Employee vs. Independent Contractor: DOL Issues New Guidance

Is the worker performing services for a business considered an independent contractor or an employee? Misclassifying employees as independent contractors is a crucial issue that poses significant costs to workers and employers. In January, the U.S. Department of Labor released a final rule for worker classification to provide clearer guidance to businesses and mitigate the risk of employee misclassification. 

What was Announced?

The final rule, Employee or Independent Contractor Classification Under the Fair Labor Standards Act, attempts to provide employees with a minimum wage and proper protections. It also aims to ensure that employers do not operate at a disadvantage if they appropriately classify their employees relative to those employers that do not.

The updated guidance takes effect on March 11, 2024, and replaces the 2021 Independent Contractor Rule, which the DOL states is inconsistent with established judicial precedent and raises the risk of misclassification. When the rule comes into effect, employers will have a 60-day window to assess their workforce and ensure compliance with the revised standards. 

The Final Rule on Worker Classification

The new rule states that a worker is not an independent contractor if they are economically dependent on an employer for work. To determine if a worker is economically dependent, employers must consider six factors:

1. The worker’s 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. The extent to which the work performed is an integral part of the potential employer’s business
6. Skill and initiative

When evaluating the different factors for a worker, the economic reality” test will apply. This test considers the entirety of the circumstances, with no single factor being conclusive. Unlike the previous standards, where certain factors carried more significance than others, the final rule does not assign varying weights to the factors.

Applying Each Factor

Let’s take a closer look at how the final ruling describes each factor. 

1. The worker’s opportunity for profit or loss depending on managerial skill. This factor assesses how a worker’s managerial skills influence their potential for profit or loss. Managerial skills include their ability to negotiate pay or choose to accept or decline work. The rule lists some facts employers should consider when making this determination but cautions that the list is not exhaustive. 
2. Investments by the worker and the potential employer. This factor considers whether costs by the worker are either capital or entrepreneurial in nature. Expenses incurred by a worker for tools and equipment essential for a specific job, labor expenses, and costs imposed exclusively by the potential employer do not signify capital or entrepreneurial investment and suggest employee status. Conversely, expenses that help workers reduce costs or expand market reach may be considered capital or entrepreneurial investments and suggest an independent contractor.  
3. Degree of permanence of the work relationship. This factor focuses on the relationship between the worker and the employer. If the relationship is indefinite, continuous, or exclusive for the employer, then the worker is considered an employee. The opposite factors would show in favor of an independent contractor; however, if the work is seasonal or temporary because of the nature of the industry, independent contractor status would not be definitive. 
4. Nature and degree of control. This factor considers the employer’s control over certain aspects of the work relationship, including whether the employer can set the worker’s schedule or supervise the performance of work. More control over the worker by the employer may indicate an employee’s status and vice versa. 
5. The extent to which the work performed is an integral part of the potential employer’s business. This factor considers whether the function that the worker performs is integral to the performance of the business. Work that is considered critical, necessary, and central to the employer’s principal business would indicate an employee classification.
6. Skill and initiative. This factor considers the degree of specialization of the worker’s skills to perform the work and whether the skills contribute to a business-like initiative. Specialized skills alone do not conclusively determine one classification over the other. However, the combination of specialized skills and a business-like initiative may suggest independent contractor status.

The Impact on Businesses and Employees

Worker classification has tax withholding and unemployment tax implications. Generally, employers are required to withhold income tax and contribute to and withhold Social Security and Medicare tax from an employee’s wages. They report these amounts on a Form W-2. Conversely, employers are not required to do this for independent contractors. Instead, independent contractors often may not have tax withheld from their pay, making them responsible for making estimated tax payments to the government. They also must pay both the employer and employee portion of their Social Security and Medicare tax and receive a Form 1099 from the business for which they performed services rather than a Form W-2. Regarding unemployment tax implications, state governments typically receive contributions from employers to fund the programs for workers classified as employees but not for those considered independent contractors. 

In contrast, workers classified as independent contractors often can treat some expenses as business deductions. Assuming this is done appropriately, these expenses can reduce the workers’ employment tax, providing them with some financial advantage. However, as the worker approaches social security eligibility, this advantage may turn into a disadvantage if it reduces the worker’s social security benefits.

Given the updated guidance, a greater number of individuals presently categorized as independent contractors will be reclassified as employees. This shift entitles these employees to specific protections, including overtime wages and the minimum wage. They may also become eligible for retirement benefits or healthcare insurance.

Final Thoughts

How workers are classified affects both the workers and the employers. The new rule highlights the importance of considering all relevant factors when determining worker classification. Businesses should consider reviewing their workforces and making necessary updates with the revised guidance. 

By Ashley Akin, CPA

Sources

Employee or independent contractor? DOL issues new guidance (journalofaccountancy.com)

Frequently Asked Questions – Final Rule: Employee or Independent Contractor Classification Under the FLSA | U.S. Department of Labor (dol.gov)

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