Author: Chris Boggs
Classifying a worker as either an “employee" or “independent contractor" is problematic for more than just workers' compensation. Status as an “employee" or “independent contractor" also has direct ramifications for record keeping requirements, payment of minimum wage and overtime, and the payment of benefits under social security. In an attempt to minimize the problems and confusion, the Department of Labor has proposed the codification of five tests to help in classifying a particular worker as an employee or independent contractor.
The “employee" versus “independent contractor" debate began shortly after the enactment of the Fair Labor Standards Act (FLSA) in 1938. The FLSA defined “employee," but it did not define “independent contractor" (first problem). However, the Act's definition of “employee" offered little help; in fact, it made things worse. The act defined employee to mean, “any individual employed by an employer" (second problem).
Predictably, not long after enactment of the FLSA, lawsuits were filed attempting to more specifically define who should be classified as an employee and who qualified as an independent contractor.
After 82 years and hundreds of lawsuits, the Department of Labor (DOL) has finally undertaken to codify five tests it believes will clarify the distinction between an employee and an independent contractor. Although these tests are meant to apply to the FLSA and assignment of employee status for social security purposes, the insurance industry can borrow these tests for workers' compensation.
Using these tests to assign “employee" or “independent contractor" status requires a preponderance of evidence. Each test is applied separately, and if a majority of the findings point to “employee" status, the person is assigned “employee" status. However, the five tests are not treated equally; the first two tests are given greater weight than the remaining three. (Essentially, if the first two tests combine to point towards “employee" or “independent contractor," the other three are used to confirm the initial opinion.)
DOL's five “employee" versus “independent contractor" tests are:
- Economic dependence
- Degree of control
- Amount of skill required
- Degree of permanence
- Part of an integrated unit of production
Is the worker economically dependent solely on the employer or does the person have the opportunity to earn profit or suffer a loss based on his or her exercise of initiative and skill? Essentially, is it possible for the worker to operate at a loss while on the job?
A true independent contractor prices the job and may enjoy a financial profit or suffer a financial loss. An employee doesn't generally stand to operate at a loss for any job. For example, an independent contractor may estimate the cost and profit for a job at $10,000; but when the work is complete, the job may have actually cost $12,000 resulting in a $2,000 loss.
Similarly, the independent contractor has the opportunity to make a greater profit than expected due to factors such as a drop in the cost of materials or the job may require fewer hours than expected. Rather than the expected $1,500 profit, the independent contractor may enjoy a $3,000 profit. He or she is paid for the job (the result), not for the time spent or other costs.
An employee would get paid for the time spent and not be subject to the possibility of a net loss nor a net gain. Employees are somewhat unable to affect their earnings other than by working more hours or more efficiently (when paid on a piece mill basis).
Economic dependence is also based on how closely tied the worker is to the employer. If the employer ceases to use the worker (fires him or her), do they have other sources of work and income. If the person works solely or nearly exclusively for one entity, there is economic dependence and the person is factually an employee.
True independent contractors have multiple sources of income and the loss of one contract does not (or should not) cut off all revenues. Being a major source is not the same as being the only or primary source of income.
Degree of Control
This test looks at the amount of control the employer has over the worker. An “independent contractor" is largely free to set his or her own schedule, can pick and choose which projects to work, and for whom to work (including the competition). The independent contractor is largely in control.
Conversely, an “employee" is controlled by the employer. The employer controls the performance of the work, the schedule, the workload, and the jobs to be performed. Plus, the worker is not allowed to work for anyone else.
Traditionally, the insurance industry has called this the “ways and means" test, meaning that the hiring party controls the hired party's ways and means such as: when to come to work, when to take a break, when to go home, how to the do the job, etc.
Understand, though, requiring an individual to comply with statutes, safety and health guidelines or adhere to certain quality standards does not necessarily constitute control. These are contractual requirements.
The greater the degree of control, the more likely the person is an employee rather than an independent contractor. What are the facts of the relationship?
Economic Dependence and Degree of Control Revisited
Remember, these tests are given greater weight than the remaining three. If these tests point to one classification or the other, the remaining three serve only to confirm the opinion. If, after applying these two tests, the classification isn't clear, the remaining three tests are needed to clarify the answer.
Amount of Skill Required
If the work requires specialized training or skill, the person is more likely to be considered an independent contractor - if the hiring party does not have the skill. If the work requires no specialized skill or training or the hiring party has the skill needed, the person is more likely to be considered an employee.
Degree of Permanence
When the relationship is definite in duration or is sporadic, the person is more likely to be considered an independent contractor. If the relationship is indefinite and/or continuous, the person is more likely an employee.
Part of an Integrated Unit of Production
When the worker is a component of the integrated production process, this points to employee status. If the worker is segregated from the process, he or she is more likely to be considered an independent contractor.
A worker on the production line with other workers is looked at as an employee. However, if the worker is in another part of the building working on an unrelated project, this person looks more like an independent contractor because they are not part of the production process.
Putting it ALL Together
Each test is separate, and a preponderance of evidence is required to decide between “employee" and “independent contractor" status. No one test gives the answer. However, as highlighted, the first two tests, economic dependence and degree of control, are given more weight by the DOL.
Although the DOL is codifying these tests for FLSA and social security purposes, the insurance industry can borrow them to help determine who might be an employee for workers' compensation purposes - and who might truly qualify as an independent contractor. A word of warning, though, labor law is just that, the realm of lawyers. Do not tell any client that a particular worker is or is not an employee.
Remind clients that paying someone using a 1099 does not automatically create an independent contractor. Employee or independent contractor status is a function of the facts of the relationship. These are the five “facts" the federal government is using; the insurance industry is already using a version of these tests to decide who is and is not an employee.
For more information on employee versus independent contractor status, see “17 'Tests' to Decide: Employee or Independent Contractor."
Also, to learn about the DOL's new guidelines as introduced in this article and in great detail, review “Independent Contractor Status Under the Fair Labor Standards Act."
Insureds will continue to misclassify individuals as “independent contractors" to save on taxes, paperwork and workers' compensation premium. Understanding the tests now being applied federally equips agents to better explain the realities of “employee" versus “independent contractor" to clients.
Last updated: October 9, 2020