Why Classification is Important
When you add an employee to your staff, you are thereafter responsible for not only paying that person for work done, including overtime if the person is eligible, but also for paying all taxes due, including federal, Social Security, Medicare, unemployment insurance (UI), and any other state or local obligation.
You are also responsible for any benefits that your business voluntarily provides all employees, including sick leave, paid time off, and contributions to medical coverage and/or a retirement plan such as a 401(k).
If the person you bring on board is a legitimate independent contractor, then that person is responsible for paying all taxes and is basically exempt from your company’s benefits program. An independent contractor is just that — independent, providing work for financial gain.
Determining Status — What is
an Independent Contractor?
The Texas Workforce Commission (TWC) defines an independent contractor as:
“...a person who contracts to perform work or provide a service for the benefit of another and who ordinarily:
- Acts as an employer of ‘any employee of the contractor by paying wages, directing activities, and performing other similar functions characteristic of an employer-employee relationship’
- Is free to determine the manner in which the work is provided, including hours of labor and method of payment
- Furnishes their own tools, supplies, and materials of the job
- Possesses the skills required for the specific job or service.”
For purposes of FLSA compliance, what is called the “economic reality” test is used by the Department of Labor (DOL) to determine independent contractor status. The economic reality test maintains that an employee is one who is dependent on the business he or she services, while an independent contractor is engaged in a business of his or her own.
The Internal Revenue Service (IRS) relies on three common-law factors to determine worker classification:
- Behavioral: If the employer determines when and where the work is to be done, the worker is probably an employee.
- Financial: Independent contractors have a significant investment in their tools of the trade, advertise for their services, maintain a separate visible location, and are available to work for more than one employer.
- Relationship: If the worker is hired with the expectation of an indefinite relationship, the worker is more than likely an employee.
The FLSA and State Laws
If a worker, after the economic reality test is applied, is deemed an employee, then he or she must be classified as exempt or non-exempt and paid overtime when applicable. This is a requirement of the FLSA, which imposes standards on all private employment in the United States.
In Texas, the Texas Unemployment Compensation Act (TUCA) explains how to determine employee versus independent contractor status, citing the “direction and control” of the employer as a major factor:
“The law defines employment as a service performed by an individual for wages under an express or implied contract for hire, unless it is shown to the satisfaction of the Commission that the individual’s performance of the service has been and will continue to be free from control or direction under the contract.”
Enforcement of Employee Misclassification
On the federal level, the Department of Labor and the IRS have oversight on issues of worker classification. The DOL and the TWC, in addition, operate jointly under a memorandum of understanding (MOU) to enforce standards of proper classification and compliance.
Generally, these three agencies field and investigate claims and complaints lodged by misclassified workers. If an employer is caught misclassifying an employee as an independent contractor, not only will that employer be responsible for unpaid back taxes, but also for any interest or penalties involved. Unpaid overtime can also be an issue, as well as benefits lost or denied.