One of the first key challenges for many business owners is deciding when to hire their first employee. You may be tempted to hire an individual as an independent contractor, but be careful--misclassification of workers (even if inadvertent) is extremely common, especially in today’s changing workplace landscape. Be sure to review the standards for employees and independent contractors to ensure you did not run afoul of labor laws.
The Basics of Classification
If a person is classified as an employee (i.e., the individual is paid a W-2 wage), the employer business must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes. Employers must abide by labor laws with regard to treatment of employees, and employees are also eligible for certain benefits (in Chicago and Illinois, for example, all employees must be given paid time off).
Independent contractors, on the other hand, are paid as 1099 workers. The business engaging the contractor does not have to pay any taxes on behalf of the contractor; rather, the contractor is responsible for paying their own income, Social Security, and Medicare taxes. Further, contractors are (generally) not eligible for benefits and they cannot take advantage of the protections of labor laws.
Given contractors have to pay their own taxes, classifying workers as contractors rather than as employees is a more cost-effective way to engage workers. However, classifying someone as a contractor when they should really be an employee can be very costly for your business in the long run, and the U.S. Department of Labor is cracking down on the misclassification of workers.
If you are unsure whether your contractor should actually be an employee, review the factors discussed below and talk to an experienced business and employment attorney to discuss how to transition your workers appropriately.
How Do I Determine Who is an Independent Contractor?
On January 10, 2024, the U.S. Department of Labor issued a final rule on independent contractor classifications. The DOL stated that there is no single rule that determines whether an individual is a contractor or an employee. Rather, an “economic reality test” looks to all the facts of a situation. To help make a determination, the DOL uses a test including six factors.
The existence of an independent contractor agreement (or simply calling someone a contractor) is not determinative (though, if someone can truly be classified as a contractor, it is best practice to have a written agreement with them and, beginning in July 2024, this will be required in Illinois).
- Degree of control exercised by the employer over the worker: How much control does the business have over the worker? Does the business set the worker’s schedule, supervise the worker’s duties, or discipline the worker? If so, then the worker is most likely an employee. In a true independent contractor relationship, the contractor has total freedom and autonomy to do the work whenever, wherever, and however the contractor sees fit.
- The worker’s opportunity for profit or loss and their investment in the business: Does the worker negotiate the amount of pay for the work provided? Does the worker engage in marketing to obtain more work? Does the worker hire other individuals or rent office space? If so, the worker may be a contractor. If the worker has opportunity for profit or loss, they are most likely running their own business and thus should not be classified as an employee.
- Degree of skill and independent initiative required to perform the work: If the worker uses specialized skills in connection with a business-like initiative (i.e., if the worker does not rely on training from the potential employer), then the worker may be a contractor. The use of specialized skills in and of itself is not indicative of a contractor relationship.
- Permanence or duration of the working relationship: If the work is continuous, indefinite, and does not have an end date, then the worker is more likely to be an employee.
- The worker’s investment in equipment and materials required for the task: If the worker invests in and uses their own equipment and materials for the work performed for the business, then the worker may be a contractor. The investments must be entrepreneurial in nature, meaning the investments can be used to build a business and in other contractual scenarios.
- Extent to which the work is an integral part of the employer’s business: If the work performed by the worker is critical, necessary, or central to the principal business, then the worker may be an employee. If the work performed is adjacent to (and does not go to the core business of the potential employer), then the worker may be a contractor.
As noted above, it is important to keep in mind that not one factor is determinative. All factors should be considered in light of the specific circumstances between the parties. Oftentimes there is a lot of grey area in these situations. Even after reviewing these factors and determining that a worker can be classified as a contractor, there is always a risk that a worker was misclassified.
The ”ABC” Test
In addition to the U.S. DOL guidelines outlined above, the Illinois Department of Labor uses the “ABC” test, as do several other states, to determine whether a worker is an employee or a contractor. An individual is considered an employee unless it can be demonstrated that:
- Such individual has been and will continue to be free from control or direction over the performance of such services, both under his contract of service and in fact; and
- Such service is either outside the usual course of the business for which such service is performed or that such service is performed outside of all the places of business of the enterprise for which such service is performed; and
- Such individual is engaged in an independently established trade, occupation, profession, or business.
These factors are similar to the U.S. DOL guidelines and essentially state that in order to be properly classified as a contractor, the individual must engage in their own business and have independence over the performance of their services. In order for an individual to be properly classified as an independent contractor, Illinois courts have generally held that all three factors must be met.
If you (ideally after consultation with an attorney) determine that your worker can be properly classified as a contractor, it is best practice to have a strong agreement in place. Such contracts may already be required in certain jurisdictions and will be required in Illinois as of July 2024.