The Tangled Web of Worker Classification: Different Legal Standards Weave Confusion

In August 2021, we published a short blog post on how the Internal Revenue Service and the Minnesota Department of Revenue determine worker classification for tax purposes. However, the risk of misclassification discussed in that post extends well beyond payroll taxes. It applies to unemployment insurance, workers’ compensation, fair labor and wage laws, third-party lawsuits, and much more. Moreover, while the IRS and Minnesota follow the traditional 20-factor common law test (relating to behavioral control, financial control, and relationship of the parties), many states follow different tests.

For example, in 2019, California codified a version of the “ABC” test. Under California’s new statute, a worker is an employee and not an independent contractor, unless the hiring entity can satisfy all three of the following conditions:

  1. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  2. The worker performs work that is outside the usual course of the hiring entity’s business; and
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

The test is incredibly difficult to meet and considerably more restrictive than the IRS’s 20-factor common law test.

Further, some agencies follow different standards even within the same state. For example, the Indiana Department of Revenue follows the IRS’s 20-factor common law test for withholding tax purposes. However, for purposes of unemployment insurance, the Indiana Department of Workforce Development follows a similar version of California’s ABC test. To complicate things further, the U.S. Department of Labor (DOL) recently issued a 184-page proposal to adopt new rules on determining worker classification, largely changing the way certain factors are considered in the DOL’s “economic reality” test. (The economic realty test examines several factors to determine whether a worker is economically dependent on the employer or whether the worker is in business for themselves.)

The difference in standards, whether between state or federal agencies, creates an administrative nightmare and increases the cost of labor. Legal confusion and aggressive state auditing puts many employers into untenable positions, often resulting in unprincipled settlements. For example, even though Uber still maintains its drivers are independent contractors, Uber agreed to pay $100 million plus interest to New Jersey after the state’s Department of Labor and Workforce Development claimed that Uber misclassified the drivers. The same is true for Instacart, which recently settled a classification lawsuit with the City of San Diego for $46.5 million. Instacart, however, still maintains its shoppers are properly classified as independent contractors.

While unprincipled settlements may be possible for large gig-economy companies, the same cannot be said for many small and mid-sized businesses. In particular, we are seeing aggressive worker classification auditing from the Minnesota Department of Revenue across many industries, including construction, healthcare, retail, transportation, computer software, and beyond. Employers must be aware of the legal standards governing classification of their workers, whether for tax, unemployment, or some other purpose, and should be ready to defend their position when the time comes.

  • Jennifer R. Pusch
    Senior Associate

    Jenny assists her clients on a variety of tax matters, including the following:

    • Tax Disputes & Litigation
      • State Corporate Income and Franchise Taxes, including nexus, Public Law 86-272, business versus non‑business income ...
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