Employee or Contractor: Understand DOL and IRS Classifications of Workers
Many not-for-profits are understaffed in 2022, thanks to a labor shortage and pandemic-related budget shortfalls. Some organizations are filling the gaps with freelancers and contractors. However, such decisions can lead to trouble if these workers should really be classified as employees according to the Department of Labor (DOL) or the IRS. To ensure your workers are correctly classified, review the rules.
The DOL and FLSA
The Fair Labor Standards Act (FLSA) doesn’t define the term “independent contractor.” But courts generally have focused on several factors related to the “economic reality” of relationships between employers and workers.
The DOL leans on U.S. Supreme Court rulings for guidance. The Court has repeatedly stated that no single rule or test applies to determine employment status under the FLSA. Rather, the totality of circumstances determines a worker’s status, including how integral the worker’s services are to your operations, the permanency of the relationship and the nature and degree of control you have over the worker. The DOL has identified other factors it deems relevant, including:
- Where the work is performed (remotely or on-site),
- The absence or existence of a formal written employment contract, and
- Whether the work is licensed by the state or local government.
Some states have even more restrictive tests. Moreover, the fact that workers qualify as independent contractors under another federal law doesn’t guarantee they qualify under the FLSA. For example, the IRS applies a different test.
Providing your workers with IRS Form 1099, “Miscellaneous Information” instead of Form W-2, “Wage and Tax Statement,” won’t automatically make them independent contractors. When assessing worker classification, the IRS typically looks at a variety of factors, as well as the totality of facts and circumstances. But in general, these factors are important:
Level of behavioral control. The more control you exercise over the worker, the more likely the worker is an employee. The IRS might look at the extent to which you instruct a worker on when, where and how to work, what tools or equipment to use and where to purchase supplies.
Extent of financial control. Contractors are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, market their services to other clients and be paid with a flat fee. Employees are more likely to be paid hourly, weekly or bimonthly.
Relationship of the parties. Contractors are often engaged for a specific project while employees are typically hired permanently (or for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.
Difference in Pay, Benefits, and Taxes
If your workers don’t qualify as independent contractors, you must properly treat them as employees:
Pay and benefits. You generally must pay covered, nonexempt employees at least the federal minimum wage of $7.25 an hour. When an employee’s hours within a workweek exceed 40, you must pay at least 1½ times the employee’s regular pay rate. If the DOL reclassifies an independent contractor as an employee, in addition to having to make up the unpaid wages, you may owe workers’ compensation premiums and unpaid leave and other benefits. Fines and penalties are also possible.
Taxes. For employees, you must withhold federal income and payroll taxes, and pay the employer’s share of FICA taxes on the wages, plus FUTA tax. If the IRS reclassifies one of your independent contractors, you may be liable for back taxes that you should have paid and payroll and income taxes you should have withheld. In some cases, interest and penalties are levied.
If budget shortfalls are preventing you from hiring the staffers you need or you aren’t sure if you’re accurately classifying the workers you have, contact us. We can help your nonprofit resolve financial and compliance issues.