What is a statutory employee? Understanding the impact of worker classification

A statutory employee is a worker who would be considered an independent contractor under common law rules but must be treated as an employee for certain tax purposes. For many businesses, the rules regarding statutory employees can add complications to compliance and other business processes, particularly because of the potential financial and legal repercussions of misclassifying workers.

Independent Contractors vs. Employees

Businesses face different legal requirements for independent contractors versus employees. Let’s examine how these requirements differ and the responsibilities a business has toward both kinds of workers.

Requirements for Employees

• Businesses must comply with FLSA wage and hour laws, including minimum wage and overtime requirements, as well as state requirements for employers.
• Businesses are responsible for paying employment taxes and collecting payroll taxes for their employees.
• Businesses typically provide employee benefits to these workers – some of which may be required by state law, such as and unemployment insurance.

Requirements for Independent Contractors

• Independent contractors generally do not have these same protections.
• Because independent contractors are not covered under the FLSA, businesses are not required to pay them minimum wage or overtime pay.
• Businesses do not pay employment taxes on independent contractors and are not responsible for withholding payroll taxes.
• Most businesses do not offer benefits to independent contractors.

These differences may mean that classifying workers as independent contractors rather than as employees could make things easier for businesses. However, businesses cannot choose to classify a worker however they want – they must follow the legal definitions and guidelines regarding worker classification.

The difficulty with this task is that there are multiple sets of definitions and ever-changing rules. For example, on March 11, 2024, the Department of Labor (DOL) adopted a new rule governing worker classifications. Replacing the ABC test, which classified workers using three criteria, the new DOL rule uses an “economic reality” test with six elements:

1. The opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the potential employer
3. The degree of permanence of the work relationship
4. The nature and degree of control
5. The extent to which the work the person is performing is an integral part of the potential employer’s business
6. Skill and initiative

The Consequences of Worker Misclassification

While it can be difficult to keep up with the evolving regulations surrounding worker classification, it’s vital for business operations, as misclassification could result in regulatory actions and lawsuits. This may be true even if the worker agreed to the classification, since the DOL states that workers cannot waive their FLSA rights.

Worker classification disputes are often expensive for businesses. For example, Human Resources Director reports that Uber has agreed to a settlement of $8.4 million over a worker misclassification lawsuit alleging that the company misclassified workers as contractors when they should have been employees.

What is a statutory employee?

The difference between independent contractors and employees is already confusing and can be subject to interpretation. The addition of statutory employees adds another layer of complexity.

According to the IRS, certain workers considered to be independent contractors under the rules of common law must be treated as employees by statute for certain tax purposes. There are four categories of statutory employees:

• Certain drivers. Two groups of drivers fall into this category. The first are drivers who distribute beverages (other than milk) or meat, vegetables, fruit or bakery products. The second are drivers who pick up and deliver laundry or dry cleaning if the driver is the employer’s agent or is paid on commission.
• Some life insurance sales agents. This applies if the life insurance agent is a full-time worker whose principal business activity is selling life insurance, annuity contracts or both, and who sells these policies primarily for one life insurance company.
• Certain home-based arrangements. Statutory employees in this category must work at home on materials or goods that the employer supplies. The goods or materials must be returned to the employer or a person named by the employer, and the employer must provide specifications for the individual’s work.
• Traveling or city salespeople. This is applicable if the salesperson works on a full-time basis on the employer’s behalf and turns in orders from wholesalers, retailers, contractors or operators of hotels, restaurants or other similar establishments. The goods must be merchandise for resale or supplies for use in the buyer’s business operation. Lastly, the work for the employer must be the salesperson’s primary business activity.

Officers may also be statutory employees. For example, the IRS states that the officers of an exempt organization may be considered statutory employees because they are deemed employees by statute. However, these workers would not usually be classified as independent contractors and would face different tax rules (see below).

States may also have regulations related to employee classification. For example, corporate officers are considered statutory employees in California, as are certain drivers, salespeople and home workers.

Social Security Taxes for Statutory Employees

When workers meet the criteria for classification as statutory employees, employers are responsible for withholding Social Security and Medicare taxes from their wages if the following three conditions apply:

• The service contract states or implies that substantially all of the services are to be performed personally by the statutory employee.
• The statutory employee does not have a substantial investment in the equipment and property used to perform the services. This consideration excludes an investment in transportation facilities.
• The statutory employee performs services for the same payer on a continuing basis.

When statutory workers are not corporate officers, the IRS says the employer should indicate the worker’s classification as a statutory employee on their W-2. Non-officer statutory employees report their wages, income and allowable expenses on Schedule C or Schedule C-EZ (Form 1040), but they do not have to pay self-employment taxes because their employers must treat them as employees for tax purposes.

What are statutory nonemployees?

It is important not to confuse statutory employees with statutory nonemployees. The IRS classifies three groups of workers as statutory nonemployees:

• Direct sellers
• Licensed real estate agents
• Certain companion sitters who may provide personal attendance, companionship or household care services to children or elderly or disabled individuals

The IRS says direct sellers and licensed real estate agents should be treated as self-employed for all federal tax purposes, including both federal income taxes and employment taxes. This applies as long as substantially all payments for their services are directly related to sales or other output (rather than the number of hours worked) and they perform their services under a written contract that states they will not be treated as employees for federal tax purposes. Likewise, companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed.

Have you classified your workers correctly?

Worker classification is a high-stakes issue, and the rules surrounding statutory employees further complicate this matter. If you’re uncertain about the correct classification for your workers and what this means for your obligations, you can refer to the IRS Employer’s Supplemental Tax Guide for additional details.

Do you need guidance on statutory employees, worker classification or other HR issues? Higginbotham can help. Our team of HR professionals can offer outsourcing and consulting services, including payroll outsourcing and compliance assistance. Get in touch with a member of our team to learn more.