Contractor or Employee? Correctly Classifying Your Workers

The Hawaiʻi Department of Labor and Industrial Relations (DLIR) formed a multi‑year partnership with federal agencies to address worker misclassification.

Under the partnership, state and federal agencies conduct joint investigations and expand educational outreach. Hawaiʻi businesses should review best practice for worker classification to avoid legal consequences.

If you hire freelancers or independent contractors, this update matters. On May 1, 2025, the U.S. Department of Labor issued a press release announcing it would loosen federal enforcement of the 2024 Final Rule: Employee or Independent Contractor Classification Under the Fair Labor Standards Act.

Key takeaways of the latest DOL announcement:

• Existing regulations of the final rule do not change. It became effective March 11, 2024, and updated how the DOL analyzes worker classification under the Fair Labor Standards Act (FLSA). The final rule rescinded the 2021 Independent Contractor Rule. It reinstated the “economic reality” test which evaluates the working relationship. This test considers the totality of the circumstances instead of a single factor.
• In its latest announcement, the DOL stated that the Wage and Hour Department “will no longer apply the 2024 Rule’s analysis” under the FLSA. Use the following factors to determine independent contractor status:
  • Under the final rule, workers who are economically dependent on an employer are not independent contractors.
  • The final rule uses six factors to determine employee or contractor status under the FLSA:
    (1) opportunity for profit or loss depending on managerial skill;
    (2) investments by the worker and the potential employer;
    (3) degree of permanence of the work relationship;
    (4) nature and degree of control;
    (5) extent to which the work performed is an integral part of the potential employer’s business; and
    (6) skill and initiative.

Contractor vs. employee—which is which?

The difference between an employee and an independent contractor is not always clear. Even the IRS notes that there is no single set of factors that determines whether a worker is an employee or an independent contractor. In addition, factors relevant in one situation may not be relevant in another.

Considerations for federal classification determination

Employers should evaluate all factors when determining how to classify a worker.

1. Behavioral control. Does the employer have the right to direct and control the worker? Do they specify how, when, or where to do the work, or provide the tools and equipment? If so, the worker should likely be classified and paid as an employee.
2. Financial control. If the worker has a significant investment in the job or if they are reimbursed for some or all businesses expenses, the individual is likely an independent contractor. Workers who can earn a profit or incur a loss are more likely to be independent contractors.
3. Type of relationship. A worker that receives benefits, such as insurance or paid leave, and who is considered a key aspect of the regular business of the company, is probably an employee.

The IRS instructs employers to look at the entire relationship. You must consider the degree of control and use each of these factors when coming up with the classification determination. For more information on how to differentiate between an employee and independent contractor, the IRS suggests referring to Publication 15-A.

What are the consequences of misclassifying employees?

Even unintentional misclassification can result in serious consequences. The employer may be held liable for employment taxes for the worker and will likely be faced with at least the following penalties:

• $50 for each Form W-2 that the employer failed to file.
• Employers may owe penalties equal to 1.5% of the employee’s wages. They may also owe 40% of unwithheld FICA taxes and 100% of the employer’s FICA contributions. Interest is also accrued on these penalties daily from the date they should have been deposited.
• A Failure to Pay penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

Misclassification also increases the risk of third-party and class-action lawsuits. If the business is guilty of intentional misclassification or fraud, the IRS can impose additional fines and penalties.

How do Hawaiʻi rules differ from the federal test?

Steps to protect your business

Your company should aim to ensure that every new hire and current worker is properly classified. Consider specifying the working relationship between your company and the worker in the job offer letter and make sure it applies. At the same time, understand that simply having a worker sign an agreement that states they are not an employee does not necessarily make it so.

If your company or the new worker has questions about classification, you can request that the IRS evaluate the relationship. The IRS will make the determination for you by filing Form SS-8. The IRS review process can take six months or longer. During that waiting period, it’s best practice to treat the worker as an employee in order to avoid any potential penalties.

To learn more about correctly classifying your workers, visit the IRS webpage. Employers should consult with their HR representative to ensure compliance with applicable state laws.

This article is for informational purposes only and does not constitute legal advice. Readers should first consult their attorney, accountant or adviser before acting upon any information in this article.