Employee or Independent Contractor? Does it Matter?
Yes! A mistake can cost you handily in penalties, fines, and taxes. Read on for details.
One of the most difficult and consequential decisions that a business owner must make involves the classification of individuals hired to perform work for the business. If the individuals are employees, amounts paid to them constitute “wages” for employment and are subject to federal and state income tax withholding as well as Social Security, Medicare, and unemployment insurance taxes. In addition, the employer is responsible for paying unemployment insurance taxes and for carrying workers’ compensation insurance on its employees. The employer must also comply with federal and state wage and hour laws, health and safety laws, and may be required to provide the employees with paid time off or healthcare coverage. Employers may also voluntarily provide employees with other fringe benefits such as short-term and long-term disability insurance, life insurance, other paid leave, or retirement benefits. Employers are required to verify an employee’s eligibility to work in the U.S. by completing U.S. Customs and Immigration Services Form I-9 and to report all new hires to the state’s New Hire Registry. In addition, employers must report wages paid to employees on IRS Form W-2.
On the other hand, if the individuals are independent contractors, federal and state laws designed to protect employees do not apply. Amounts paid to independent contractors do not constitute “wages,” but rather are deemed to be “non-employee compensation.” The business is not required to withhold or pay income taxes and employment taxes on the independent contractor’s compensation and is not required to provide the independent contractors with any employee type benefits including healthcare coverage, unemployment insurance or workers’ compensation insurance. Health and safety laws designed to protect employees do not apply to independent contractors either. There are also no requirements to verify the individual’s eligibility to work or to report newly hired independent contractors to the state’s New Hire Registry. Non-employee compensation paid to an independent contractor is reported on IRS Form 1099 only if the amount of compensation paid during the calendar year is $600 or more.
With the rise of the “gig economy” in the past decade, the question of whether certain individuals are employees or independent contractors has been a hot topic among businesses, individuals, government agencies and the courts. Various federal and state agencies have weighed in on the issue and the courts have ruled on a number of cases where an individual’s status has been a point of contention. To say that there is a lack of consensus in these determinations would be an understatement. While the U.S. Department of Labor issued an opinion letter in April 2019 holding certain workers engaged in the gig economy to be independent contractors, other agencies and courts have reached a different conclusion in other cases, although the circumstances in many of these cases are quite similar. Several years ago, the Massachusetts Attorney General announced a “landmark settlement” with a healthcare company which requires the company to treat healthcare workers as employees beginning January 1, 2020, when those healthcare workers use its digital platform to find shifts. In New Jersey, the state found a ride share company liable for nearly $650 million in unemployment and disability taxes as the result of the misclassification of its drivers as independent contractors. In 2021, they passed legislation which makes it more difficult for an individual to be classified as an independent contractor and strengthens the State’s enforcement authority. In California, new legislation establishes a presumption that a person providing labor or services for remuneration is an employee of the business for which services are performed and not an independent contractor, unless certain conditions are met.
The difficulty in determining whether an individual is an employee, or an independent contractor, arises from the fact that there is no clear statutory definition of employee or independent contractor in federal or state law. The determination requires an application of the appropriate legal test to the facts and circumstances in each case. To further complicate this issue, there are at least three different legal tests utilized for different statutory purposes.
For certain federal tax purposes, including the withholding of federal income taxes and the withholding and payment of Social Security, Medicare, and federal unemployment taxes, the IRS applies what is known as the “common law test” to determine whether an individual is an employee or an independent contractor. Under the common law test, the right of the employer to direct and control the individual is key, regardless of whether the employer exercises that right. The U.S. Department of Labor utilizes what is known as the “economic realities test” which focuses on the economic aspects of the relationship between the parties to determine an individual’s status.
In Maryland, the Workers’ Compensation Commission applies the common law test to determine whether an individual is an employee for purposes of workers’ compensation coverage. The Comptroller and the Commissioner of Labor and Industry apply the economic realities test to determine whether an individual is an employee for purposes of state income tax laws, wage and hour laws, and occupational safety and health laws. Under Maryland’s unemployment insurance law, individuals are presumed to be employees unless the employer can demonstrate that the individual is, in fact an independent contractor. To be classified as an independent contractor for state unemployment insurance tax purposes, the individual must meet three requirements:
- the individual who performs the work is free from control and direction over its performance both in fact and under the contract;
- the individual customarily is engaged in an independent business or occupation of the same nature as that involved in the work; and
- the work is outside of the usual course of business of the person for whom the work is performed; or performed outside of any place of business of the person for whom the work is performed.
This is commonly referred to as the “A-B-C test.” Numerous states have adopted similar three‑part tests to determine whether an individual is an employee or an independent contractor for various statutory purposes. While the common law test, the economic realities test, and the A‑B-C test are similar, they are not identical and may be interpreted differently by different agencies and courts for different statutory purposes. The penalties and consequences for businesses that have been found to have misclassified employees, can be severe and costly. Accordingly, businesses considering engaging independent contractors, should consult an attorney before entering into such business relationships. An attorney can review the facts and circumstances of the proposed relationship and provide guidance regarding the proper classification of all individuals performing services for the business, potentially saving the business considerable costs and headaches.
This Update is provided for informational purposes only. It is not intended as legal advice, nor does it create an attorney/client relationship between The Moore Law Group, LLC and any readers or recipients. Readers should consult counsel of their own choosing to discuss how these matters relate to their individual circumstances. Reproduction in whole or in part is prohibited without the express written consent of The Moore Law Group, LLC.
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