Here’s a multiple-choice quiz for nonprofit employers, based on frequent client scenarios with our law firm. How many of the following statements are legally correct?
(a) A part-time worker may be classified as an independent contractor, instead of an employee, based on the employer’s or worker’s preference.
(b) A full-time worker is always an employee, regardless of the worker’s location.
(c) A person who engages in a wide variety of job activities over an extended time period is likely be classified as an independent contractor.
(d) A worker can be a “1099 employee.”
(e) A paid nonprofit officer (e.g., president or secretary) may be an independent contractor instead of an employee.
The answer? None of the above!
Correctly distinguishing between employees and independent contractors can be tricky. For example, if the worker is well integrated into a nonprofit’s operations and carries out many types of activities on a relatively long-term basis, then the answer to letter (c) above is likely employee status. In California, a person who works full-time is necessarily an employee, and such simplistic classification could be followed in other states too. Note also that employee classification under state law depends on the worker’s location, which in turn may raise a host of legal compliance issues for nonprofits with multi-state operations or remote workers. Additionally, there is no such thing – legally speaking – as an employee who receives an IRS Form 1099. Such tax form is only for independent contractors; employees receive IRS Form W-2. The Internal Revenue Code also mandates that every corporate officer generally be classified as an employee, regardless of how much time the worker spends on nonprofit business or the nature of the worker’s specifics, as a bright-line approach presumably based on governing boards’ direct control of corporate officers.[1]
What should responsible nonprofits do when the line seems blurred? Key pointers: lean towards employee rather than independent contractor status; make sure that any independent contractors are correctly classified (based on their work responsibilities and applicable state law); memorialize all work arrangements correctly through offer letters and other written agreements; and seek legal counsel for clarifying guidance.
The following sections provide further background considerations, address resulting implications for employment-related legal compliance, compare and explain the varying legal tests under IRS and state law, and provide related recommendations.
Why the Legal Fuss – So Much to Consider!
Most nonprofits hire workers for various purposes and under diverse circumstances. Whether these workers should be treated as “employees” or “independent contractors” can be confusing. If classified incorrectly, such mistakes can lead to unintended liability and other consequences. Indeed, a nonprofit may face significant liability for misclassification in terms of income and other employment taxes, unlawful discrimination, tort claims (i.e., civil wrongs like personal injuries), wage-hour obligations (sometimes involving personal liability for leaders under specific state laws), and workers’ compensation benefits.
More specifically, the following legal areas are affected by the employee versus independent contractor distinction:
· Federal and state tax withholding and Form W-2 reporting for employees (or Form 1099 reporting for independent contractors, with no withholding);
· Unemployment insurance coverage;
· Workers’ compensation coverage for employees and other potential liability based on harm suffered by the workers under negligence and related legal theories;
· Liability to others based on employees’ negligence, intentional misconduct, or other civil wrongs under the respondeat superior doctrine, which does not apply to acts of independent contractors;
· Wage and hour laws such as overtime pay provisions that apply only to employees;
· Other employment-related liability such as provided under Title VII, the Age Discrimination in Employment Act, and the Americans with Disabilities Act (unlawful employment discrimination);
· Collective bargaining rights for employees under the Labor Relations Act;
· Immigration reporting requirements for employees (I-9 forms);
· New hire reporting requirements for child support enforcement; and
· Personnel records requirements for employees.
It is thus imperative that a nonprofit’s leaders, whether through its governing board or its executive team, fully understand how to properly define its workers, the related risks and responsibilities involved, and the necessary tax withholding practices and other policies that should be followed.
Before the Legal Test(s) – Key Risk Management Aspects
Technically speaking, certain legal tests apply depending on legal areas at stake, as listed above and further. These tests involve overlapping factors, most fundamentally focused on an employee’s “right to control” as the primary determinant in properly classifying a worker as an employee or an independent contractor.
Regardless of how an employer may label a worker, the IRS, a court, or other government official may disregard such designation and impose liability as well as penalties (for employment taxes) in the event of a differing conclusion. An incorrect classification can cause a myriad of problems including liability for payment of back taxes, liability in tort for injured workers, absence of sufficient insurance coverage, and expensive legal fees to dispute these issues. Basic risk management considerations thus warrant addressing these issues before problems arise.
To make things more complicated, workers may be considered “employees” for one legal purpose while simultaneously qualifying as an “independent contractor” in another area of law. Generally, a person is more likely to be considered an employee for certain legal areas such as workers’ compensation (the broadest approach to employee classification) than for other legal purposes, because of an underlying policy to provide an economic safety net (i.e., through worker compensation benefits).[2] As a practical matter, the government and courts will classify workers as employees whenever possible. And whether an employer wins after incurring significant legal expenses, such as to refute liability for the employer’s share of payroll taxes (i.e., for social security and Medicare taxes) and related tax penalties or to contend that employment discrimination laws are inapplicable based on a worker’s independent contractor status, depends on a very fact-specific inquiry. Legally and practically speaking, the burden to accurately classify a worker as an independent contractor thus may be heavy.
As many of our law firm’s nonprofit clients can attest, organizations often prefer using independent contractors rather than employees – especially for new or small nonprofits with a limited budget and reticence to hire a payroll company. Indeed, with only independent contractors, no withholding is required for the employer’s share of social security and Medicare taxes or for income taxes, no overtime obligations apply, no unlawful discrimination claims may be asserted, and no workers’ compensation insurance must be paid. In addition, no liability for negligence committed by workers against others will likely exist. The benefits thus may seem to outweigh the risks.
On the other hand, an employer may risk an IRS audit in the event of questionable employment classifications or wholesale classifications of workers as independent contractors. A safe harbor is available for federal income tax purposes, though its applicability is somewhat limited and may require a formal legal opinion; no such protection exists for other legal areas listed above. In addition, an employer may face a lawsuit from an injured worker who is an independent contractor, instead of having insurance coverage under a workers’ compensation policy for the same person. Also notable, if the individual has been classified an employee, then the employer may correspondingly exercise more control over the workers’ actions. Last, an employer may get into trouble under wage and hour laws for workers who should have been classified as employees and have worked overtime, but who have not been paid properly as such and for whom time records have not been maintained.
Nonprofit leaders therefore should fully consider its risk management goals in structuring work opportunities and agreements, as well as the accompanying legal requirements that may apply to its workers’ employment status regardless of attendant goals. Other important considerations include the extent to which nonprofit leaders want or need to exercise control over its workers in order to get certain work done, along with any organizational goals regarding providing work and/or training opportunities to individuals. An employer also should weigh the related costs of having additional employees covered by increased workers’ compensation insurance as well as potentially higher liability insurance for acts related to its independent contractors. Certain high-risk activities (e.g., roofing or electrical work) generally should be carried out by an independent contractor – with documented proof of adequate liability insurance – regardless of other goals. Otherwise, an employer should check with its liability and workers’ compensation insurance carriers regarding coverage for these high-risk activities.
Now for the Legal Tests
First Test: IRS (Payroll Taxes)
For federal income tax purposes, the IRS’s primary inquiry is whether an employer has the right to control its workers. The IRS has identified three groups of factors to aid this determination. Overall, the less control the employer has over its workers, the more likely the workers will be classified as independent contractors. The weight accorded to each factor varies depending on the nature of the work and the facts of each case. A careful analysis of an employer’s current and intended workers is thus well warranted. Although the IRS does not automatically require all factors in support of independent contractor status to exist, it will require most to be present as well as adequate justification for those factors that are missing.[3] The IRS test is often the only test considered by employers, which may be sufficient – depending on other considerations as addressed below regarding other tests.
The first IRS group is “behavioral control.” Facts that show whether an employer has a right to direct and control the worker’s behavior include “instruction” and “training.” The more an employer is involved with training and instruction, the more likely the worker will be classified as an employee. “Training” includes the right to determine the manner in which the worker receives training to perform the services. “Instruction” includes the right to determine:
· When, where, and how work should be done;
· What tools or equipment to use;
· What workers to hire or assist with work;
· Where to purchase supplies;
· What work must be performed by a specific individual; and
· What sequence to follow.
The second group is “financial control.” Factors showing whether an employer has a right to control the business aspects of the worker’s job include:
· The extent to which the worker has unreimbursed expenses;
· The extent of the worker’s investment;
· The extent the worker makes him/herself open to the public market;
· How the worker is paid; and
· The extent to which the worker can realize profit or loss.
The third group is the “type of relationship.” Factors that show the type of relationship include:
· Written contracts describing the relationship;
· Provision of employee-type benefits;
· Permanency of the relationship; and
· How integral the services are to the principal activity of an employer.
Applying these factors, if an employer requires a contractor to employ certain individuals, to use an employer’s tools, to hire certain people from the community, or to perform their job in a specific way, the worker may well need to be classified as an employee. In addition, if an employer hires a worker to paint or clean, employee status likely will result if an employer needs to provide the supplies, explain how the work is to be done, and closely supervise such person’s work. In contrast, if an employer simply directs such a worker to “get a room painted” or “clean the premises,” without further guidance (and preferably without supplying the necessary materials), then such a worker should be treated as an independent contractor. If an employer keeps hiring a worker for various different tasks (e.g., painting, then cleaning, then moving boxes), it is likely that such worker has become an employee because an employer is controlling what he or she is doing, in what order, and how. The opposite result would likely occur if an employer would hire someone already skilled in various jobs, provides his or her own supplies, is paid by the job, and has a separate company (e.g., “Rent a Handy- Man”). The IRS test is often the only test considered by employers, which may be sufficient – depending on other considerations as addressed in subsequent tests below.
Second Test: Tort-Related Worker Classification – Potential Employer Liability for Employees
As with the IRS’s employment classification test, the test under state tort law principles (i.e., civil wrongs including negligence) focuses on whether an employer has a “right to control” the worker at issue. In addition, the following factors are relevant: (1) the method of payment; (2) the right to discharge; (3) the skill required in the work to be done; and (4) the party providing tools, materials, or equipment. Typically, a court determining the issue of liability for someone’s negligence would apply this test. From this tort law perspective, an employer will need to balance any interest it has in avoiding liability for workers’ misconduct with its need to control the workers’ day-to-day activities. For example, an employer’s need to have certain safety measures and task timetables in place and closely monitored may outweigh any benefit from structuring a particular job as an independent contractor arrangement. In addition, an employer should be aware that liability might otherwise be imposed even for an independent contractor’s wrongdoing based on agency principles.
Third Test: Workers’ Compensation State Laws
State workers’ compensation laws were developed to provide employees with recovery from their employers when hurt on the job, regardless of fault. As a result, workers’ compensation laws are interpreted very broadly to include as many workers as possible. The practical result is that it is more difficult to classify workers as independent contractors, and employers are held more accountable for their injuries.
Careful consideration should be given as to whether an employer even wants its workers to be independent contractors for workers’ compensation purposes. Having workers classified as “employees” will increase an employer’s workers’ compensation insurance costs, but then these workers will not have any independent right to sue an employer for work-related injuries. In addition, an employer’s insurance carriers will be obligated to provide legal defense and handle any resulting workers’ compensation litigation. Having workers classified as independent contractors will result in cheaper insurance for an employer, but the workers will retain the right to sue an employer for their injuries caused by an employer’s negligence.
As one example, the Illinois Workers’ Compensation Act defines “employee” expansively as “every person in the service of another under any contract of hire, express or implied, oral or written . . . .” 820 ILCS 305.1(b)(2). This definition encompasses all independent contractors unless three statutory exceptions are all satisfied, as follows: (1) the worker must be free from control or direction over the performance of services under the contract and in fact; (2) it must appear that the service was either outside the usual course of the business of an employer or that such service is performed outside of all the places of business of an employer for which such service is performed; and (3) the person performing the service must be engaged in an independently established trade, occupation, profession, or business.
These exceptions could all be met regarding an employer’s workers, depending on the level of supervision needed, the type of work done, and the person hired. The issue of right to control is again paramount. Significantly, more workers likely will be classified as “employees” for purposes of workers’ compensation coverage under its broad definition than for IRS purposes, tort liability, or other purposes. Conceptually, cleaning workers, construction contractors, and other occasional laborers – depending on the nature of their work – may be independent contractors for workers’ compensation purposes, but an employer will have to be very diligent and careful to clearly meet all three exceptions if it intends not to provide insurance for these workers. Even if workers plainly fit into the definition of an independent contractor, one may reasonably assume that they will file for workers’ compensation benefits anyways. An employer will have the burden, risk, and expense of establishing the workers’ independent contractor status.
Fourth Test: Economic Realities (Federal and Some States), Such as for Overtime Wages
Federal courts and the United States Department of Labor (DOL) apply the “Economic Realities Test” when determining whether a person qualifies as an employee protected by the Fair Labor Standards Act (for overtime and other benefits enjoyed by non-exempt employees)[4] and the Family and Medical Leave Act. A few states also use this test in a limited context, such as comparable state protections. Notably, California uses the economic realities test for certain entities that are not subject to the statute implementing the ABC test (as addressed below).
The United States Supreme Court established the economic realities test in 1947 with the Rutherford Food Corp. v. McComb, and numerous courts have applied and reformed this test.
The key inquiry is whether, as a matter of economic reality, the worker is economically dependent on the employer for work (and is thus an employee) or is in business for themself (and is thus an independent contractor). As reflected in related DOL guidance :
In assessing economic dependence, courts and the Department have historically conducted a totality-of-the-circumstances analysis, considering multiple factors to determine whether a worker is an employee or an independent contractor, with no factor or factors having predetermined weight. There is significant and widespread uniformity among federal courts of appeals in the adoption and application of the economic reality test, although there is slight variation as to the number of factors considered or how the factors are framed. These factors generally include the opportunity for profit or loss, investment, permanency, control, whether the work is an integral part of the employer's business, and skill and initiative.
In 2021, the Department of Labor (“DOL”) announced a new five-factor test, but heavily relied on the “core factors” of the nature and degree of control over the work and the worker's opportunity for profit or loss. The three less probative factors were the amount of skill required for the work, the degree of permanence of the working relationship between the worker and the potential employer, and whether the work is part of an integrated unit of production.
After three years of implementation and widespread criticism, the DOL decided to rescind the 2021 rule. In early 2024, the DOL announced a return to the “totality of the circumstances” test, focusing again on economic dependence as the ultimate inquiry for determining worker classification. As set forth in the final DOL rule published in March 2024:
A worker is an independent contractor as opposed to an employee under the Act if the worker is, as a matter of economic reality, in business for themself. The final rule explains that the economic reality test is comprised of multiple factors that are tools or guides to conduct the totality-of-the-circumstances analysis to determine economic dependence. The six factors described in the regulatory text should guide an assessment of the economic realities of the working relationship, but no one factor or subset of factors is necessarily dispositive. The final rule provides guidance on how six economic reality factors should be considered—opportunity for profit or loss depending on managerial skill, investments by the worker and the potential employer, the degree of permanence of the work relationship, the nature and degree of control, the extent to which the work performed is an integral part of the potential employer's business, and skill and initiative. Just as under the 2021 IC Rule, and in accordance with longstanding precedent and guidance, additional factors may also be considered if they are relevant to the overall question of economic dependence.
Whether the above distinctions ultimately make any significant difference in an employer’s determination of worker status is a valid question. The key practical pointer is likely to keep the IRS test paramount, lean toward employee status when in doubt, or otherwise modify a person’s work responsibilities to be assured of independent contractor status (whatever the applicable legal test may be – for federal payroll taxes, potential overtime liability, or state law concerns).
Fifth: The “ABC” Test
While rarely used in the federal employment law context, the ABC test is important for employers to know because more than half of the states use this test in some capacity, especially in the context of unemployment insurance. Most notably, California codified the ABC test and applies it to matters concerning the Labor Code, the Unemployment Insurance Code, and the Industrial Welfare Commission wage orders.[6]
More specifically, the ABC test provides that a worker is an independent contractor if all three of the following conditions are met:
A. The person is free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work and in fact;
B. The person performs work that is outside the usual course of the hiring entity's business, and;
C. The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.[7]
While providing a fewer number of factors than the other above-listed tests (especially per the IRS for payroll tax liability), the ABC test is far from straightforward, making it difficult for organizations to know whether they are following the law when classifying workers. Importantly, the ABC test requires an organizing to satisfy all three factors, instead of implementing a balancing test of all factors.
Related significant considerations and best practices when classifying a worker include the following. First, if in doubt, classify the worker as an employee. California and many other states operate on the assumption a worker is an employee, creating an uphill battle for employers trying to classify workers as independent contractors. Second, use a written independent contractor agreement that explicitly details the autonomy of the worker and how the organization will create those boundaries (e.g., the independent contractor sets own work hours and days). Third, consider whether and to what extent any overlap exists between the independent contractor’s work and the organization’s purpose or mission. A clear example that meets part B of the test is an accountant for a disaster relief nonprofit. The accountant strictly files the corporations’ taxes and is separate from the nonprofit’s business purpose. A person hired for marketing purposes for a disaster relief nonprofit is a closer legal call. While marketing might not strictly relate to the business of disaster relief, satisfying part B depends on the responsibilities given to that certain worker. Perhaps the worker is expected to create materials pertaining to volunteer disaster relief training. Satisfying part B of the test becomes murkier in that scenario. Fourth, consider whether the worker is involved in an independent trade that requires special degrees or licenses (e.g., electricians, car mechanics, architects, etc.). If so, nonprofits have fairly solid grounds for satisfying Part C.
Keep Going, and Watch the State Law Trends
When classifying a worker, a nonprofit must also consider state laws. While most states follow the federal employment tests, some use their own tests or add on to federal test. For example, Washington uses the federal control test but puts special emphasis on ten specific factors. It is additionally important that nonprofit employers familiarize themselves with state standards in order to avoid misclassifying workers, in light of recent state government coordination for enforcement activities. For example, several states, such as Iowa, Michigan, Nevada, New Jersey, New York, North Carolina, Virginia, and Wisconsin have created task forces designed to track down worker misclassification and to pursuer resulting employer liability.[8] Still other states have stepped up their enforcement efforts by adopting independent contractor legislation containing stringent definitions of "employee" and/or imposing greater fines and penalties for employers with misclassified employees (e.g., California’s adoption of the ABC test).
Pressing On Toward Optimal Legal Compliance and Risk Avoidance
While classifying workers correctly is time-consuming and confusing, nonprofit leaders who takes the time to figure out a proper classification on the front end save so much time and hassle on the back end as well as significantly mitigate legal risks. Here are some concluding pointers that have been particularly helpful for our law firm’s nonprofit clients.
· When creating any sort of relationship (whether between an independent contractor or an employee) memorialize the relationship with a written agreement.
· Use consistent worker terminology throughout the written agreement. For example, do not use the term “employee” or “employment” in an independent contractor relationship or vice versa.
· Correspondingly, do not indicate that an independent contractor is hired ”at will,” as may be accurate for an employment relationship. Rather, reflect in the agreement that an independent contractor is hired to complete a specific project (perhaps by a specified deadline) or for a specific term (e.g., monthly) subject to termination (for cause or without cause, as may be mutually agreed).
· A legally compliant agreement describes the workers’ responsibilities consistent with the concluding label – “employee” or “independent contractor” – that best fits all potentially applicable legal tests. Such tests will include federal law such as IRS requirements, which apply to all paid workers, as well as state laws depending on where workers are physically located in carrying out their work.
· Keep up with the implications of a nonprofit’s changing work force, especially the multi-state aspects involved with remote workers and state-related legal trends such as increasing use of the “ABC” test.
Overwhelming? Perhaps, depending on the nonprofits’ work force, goals, and activities. But manageable? Yes, definitely, with due attentiveness to the “right to control” test as fundamental to many worker evaluations, avoidance of undue risk through aggressive classifications, and a willingness to lean toward employee status as a default approach.
[1] See Internal Revenue Code Section 3121(d)(1) (“For purposes of this chapter, the term “employee” means . . . any officer of a corporation”) and 26 CFR § 31.3121(d)-1(b) (“Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.”
[2] Keep in mind though that a worker who is classified as covered by employee-related workers’ compensation will have capped benefits, whereas a person who sues for personal injuries as an independent contract is not subject to such insurance-related constraints. Such considerations are addressed in further detail below.
[3] If an employer wants explicit direction from the IRS, it may seek a written determination of employment status from the IRS by completing IRS Form SS-8. Most likely, however, such an inquiry will result in an answer that the worker in question is an employee, since the IRS generally favors employee status. An employer may also find comfort in the “safe harbor” afforded employers who follow established judicial precedent or otherwise have a “reasonable basis” for its position, if it is willing to incur the attendant extra legal expenses to justify its legal position.
[4] For more information about exempt and non-exempt employees, please see our law firm’s blog article here.
[5] 29 CFR 795.105(d).
[6] Cal. Lab. Code § 2775 et. seq.
[7] Cal. Lab. Code § 2775(b)(1).
[8] See, e.g., N.J. Executive Order No. 25 (May 3, 2018).
