Worker classification is anything but simple. As companies increase their reliance on freelancers and independent contractors, they are quickly realizing that correctly classifying their non-payroll workers is a challenge—and the stakes are high.
The main reason worker classification is so complex is because there is no single source of truth for employers to turn to on how to determine worker status – worker classification tests change from state to state, and they continuously evolve to become stricter.
If you want to take advantage of all of the benefits of working with freelancers, the first step is understanding how to get worker classification right. Once you know which tests to use and how to play by the rules, you’ll have what it takes to scale up your freelancer ranks and gain more access to their skills.
This article is part of our guide on Employee Classification.
What is worker classification?
Worker classification is the process of determining whether you can classify a worker as an independent contractor, or does the law classify them as employees.
A worker’s status is important because companies need to withhold taxes, pay social security and pay medicare taxes for their employees. In addition, labor laws also offer a lot of protection to employees, like minimum wage, sick days, family leave, and more.
Even though many workers consider themselves as freelancers, they could be defined as employees in the eyes of the IRS, or the Department of Labor (DOL). It depends on the nature of their work relationship with a company. That’s where classification tests come into play.
The evolution of worker classification tests
The freelance workforce is growing at a rapid pace. In 2020, 59 million Americans considered themselves freelancers, accounting for 36% of the US workforce. By 2025, that number will pass 90 million.
As the number of freelancers rises and companies increase demand for them, federal and state governments are paying attention. Both the IRS and DOL are cracking down on how companies classify workers. In recent years, the DOL has even expanded its ranks of auditors who exclusively focus on identifying cases of employee misclassification.
Scrutiny on worker classification is increasing as the laws surrounding it evolves. The result is a stringent framework of penalties, fines, and legal consequences for misclassifying workers. The key to avoiding these consequences is learning about the different classification tests and knowing when to use them.
How to classify your workers
As we said in the beginning, worker classification is complicated. In addition to individual states stipulating which test to use, the IRS and DOL each rely on different ones.
On top of that, the tests rarely produce a clear yes or no answer. Aside from the ABC test, the most commonly used tests require companies to assess a variety of factors, which makes it difficult to produce a clear, definitive answer.
Here’s a rundown of the four tests most commonly used in the US.
Economic Realities Test
The DOL relies on the Economic Realities Test under the FLSA of 1938 (FLSA) to determine worker classification. It evaluates the extent of the worker’s economic dependence on the hiring company to define the work relationship.
The test includes five factors, with no single factor being determinative:
- The nature and degree of the worker’s control over the work
- The worker’s opportunity for profit or loss
- The amount of skill required for the work
- The degree and permanence of the working relationship between the worker and the potential employer
- Whether the work is an integral part of the hiring company’s business
IRS 20-Factor Test
The IRS 20-Factor Test helped the IRS and many state agencies determine worker classification. It is the first published worker classification test companies could follow. Its guiding principle is that while companies have the right to control how, when, and where employees perform work, they do not have that right to do so with contractors and freelancers.
Specifically, the 20-Factor Test aims to determine the degree of control a company holds on a certain worker. It is important to note that it is not a definitive test since the weights of each factor changes per case.
The Borello Test was defined after the ruling on ‘Borello & Sons vs California’ in 1989.
The Borello Test includes is stricter than the IRS 20 factors, but like the previous test, it is not a definitive test so a worker should not pass all 11 factors to be defined as a freelancer.
The factors are also focused on the level of control a company holds on workers, as a rule, to define their relationship (see all 11 factors here). For example, some factors focus on the worker’s ability to profit or lose, who supplies their tools, and whether the length of the work engagement is temporary or indefinite.
The ABC Test is regarded as the strictest worker classification test in the States. It was defined as a classification test after the 2018 ‘Dynamex vs. California’ ruling.
Unlike previous classification tests, independent contractors and freelancers must meet ALL three factors. If they don’t meet just one of these requirements, the hiring company must classify them as an employee.
- The company does not control or direct what the worker does, either by contract or in actual practice.
- The worker performs tasks outside of the hiring entity’s usual course of business.
- The worker is engaged in an independently established trade, occupation, or business.
Which classification test implies?
This is a tricky question, as some states define the freelancers’ location as the defining jurisdiction (like California) and some define the company’s HQ to be the relevant one (like NY).
When looking at international workers, this becomes even a more complex question. One that only labor law legal consoles can advise per the freelancer’s location, your company’s international distribution, and the type of services they perform.
Keep it simple
Identifying the right classification test to use for each individual freelancer and doing it correctly is a challenge, especially if you work with more than just a few freelancers. Attempting to manage worker classification manually makes this challenge monumentally harder.
With the right tools, you can reduce this complexity, gain control over your worker classification, and eliminate the headache of guesswork. A Freelance Management System (FMS) is designed to help HR teams quickly and accurately classify workers by automatically identifying the correct test and periodically assessing the contractor relationship to ensure you stay compliant.