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Classification of workers as either employees or independent contractors has become a heated issue. One reason is the growth of companies like Uber and Handy, which rely on networks of workers the companies say are independent contractors.

Both the U.S. Department of Labor (DOL) and the IRS, as well as a number of states, are paying more attention to this issue. In recently issued guidelines, the DOL stated, “The misclassification of employees as independent contractors is found in an increasing number of workplaces in the United States.”

Different tax treatments

Why do businesses prefer to classify workers as independent contractors? One of the main reasons is to reduce their tax-related obligations. First, an employer is obligated to pay the employer portion of FICA taxes for employees, but not for independent contractors. Second, an employer is obligated to withhold income taxes from employee pay, but isn’t required to withhold them from independent contractor pay.

While there are many other obligations associated with employees that make independent contractors appealing to businesses, these two tax obligations draw the attention of federal and state tax authorities.

5 factors

The latest guidelines say that no single factor typically determines whether a worker should be classified as an employee or independent contractor. Instead, the decision hinges on an “economic realities” test that attempts to distinguish workers who are economically dependent on an employer — and thus employees — from those in business for themselves.

Fortunately, the DOL and IRS have established five factors that can help employers determine a worker’s status, including the following:

1. The extent to which the work performed by the worker is an integral part of the employer’s business. The more integral the work, the more likely the worker is economically dependent on the employer and is an employee. Moreover, the work can be considered integral, even if it’s one step in a process, performed by multiple people, and/or performed away from the employer’s place of business. For instance, most carpenters perform work integral to a construction company, even though they typically work outside the headquarters office.

2. The worker’s opportunity for profit or loss, depending on his or her managerial skill. A key word here is “managerial.” Just because a worker is technically proficient at a task — say, installing and repairing cable services — doesn’t mean he or she operates his or her own business. Similarly, a worker’s ability to earn more money by taking on extra work from the employer typically doesn’t signal an independent contractor relationship.

Instead, an independent contractor demonstrates managerial skill by, for instance, deciding whether to hire employees or purchase equipment, and marketing his or her business. A worker in business for him- or herself also faces the possibility of a financial loss, such as if what he or she charges for services doesn’t cover costs.

3. The extent of the relative investment by both the employer and worker. A truly independent business owner will invest in his or her company, and the investment will go beyond simply purchasing the tools needed to do the job. The DOL provided this example: A cleaning person who uses his or her own cleaning supplies, while the employer provides a vehicle and insurance and covers the cost of marketing the business, likely isn’t an independent contractor.

4. Whether the relationship between the worker and employer is permanent or indefinite. When the relationship is permanent or indefinite — the case with many at-will employees — rather than project- or contract-based, the worker is more likely to be an employee.

5. The nature and degree of the employer’s control. A truly independent contractor will exert control over a meaningful part of the work and relationship with the employer. For example, he or she typically will control the way the work is completed. What’s more, few companies can escape this provision by stating that client demands or regulations require them to tightly control their workers.

Consequences of misclassification

Employers that misclassify workers as independent contractors rather than employees may have to pay back taxes, interest and penalties, among other costs. Clearly, the ramifications of misclassifying workers can be severe. So be sure to enlist your tax professional. He or she can help you accurately determine whether your workers are employees or independent contractors.