The Worker Classification Dilemma in Small Business
When your business has so much happening you need more help, that's usually good. But should you classify your new helper as an “employee” or “independent contractor”? Or can you hire an unpaid student intern? Why do worker classifications even matter?
Why worker classifications matter
Simply put, federal and state labor laws and regulations apply to employees, but not to independent contractors or unpaid interns. Perhaps the best known is the federal Fair Labor Standards Act (FLSA), but the same is true for the federal Family & Medical Leave Act, Employee Retirement Income Security Act, Civil Rights Act of 1964 and Occupational Safety and Health Act. Meanwhile, state laws and regulations generally dictate in areas such as state unemployment insurance taxes and workers’ compensation insurance.
In a desire not to make your business life more complicated, it might seem as if avoiding the classification of “employee” is the way to go. But there is more involved than asking your new helper to sign a document titled “independent contractor agreement.” Government agencies tend to look at multiple factors in the relationship.
What follows provides an overview of some federal law issues, but states (and different agencies), have their own rules and regulations for worker classification, which you need to consider as you build your business — and in Vermont, worker classification has become a contentious legislative and business debate.
When should a worker be classified as an employee?
The U.S. Department of Labor (DOL) uses six factors or questions in the FLSA “economic realities” test to help determine whether a worker is economically dependent on the employer and thus an employee, or in business for him or herself and thus an independent contractor. No one factor is determinative.
- Is the work performed an integral part of the employer’s business?
- Does the worker’s managerial skill affect the worker’s opportunity for profit or loss?
- How does the worker’s relative investment compare to the employer’s investment?
- Does the work performed require special (business and management) skill and initiative?
- Is the relationship between the worker and the employer permanent or indefinite?
- What is the nature and degree of the employer’s control?
If there is an employment relationship, and your business has an annual dollar volume of sales or receipts in the amount of $500,000 or more, you must comply with FLSA requirements related to minimum wage, (and, no, your company’s stock doesn’t count), overtime, withholding taxes, workers’ compensation insurance, and so forth.
Often, new businesses simply don’t have the resources to comply with all of these laws. But if the factors above indicate a worker is not an “employee,” you can consider classifying the individual as an “independent contractor.”
When is an independent contractor classification appropriate?
The IRS applies “common law rules” to elaborate on the general rule “that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
An independent contractor is an individual who is in business for her or himself and not under direct control or supervision. Services being provided should not be core to the company that is paying. This “nature of the business” test is perhaps the biggest hurdle that companies in creative industries or the on-demand economy face.
What are the guidelines for unpaid interns?
Alternatively, hiring an intern may seem appealing. You need help but don’t have the money to hire an employee, and the intern gains valuable experience. A win-win, yes? Not necessarily. In for-profit businesses, unpaid interns can carry a lot of risk.
Numerous public lawsuits have highlighted the risks of operating a non-compliant unpaid internship program. In a for-profit business, only if all of the following factors are met will an unpaid internship be in compliance with the FLSA:
- The internship, even though it includes actual operation of the facilities of the employer, is similar to training which would be given in an educational environment;
- The internship experience is for the benefit of the intern;
- The intern does not displace regular employees, but works under the close supervision of existing staff;
- The employer that provides the training derives no immediate advantage from the activities of the intern, and on occasion its operations may actually be impeded;
- The intern is not necessarily entitled to a job at the conclusion of the internship; and
- The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship.
From the small business or lean startup perspective, these are limiting factors. The conclusion is bringing on unpaid interns is not a feasible way to scale a for-profit business.
The business dilemma
On one hand, employers face a fundamental financial tension between increasing fixed costs with an additional 18-30% cost for payroll taxes and benefits plus workers’ compensation insurance for every worker classified as an employee, versus the increasing risk of a lawsuit or government penalty for employee misclassification as an independent contractor. On the other hand, there are significant operational and flexibility tensions between a projected short-term need for additional help and a sustained long-term need that would warrant investing in hiring an employee. The relative importance of these two tensions varies by business model, industry, and competitive environment, but in some sectors, it has become the norm for the majority of workers to be classified as independent contractors.
The societal dilemma
Labor laws were established to provide basic protections for employees and prevent abuse. Workers classified as independent contractors not only lose these protections while creating an uneven playing field for employers who properly classify their workers, but there is growing concern society loses out from the “tax gap” created because employee payroll tax revenues are not collected on the compensation independent workers receive. For example, independent contractors operating as partners or sole proprietors without employees are not required to pay for workers compensation coverage or unemployment insurance. If that “independent contractor” is working for a construction company, falls from a roof, is seriously injured and unable to work for an extended period, that worker’s medical bills may be paid through publicly funded Medicaid, and their family may need an array of publicly funded services.
Class-action lawsuits and enforcement of worker classification are increasing, so entrepreneurs need to be informed, properly classify your workers under current laws, and talk with your legislators about suggestions for ways to improve the status quo for Vermont’s businesses, workers, and economy.
Pat Heffernan is President of Marketing Partners in Burlington, VT, a board member of the Women Business Owners Network and co-chair of WBON’s public policy committee. This blog post is adapted from a Money & Your Business column published in BusinessVermont June 12, 2016.