Independent Contractor vs Employee: The IRS Test and AB5 California Standard

A Misclassification Can Cost Millions—and It Happens Every Day

In 2016, FedEx settled a class-action lawsuit over driver misclassification for $228 million. In 2019, Uber and Lyft faced a California ballot initiative, Proposition 22, after a state law threatened to force reclassification of their entire driver workforce. The IRS estimates that worker misclassification costs the federal government billions in unpaid payroll taxes annually. Whether a worker is an employee or an independent contractor is not merely a paperwork formality—it determines who pays Social Security and Medicare taxes, who is entitled to minimum wage and overtime protections, who can file for unemployment, and who can join a labor union. And the answer depends on which legal test applies, because no single nationwide standard exists.

Why Classification Matters: Rights at Stake

Employees and independent contractors occupy fundamentally different legal positions:

The IRS Common Law Test

For federal tax purposes, the IRS applies a common law test examining the degree of control the hiring entity exercises over the worker. The IRS groups relevant factors into three categories:

• Behavioral control: Does the company direct when, where, and how the worker performs tasks? Control over work schedule and methods indicates employee status.
• Financial control: Does the worker have a significant investment in tools or facilities? Can the worker profit or lose money from the work? A worker who bears financial risk is more likely an independent contractor.
• Type of relationship: Is there a written contract characterizing the relationship? Does the work performed represent a key aspect of the hiring company's regular business? A worker doing the company's core business is more likely an employee.

No single factor is determinative, and the IRS weighs all facts and circumstances. A worker who wears the company's uniform, works specified hours, uses company equipment, and cannot work for competitors is almost certainly an employee regardless of any contract language calling them a contractor.

California AB5: The ABC Test

California Assembly Bill 5, enacted in 2019 and codified at Labor Code § 2750.3, adopted the "ABC test" for most worker relationships—a stricter standard than the IRS test. Under AB5, a worker is presumed to be an employee unless the hiring entity proves all three prongs:

• A: The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both as a matter of contract and in fact.
• B: The worker performs work that is outside the usual course of the hiring entity's business.
• C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Prong B is the most consequential: a rideshare driver cannot be classified as an independent contractor under AB5 because driving rides is within Uber or Lyft's usual business. AB5 was the legal foundation for the 2020 California Supreme Court case Dynamex Operations West v. Superior Court, which held that thousands of delivery drivers were misclassified employees. Proposition 22, passed by California voters in November 2020, created an exemption for app-based transportation and delivery companies—exempting Uber, Lyft, DoorDash, and similar platforms—but was partially invalidated by California courts and remained subject to ongoing litigation as of 2024.

The DOL Economic Reality Test

For purposes of the federal Fair Labor Standards Act (FLSA), the Department of Labor applies an "economic reality" test that asks whether the worker is economically dependent on the hiring entity or is in business for themselves. Key factors include the degree of permanency of the relationship, the worker's opportunity for profit or loss, and the degree of control the hiring entity exercises over the worker's work.

Businesses operating in multiple states must navigate a patchwork of state and federal tests. The DOL's 2024 final rule on independent contractor classification reinstated the broader economic reality analysis, signaling continued federal scrutiny of gig economy business models. Proper classification is not just a legal compliance issue—it is a fundamental question about who bears the risks and costs of work in the modern economy.

This article is for informational purposes only and does not constitute legal advice. Consult a qualified employment attorney before classifying workers as independent contractors.