simpler ones.
- Income Tax: Employers withhold income taxes for you, meaning you either owe less at tax time, or are entitled to a refund. This also means that you do not need to worry about paying an estimated quarterly tax.
- Other Taxes: Employers automatically take money (7.65%) out of your earnings to put towards FICA (Social Security and Medicare) for you, meaning that you don’t owe this at tax time.
- Perks: Employers contribute an equal amount of money to your FICA, and also pay an unemployment tax for you. These do not come out of your earnings, but instead out of the employer’s pocket. They mean that you are not responsible for paying all of the tax associated with FICA, and that you can rely on unemployment services when needed.
Independent Contractor Benefits and Responsibilities under the IRS
- Tax Return: In most cases, you have to file your annual return, but the form is a little more convoluted and itemized.
- Income Tax: In most cases, you have to pay estimated tax quarterly, or else you might suffer a penalty. This is because you do not have an employer withholding taxes for you as you earn income. If you did not have to pay estimated taxes, you will have more money in your pocket for the year, but have to owe a larger amount at tax time.
- Income Tax: Due to being classified as a business, you can report certain legitimate purchases as business expenses or capital expenses. This ultimately results in having to pay less in income taxes, as it reduces your net income. This takes more bookkeeping and researching current IRS publications, and might make you more likely to be audited.
- Other Taxes: You must pay self-employment tax (SE tax), which is separate from your income tax. SE tax is the full 15.3% of earnings that is paid toward Social Security and Medicare, since you don’t have an employer who is contributing half of the amount.
- Costs: Because you have no employer contributing to unemployment for you, you have no coverage under that program.
- Other: Due to the nature of independent contractor work and employers potentially not needing to issue you a 1099, it is easier to hide your income from the IRS and avoid paying taxes on that work. However this is 1) illegal, and 2) might mean that it takes longer before you are able to benefit from Social Security or Medicare, and reduce your future benefit.
State Tax Dept. and State Dept. of Labor
The other main entity to determine what happens to your money as an independent contractor or as an employee is your state government. Unfortunately, this varies quite a bit state-to-state, as do the benefits and industry-specific exemptions. This variation appears to be the genesis of much of the confusion about independent contractors.
It is in every worker’s best interest to educate themselves about their state’s particular benefits and requirements, but especially for those that the state deems independent contractors. Besides checking with the state’s Department of Labor, you can typically do a web search and find a few write-ups by legal firms or insurance companies pointing out what the state requirements are, as well.
Fortunately, states only use one of two tests for determining employment classification: The Common Law Test, and the ABC Test.
The Common Law Test
This is the same test that the IRS uses; however, the ruling the state makes is independent from that ruling that the IRS gave, and the two rulings may not match. Typically, state interpretations of this test are less strict than the IRS’s “assume employee until proven otherwise” interpretation, meaning that it is entirely possible for the IRS to deem you an employee, but the state to deem you an independent contractor.
The ABC Test
This is the strictest legal test for determining employment classification, as the worker is assumed to be an employee, and is only considered an independent contractor if they meet every factor on the test. Typically, the ABC Test has three factors (A, B, and C), but some states may only use two of the factors. The three factors are:
- Absence of Control: The worker must be free from control or direction by the company, both under the terms of the contract, and in practice. (Basically, if the business controls or directs the worker at all, then the worker is an employee.)
- Unusual Business: The work the worker is performing for the company cannot be the same work that the company is primarily engaged in for its customers. (If a scenic artist is painting a set for a set rental company, then that scenic artist is an employee.)
- Customary Engagement: The worker needs to have their own ongoing business with multiple customers, and the work done for the company has to be that same kind of work. (If an audio specialist with their own audio mixing company is hired to both operate the audio board and also to push boxes and build a stage, then the worker is an employee.)
Benefits and Responsibilities under State Law
- Withholding state income tax
- State minimum wage and overtime laws
- Who, if anyone, must pay into unemployment insurance
- Who, if anyone, must provide workers’ compensation insurance
- Who, if anyone, must provide general liability insurance
- Who, if anyone, must provide professional liability insurance
- Who, if anyone, must provide commercial auto insurance
- Who, if anyone, must provide business income insurance
- Who, if anyone, must provide commercial property insurance
- Whether or not workers are allowed to collectively bargain
States Vary on Each
As an example of how widely the employee protections vary state-to-state, compare Texas’s workers’ compensation requirements (employers are generally not required to provide workers’ compensation insurance for their employees) against Colorado’s (if an employer has at least one employee, then the employer must provide workers’ compensation insurance to the employee(s)). Some states require independent contractors to carry their own workers’ compensation insurance, or their own liability insurance.
Employees typically have a lot more built-in protections than independent contractors, and are responsible for a lot less. Independent contractors typically need to do more work in order to make sure that they’re meeting the letter of the law, and in order to protect themselves. These laws change not infrequently, so you should make an effort to keep up to date regarding your state’s laws.
That’s a lot of vague information, and I don’t think I need most of those
Even if you can’t or don’t want to figure out what you are, you should at least be informed about what you’re responsible for or what you’re risking by accepting certain kinds of jobs. If you’re going to do something illegal, then you should really be aware that’s what’s happening. And if you do a physically demanding job, you should always be aware of the status of your workers’ compensation coverage, if only so that you understand whether or not you’re taking a risk.
The US Department of Labor
This last entity determines general worker protections which many of us take for granted. Did you know that independent contractors aren’t protected against discrimination, the way that employees are? Everyone wants to be protected against that, right? Well, maybe it’s worth poking your nose into what other federal rights and protections you might not be granted as an independent contractor.
The Economic Reality Test
This is the vaguest test yet, because it is judged on the total activity, or the “economic reality” as opposed to “technical concepts.” In essence, the test seeks to define the worker by their dependence on their employer, or by themself. There is no complete list of factors that are relevant, but here are some explanations of a few that the Supreme Court has previously found significant:
- Is the worker doing work that is unique from what the company does?
- Is it assumed that the job will be offered and accepted due to a long standing relationship?
- Does the worker own the facilities or equipment?
- How much input does the company have over how the worker does their job?
- Is it possible for the worker to lose money because of the job?
- Does the worker have to use initiative, judgment, or foresight in open market competition? (Do they price their services competitively, market themselves, etc?)
- Does the worker operate as a business, with its own organization and workers?
Benefits Not Offered to Independent Contractors
- (FLSA) Employers must pay at least the Federal minimum wage for every hour worked
- (FLSA) Employers must pay overtime (time and a half) for every hour worked over 40 in a workweek This applies to day-rates and other flat-rate pay, too!
- (FLSA) Employers must keep records of their employees’ hours
- (EEOC) Civil rights protections (no discrimination; equal pay)
- (OSHA) Health and safety protections
- (ERISA) Employee benefit security
- (Multiple) Employee protection, such as whistleblower protections
- (FMLA) Employers of 50 or more employees must, after 12 months of employment (and 1,250 hours of work given) give up to 12 weeks of unpaid, job-protected leave for the birth or adoption of a child or for the serious illness of the employee or a spouse, child, or parent.
There are an annoying number of caveats to this whole thing that mean that even if a worker is found to be an employee, they might still not be granted certain benefits. Each of those listed programs have their own exemptions, and even exceptions to the exemptions. A few noteworthy exemptions include:
- Businesses whose annual gross volume of sales made or business done is less than $500,000 — are not covered enterprises under the FLSA.
- Though they may still be subject to the provisions in many cases.
- Employees of certain seasonal amusement or recreational establishments (doesn’t operate for more than 7 months of the year) — are exempt from the Overtime and Minimum Wage provisions.
- Employers with a small number of employees — are exempt from some provisions of EEOC.
So, Which is Better?
Well, federally speaking, through the US DoL, we can probably all agree that being an employee is better, as it provides benefits without any responsibilities. But for state law and the IRS, the answer depends on what you deem important. Ultimately, more research and more work go into being an independent contractor than an employee, but the payoff is that you have more choices available to you. Legal counsel is always a great first step when you’re considering being an independent contractor, and being well-organized in your bookkeeping is practically a requirement. Of course, you can be an independent contractor without any extra effort, but it’s incredibly risky if you’re not doing any of the legwork to find out what that actually means for you.
Do I Get to Choose What I Am?
No, but you’re not powerless over the determination, either. You can negotiate your duties to match the definition for independent contractor or employee for whichever entity it is that you want to ensure that you are defined by. There are ways to make the system work to get whatever it is that you want to get out of the relationship, but there are correct, legal ways which won’t get you fined or thrown in jail, and then there are the illegal ways. It’s never an advisable practice to assume that nothing bad will ever happen to you, or that you will never get caught committing fraud; but if you choose to live by either of those ideas, then you’d better make sure you know exactly what risks you are taking.