As an employer, it can be enticing to classify your workers as contractors. Hiring independent contractors means no payments to social security, unemployment taxes, workers comp insurance, or benefits like vacation and health insurance – avoidances that can add up to savings of 30% on average. However, don’t be too quick to check that 1099 box. Workers may wish to receive the same benefits and assurances a W2 employee would receive, and if they feel they’ve been shorted as a contractor, they could bring a lawsuit or an audit your way. To reduce the risk of litigation, punitive fees, and negative press, it is helpful to understand how to accurately classify your workforce.
FLSA’s 6 Factors for Classification
The Department of Labor (DOL) uses six factors to distinguish between employees and contractors.
The criteria below can serve as a test to classify each position and worker within the company. According to the DOL Wage and Labor Division’s Fact Sheet 13, the basis for the test is to establish whether the worker is dependent on the employer for the job or if they are in business for themselves. Having a solid understanding of how to answer each of the factors for your workers will mitigate the risk of breaking labor laws in the name of saving.
If the response to a majority of the questions in each section is “No”, then the worker should be classified as an employee. Consistent “Yes” responses mean you should consider the worker an independent contractor. It is important to note that these questions are not majority rules. If your analysis reveals that the worker should be classified as an employee in any of the factors, then the worker should be treated as an employee of the company.
- Opportunity for Profit or Loss
- Investment by worker and employer
- Permanence of the relationship
- Degree of Control
- Work performed is integral to the employer’s business
- Skill & Initiative
1. Opportunity for Profit or Loss
The opportunity for profit or loss criteria focuses on whether or not the worker can make decisions that directly impact the business’s profitability. This goes beyond a manager who has purchasing authority and gets more specific on larger decisions like increasing staffing, equipment investments, and taking on new clients.
Questions to analyze “Opportunity for Profit or Loss”:
- Does the worker negotiate their own pay?
- Can the worker accept or decline their own work?
- Can the worker hire their own workers?
- Can the worker make material purchases that would expand the business without prior approval?
- Can the worker enter into agreements to bring on additional clients without prior approval?
2. Investment by Worker and Employer/Owner
The investment by the worker and employer criteria speaks to who makes capital equipment purchases and investments as an entrepreneurial effort. This factor includes investment in the tools to do the job as well as grow the business, purchases of material and equipment. The size of the spend is not a factor, but instead, the use of the investment weighs heavily along with whether or not the purchases will allow the worker to operate independently of the employer.
Questions to analyze “Investment by Worker and Employer”:
- Does the worker purchase the equipment to perform the daily work? (Computers, software, office supplies, etc.)
- Does the worker invest in cost-reduction activities?
- Can the worker invest effort and costs to obtain additional clients?
- Can the worker establish their own working space? (Do they rent their own space to operate from?)
3. Degree of Permanence of the Relationship
The degree of permanence criteria is based on the characteristics of the relationship and whether the work is continuous. Characteristics would include whether the worker performs a job regularly for a company, whether they work for several companies doing the work occasionally, and whether it is a long—or short-term relationship.
Questions to analyze “Degree of Permanence of the Relationship”:
- Is the work project-based with a fixed end date?
- Can the worker take on more than one job at the same time?
- Does the worker perform the job occasionally? (Not including seasonal)
4. Nature & Degree of Control
The nature and degree of control that the worker has over the working relationship, including assessing performance and the ability to work for other companies congruently are essential pieces to the fourth criteria. This factor speaks to areas like setting rates of pay, scheduling, and who supervises the worker. It also covers the distinction between control over company policy versus legislative policy.
Questions to analyze “Nature & Degree of Control”:
- Can the worker set their own schedule?
- Can the worker set their own rates of pay?
- Is the worker self-regulated? (Not supervised by a company employee)
- Can the worker supervise other company employees and contractors?
- Is the worker governed by legislative policy, but not internal company policy?
5. The Extent of the Work Performed is Integral to the Employer’s Business
The impact of the work performed is the central theme of the fifth factor. This criteria looks at how integral the work is, meaning that the job the worker does directly relates to the success or failure of the business. Without the work, the central
Questions to analyze “Extent of the work performed”:
- Can the main function of the business operate without the work performed?
- If this work was not performed, would the business’s central functions continue?
6. Skill & Initiative
The skill and initiative factor can be tough to decipher, as both contractors and employees can be expected to bring specialized skills to a role. However, this criteria focuses on whether or not the worker uses their skill to bring additional value to the business or contribute to its growth.
Questions to analyze “Skill & Initiative”:
- Is the worker expected to come to the role with their own training and skills?
- Does the worker use their skill to help expand the business?
- Is the worker utilizing their specialized skill to gain additional clients for themselves?
Simply classifying a worker as a contractor does not make it so. A contractor may have signed an agreement, worked remotely, and been classified as a contractor for years. Even if it’s traditional in your industry to classify workers as contractors, due diligence must still be undertaken to protect the company from financial exposure and a tarnished reputation. Department of Labor and Unemployment audits are not that common, but if a contractor makes a claim and you are found to have misclassified your workforce, you could face serious financial penalties. Consequences include:
- Paying back lost wages due to the worker,
- Taxes and penalties to government agencies, and
- Negative impact to the company image.
Valor Payroll Solutions is a resourceful team of experts ready to help take the burden of payroll and complicated classification analysis off your shoulders. We are dedicated to being your partners in growth, compliance, and long-term success through payroll processing excellence. Need help determining if your workers are employees or contractors? Reach out today to take advantage of our free consultation!
