ABC Test:

To determine whether an employment relationship exists, and whether the employer is required to provide unemployment insurance coverage to an individual, many states use what is known as the “ABC” test. An employment relationship exists (and unemployment insurance coverage is required) unless and until the employer is able to demonstrate that all three parts of the ABC test are met:

  1. The individual has been and will continue to be free from control or direction over the performance of services, both under his or her contract of service and in fact and
  2. Such service is either outside the usual course of the business or such service is performed outside of all business locations and
  3. The individual is customarily engaged in an independently established trade, occupation, profession or business.

Check your state law to ensure compliance

An employer’s administrative responsibilities related to independent contractors differ from those required for an employee. Here are some general requirements:

  • Employers must issue IRS Form 1099 for income reporting (see below), instead of Form W-2 (issued to employees), to employees and transmit the forms to the IRS.
  • Employers must use Form 1096 to transmit paper 1099s to the IRS.
  • Independent contractors are not subject to state and federal income tax withholding and employers are not required to make FICA contributions on behalf of independent contractors.
  • Independent contractors are not entitled to traditional benefits offered to employees, including health insurance, stock options, retirement plans, and paid time off.
  • Employers are not required to pay premiums for workers’ compensation or unemployment insurance for an independent contractor.
  • Employers should ensure that independent contractors carry their own insurance.

Form 1099:

Businesses that pay $600 or more to an independent contractor in a tax year must supply a completed Form 1099-MISC to both the independent contractor and the Internal Revenue Service. On the form, use box 7 to enter the independent contractor’s total compensation.

The fines and penalties for misclassifying an employee as an independent contractor vary by state. For example, some states (such as Pennsylvania and Colorado) have imposed criminal penalties for employers that intentionally misclassify a worker as an independent contractor.

In general, if it’s been determined that an employee has been incorrectly classified as an independent contractor, he or she may be awarded back pay, overtime and benefits. In addition, the employer may be ordered to pay back taxes, interest, and fines.

Given increased government focus on employee misclassification, including an increase in the number of audits conducted by the Internal Revenue Service (IRS) and other government agencies, it’s extremely important for employers to ensure all workers are classified correctly.