FAQs About Worker Classification
Worker Classification FAQs
Correctly classifying workers is one of the most important responsibilities for payroll, HR, accounting, and business professionals. Whether a worker is classified as an employee or independent contractor can affect payroll taxes, wage and hour requirements, benefits, reporting, withholding, and employer responsibilities.
Bottom line, employers must also determine whether employees are exempt or nonexempt from applicable overtime requirements or face fines and penalties if assigned incorrectly.
General Worker Classification FAQs
The Worker Classification FAQs from Payroll Training Center provide answers to common questions about employee classification, independent contractors, exempt and nonexempt employees, payroll tax treatment, misclassification, state requirements, and compliance.
What is worker classification?
Worker classification is the process of determining the legal and payroll status of an individual performing services for a business. Common classification questions include whether a worker is:
- An employee or independent contractor
- Exempt or nonexempt from federal overtime requirements
- Covered by particular state wage and hour laws
- Subject to payroll tax withholding
- Eligible for employee benefits
What is the difference between an employee and an independent contractor?
The distinction generally depends on the nature of the relationship rather than the job title. Factors can include:
- Who controls the work
- How the work is performed
- Degree of independence
- Financial aspects of the relationship
- Permanency of the relationship
- Opportunity for profit or loss
- Whether the worker operates an independent business
What is an independent contractor?
An independent contractor is generally a self-employed individual who provides services to a business under a relationship in which the worker is not treated as an employee under the applicable legal test.
What is an employee?
An employee is generally a worker who performs services under circumstances that make the worker an employee under applicable federal or state law. Employees are generally subject to employer payroll withholding and other employment requirements.
Independent contractors generally handle their own federal income tax obligations and self-employment tax rather than having employee payroll taxes withheld in the same manner as employees.
What is an exempt employee?
An exempt employee is an employee who meets the requirements for an applicable exemption from certain FLSA requirements, such as federal overtime requirements. Exempt status is based on applicable legal requirements rather than simply an employee's job title.
What is a nonexempt employee?
A nonexempt employee is generally covered by applicable FLSA minimum wage and overtime requirements. Covered nonexempt employees generally must receive overtime at not less than one and one-half times their regular rate for qualifying hours worked over 40 in a workweek.
Why is worker classification important?
Worker classification affects an employer's responsibilities for:
- Payroll tax withholding
- Social Security and Medicare taxes
- Unemployment taxes
- Wage and hour requirements
- Overtime
- Minimum wage
- Benefits
- Workers' compensation
- Employee reporting
- Tax forms
- Recordkeeping
An incorrect classification can result in back wages, additional taxes, penalties, interest, and other compliance problems.
How does the IRS determine whether someone is an employee or independent contractor?
The IRS considers evidence concerning the degree of control and independence between the business and worker. The IRS groups relevant evidence into three general categories:
- Behavioral control
- Financial control
- Type of relationship
No single factor necessarily determines the result.
What is behavioral control?
Behavioral control concerns whether the business has the right to direct and control how the worker performs the work. Examples can include instructions about:
- When to work
- Where to work
- What tools to use
- What procedures to follow
- What sequence or order to use
What is financial control?
Financial control concerns aspects of the business relationship involving the worker's economic circumstances. Factors can include:
- Significant investment
- Unreimbursed expenses
- Opportunity for profit or loss
- Whether the worker makes services available to other businesses
- Method of payment
What is the type of relationship?
The IRS considers these factors as part of its broader worker-classification analysis. The type of relationship can include factors such as:
- Written contracts
- Employee benefits
- Permanency
- Whether the services are a key aspect of the business
Who is responsible for classifying workers?
The employer is generally responsible for properly determining how workers should be classified under applicable laws. Payroll, HR, accounting, legal, and management personnel may all participate in the classification process.
Can an employer simply choose whether someone is an employee or contractor?
No. Worker classification generally depends on the actual facts and circumstances of the relationship rather than simply the label used in a contract or payroll system. The IRS states that whether someone is an employee or independent contractor depends on the facts of the relationship, including the degree of control and independence.
Who decides whether a worker is a contractor or employee?
Not the parties. A signed independent contractor agreement is evidence of intent and nothing more; agencies and courts look at the actual working relationship. A worker can be correctly classified as a contractor under one agency's test and misclassified under another's at the same time, because the tests differ.
What does the IRS look at?
Whether the business has the right to control what will be done and how, examined through behavioral control, financial control, and the type of relationship. The IRS test is separate from the DOL test and governs employment tax treatment. A business can lose an IRS determination and a DOL determination on different grounds.
What is the ABC test?
A stricter test used by a number of states, under which a worker is presumed to be an employee unless the hiring entity proves all three: the worker is free from control and direction, performs work outside the usual course of the hiring entity's business, and is customarily engaged in an independently established trade of the same nature. The middle prong is the one most contractors fail — someone doing the company's core work is an employee under this test regardless of independence.
Does issuing a Form 1099 make someone a contractor?
No. The form reflects a classification decision; it does not make it correct. Agencies routinely reclassify workers who received 1099s for years, and the paper trail of consistent 1099s is not a defense — in some analyses it is evidence the misclassification was systematic.
What are the penalties for misclassification?
Back employment taxes with interest, penalties for failure to withhold and deposit, unpaid overtime and minimum wage with liquidated damages under the FLSA, unpaid unemployment and workers' compensation contributions, potential state penalties that in some states are substantial per worker, retroactive benefit plan liability, and — where conduct is deemed intentional — significantly higher exposure. Misclassification is also readily discovered, because a single worker filing for unemployment can trigger a state audit of the whole workforce.
Can a worker be a contractor and an employee at the same company?
It is possible but heavily scrutinized, and the safe answer for most employers is no. Where an individual performs services in two genuinely distinct capacities, documentation must be unusually strong. The common failing pattern — an employee who "also does contract work on weekends" doing similar tasks — will not survive review.
What is Section 530 relief?
A federal safe harbor that can relieve an employer of employment tax liability for misclassified workers where the employer had a reasonable basis for the treatment, treated the workers and all similar workers consistently as non-employees, and filed all required returns consistent with that treatment. Consistency is the requirement most employers fail, because they have treated some similar workers as employees.
What makes an employee exempt from overtime?
Meeting both a salary test and a duties test under an established exemption — most commonly executive, administrative, professional, outside sales, or certain computer employees. Both must be satisfied. Paying a salary does not create an exemption, and neither does a title.
Are salaried employees automatically exempt?
No, and this is the single most common wage and hour error. A salaried employee who does not meet a duties test is non-exempt and owed overtime for hours over 40 in a workweek. Salaried non-exempt is a legitimate and frequently correct classification — it means the employee receives a salary and also receives overtime.
What is the salary basis rule, and how do employers break it?
An exempt employee must generally receive their full predetermined salary for any workweek in which they perform work, regardless of quantity or quality, subject to limited permitted deductions. Improper deductions — for partial-day absences, for a slow week, as a disciplinary measure outside the permitted categories — can defeat the exemption for that employee and potentially for others in the same classification.
How is overtime calculated for non-exempt employees?
One and one-half times the regular rate for hours over 40 in a workweek. The regular rate is not simply the hourly rate: it includes nondiscretionary bonuses, shift differentials, commissions, and certain other compensation, allocated over the hours worked. Failing to include a nondiscretionary bonus in the regular rate is a widespread and easily proven violation.
How should an employer audit its classifications?
Start with job families rather than individuals; compare actual duties against the exemption criteria using input from supervisors and the employees themselves; check every salaried position against the current salary threshold and any applicable state threshold; review any position where the title suggests management but the person primarily performs the same work as those they oversee; and document the analysis. Conduct the review under privilege where possible, because the working papers are discoverable otherwise.
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