Employee or Subcontractor?

Justin Schellenberg, CPAAdvice, Featured Content

Employee or Subcontractor

On July 15, 2015 the US Department of Labor issued some guidance on how to classify workers as employees or subcontractors.  On one hand the clarification is welcomed because we often get the question “Do I need to set Tim up on payroll as an employee, or can I pay him has a subcontractor?”, and the clarification and summary we have provided below will make it easier for businesses to determine the answer.   On the other hand many businesses will not like the answer going forward because the new guidance make it  more difficult to classify workers as independent contractors thus requiring the need to establish payroll policies/processes and pay the associated taxes.  Most of the following is taken or summarized directly from the document released by the US Dept. of Labor.

The financial risk to business

Aside from any moral or ethical obligations of properly classification workers properly and affording the rights thereof, there are financial risks to Businesses that misclassify workers. Firstly, businesses could be held liable for minimum and overtime wages. Secondly, the IRS and State Department of Labor could audit a business and find the business liable for employer taxes not paid. We are aware of instances in which the State of Tennessee has audited businesses and imposed back taxes and penalties for several years’ worth of misclassified workers.

When employers improperly classify employees as independent contractors, the employees may not receive important workplace protections such as the minimum wage, overtime compensation, unemployment insurance, and workers’ compensation. Misclassification also results in lower tax revenues for government and an uneven playing field for employers who properly classify their workers.Interpretation No. 2015-1

How to determine the proper status

In the guidance issued by the US Dept. of Labor there are 6 factors to consider when determining if a worker should be classified as an employee or an independent contractor. In undertaking this analysis, each factor is examined and analyzed in relation to one another, and no single factor is determinative. The factors should be considered in totality to determine whether a worker is economically dependent on the employer, and thus an employee.
It is important to note that courts have determined that an agreement between an employer and a worker designating or labeling the worker as an independent contractor is not indicative of the economic realities of the working relationship and is not relevant to the analysis of the worker’s status. An employee is not permitted to waive employee status.

The Factors

The factors should not be applied as a checklist, but rather the outcome must be determined by a qualitative rather than a quantitative analysis.

1.   Is the Work an Integral Part of the Employer’s Business?

If the work performed by a worker is integral to the employer’s business, it is more likely that the worker is economically dependent on the employer. A true independent contractor’s work is unlikely to be integral to the employer’s business.

For a construction company that frames residential homes, carpenters are integral to the employer’s business because the company is in business to frame homes, and carpentry is an integral part of providing that service.

In contrast, the same construction company may contract with a software developer to create software that, among other things, assists the company in tracking its bids, scheduling projects and crews, and tracking material orders. The software developer is performing work that is not integral to the construction company’s business, which is indicative of an independent contractor.

2.   Does the Worker’s Managerial Skill Affect the Worker’s Opportunity for Profit or Loss?

A worker in business for him or herself faces the possibility to not only make a profit, but also to experience a loss. The worker’s managerial skill will often affect opportunity for profit or loss beyond the current job, such as by leading to additional business from other parties or by reducing the opportunity for future work. For example, a worker’s decisions to hire others, purchase materials and equipment, advertise, rent space, and manage time tables may reflect managerial skills that will affect his or her opportunity for profit or loss beyond a current job.

It is important to note that the worker’s ability to work more hours and the amount of work available from the employer have nothing to do with the worker’s managerial skill and do little to separate employees from independent contractors—both of whom are likely to earn more if they work more and if there is more work available.

A worker provides cleaning services for corporate clients. The worker performs assignments only as determined by a cleaning company; he does not independently schedule assignments, solicit additional work from other clients, advertise his services, or endeavor to reduce costs. The worker regularly agrees to work additional hours at any time in order to earn more. In this scenario, the worker does not exercise managerial skill that affects his profit or loss. Rather, his earnings may fluctuate based on the work available and his willingness to work more. This lack of managerial skill is indicative of an employment relationship between the worker and the cleaning company.

In contrast, a worker provides cleaning services for corporate clients, produces advertising, negotiates contracts, decides which jobs to perform and when to perform them, decides to hire helpers to assist with the work, and recruits new clients. This worker exercises managerial skill that affects his opportunity for profit and loss, which is indicative of an independent contractor.

3.   How Does the Worker’s Relative Investment Compare to the Employer’s Investment?

The worker should make some investment (and therefore undertake at least some risk for a loss) in order for there to be an indication that he or she is an independent business. However, even if the worker has made an investment, it should not be considered in isolation; it is the relative investments that matter. An analysis of the workers’ investment, even if that investment is substantial, without comparing it to the employer’s investment is not faithful to the ultimate determination of whether the worker is truly an independent business.

A worker providing cleaning services for a cleaning company is issued a Form 1099-MISC each year and signs a contract stating that she is an independent contractor. The company provides insurance, a vehicle to use, and all equipment and supplies for the worker. The company invests in advertising and finding clients. The worker occasionally brings her own preferred cleaning supplies to certain jobs. In this scenario, the relative investment of the worker as compared to the employer’s investment is indicative of an employment relationship between the worker and the cleaning company. The worker’s investment in cleaning supplies does little to further a business beyond that particular job.

A worker providing cleaning services receives referrals and sometimes works for a local cleaning company. The worker invests in a vehicle that is not suitable for personal use and uses it to travel to various worksites. The worker rents her own space to store the vehicle and materials. The worker also advertises and markets her services and hires a helper for larger jobs. She regularly (as opposed to on a job-by-job basis) purchases material and equipment to provide cleaning services and brings her own equipment (vacuum, mop, broom, etc.) and cleaning supplies to each worksite. Her level of investments is similar to the investments of the local cleaning company for whom she sometimes works. These types of investments may be indicative of an independent contractor.

4.   Does the Work Performed Require Special Skill and Initiative?

A worker’s business skills, judgment, and initiative, not his or her technical skills, will aid in determining whether the worker is economically independent.  The fact that workers are skilled is not itself indicative of independent contractor status. Even specialized skills do not indicate that workers are in business for themselves, especially if those skills are technical and used to perform the work.

A highly skilled carpenter provides carpentry services for a construction firm; however, such skills are not exercised in an independent manner. For example, the carpenter does not make any independent judgments at the job site beyond the work that he is doing for that job; he does not determine the sequence of work, order additional materials, or think about bidding the next job, but rather is told what work to perform where. In this scenario, the carpenter, although highly-skilled technically, is not demonstrating the skill and initiative of an independent contractor (such as managerial and business skills). He is simply providing his skilled labor.

In contrast, a highly skilled carpenter who provides a specialized service for a variety of area construction companies, for example, custom, handcrafted cabinets that are made-to-order, may be demonstrating the skill and initiative of an independent contractor if the carpenter markets his services, determines when to order materials and the quantity of materials to order, and determines which orders to fill.

5.   Is the Relationship between the Worker and the Employer Permanent or Indefinite?

Permanency or indefiniteness in the worker’s relationship with the employer suggests that the worker is an employee. However, a lack of permanence or indefiniteness does not automatically suggest an independent contractor relationship.

An editor has worked for an established publishing house for several years. Her edits are completed in accordance with the publishing house’s specifications, using its software. She only edits books provided by the publishing house. This scenario indicates a permanence to the relationship between the editor and the publishing house that is indicative of an employment relationship.

Another editor has worked intermittently with fifteen different publishing houses over the past several years. She markets her services to numerous publishing houses. She negotiates rates for each editing job and turns down work for any reason, including because she is too busy with other editing jobs. This lack of permanence with one publishing house is indicative of an independent contractor relationship.

6.   What is the Nature and Degree of the Employer’s Control?

The worker must control meaningful aspects of the work performed such that it is possible to view the worker as a person conducting his or her own business.  It is important to note with this test that it is not what the workers could have done that counts, but what the actual reality as to what the worker actually does.

A registered nurse who provides skilled nursing care in nursing homes is listed with Beta Nurse Registry in order to be matched with clients. The registry interviewed the nurse prior to her joining the registry, and also required the nurse to undergo a multi-day training presented by Beta. Beta sends the nurse a listing each week with potential clients and requires the nurse to fill out a form with Beta prior to contacting any clients. Beta also requires that the nurse adhere to a certain wage range and the nurse cannot provide care during any weekend hours. The nurse must inform Beta if she is hired by a client and must contact Beta if she will miss scheduled work with any client. In this scenario, the degree of control exercised by the registry is indicative of an employment relationship.

Another registered nurse who provides skilled nursing care in nursing homes is listed with Jones Nurse Registry in order to be matched with clients. The registry sends the nurse a listing each week with potential clients. The nurse is free to call as many or as few potential clients as she wishes and to work for as many or as few as she wishes; the nurse also negotiates her own wage rate and schedule with the client. In this scenario, the degree of control exercised by the registry is not indicative of an employment relationship.


The guidance recently issued by the US DOL explicitly states that “In sum, most workers are employees under the FLSA’s broad definitions.” Naturally, compliance with this guidance may create increased costs for businesses.  Some businesses have never had to process a traditional payroll with all the associated filing of tax forms, issuing W-2s and submitting income tax withholding to the government.   However, not complying with the new guidance could end up being more costly than complying.  If you have additional questions about the proper classification or payroll processing we would love to speak with you.