The U.S. Department of Labor (DOL), the government agency tasked with protecting the American workforce, recently released a rule that could affect how business owners classify their workers. Determining whether workers are independent contractors or employees is essential because making an incorrect classification can expose a business to labor lawsuits, penalties, and back payroll taxes. The rule relies on an “economic reality” test that assesses the degree to which the worker is economically reliant on a business for work. This change simplifies the classification process in some ways, but it generates new questions that business owners should be prepared to tackle when this rule goes into effect on May 7.
Old Guidelines vs. New Employee Classification Rule
There has never been a bright-line test for determining when a worker is considered an employee. Current DOL guidance lists seven economic factors that, when taken as a whole, can point to how the worker should be classified. No single factor is more important than the others; the DOL will look at the facts and circumstances holistically to determine how the worker is classified under the new employee classification rule. These seven factors are:
- The extent to which the services rendered are an integral part of the principal’s business.
- The permanency of the relationship.
- The amount of the alleged contractor’s investment in facilities and equipment.
- The nature and degree of control by the principal.
- The alleged contractor’s opportunities for profit and loss.
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
Because the test is subjective, some business owners worry that the DOL will make a different determination than their organization made internally. The new employee classification rule seeks to mitigate this uncertainty.
The rule also relies on economic factors, but rather than consider seven economic factors, the DOL will look to two “core factors” and – if needed – three “guidepost factors” for determining if the worker is an employee or independent contractor.
Core Factors
Core Factor #1: The nature and degree of the worker’s control over the work.
If the worker has substantial control over how they perform their duties, this points in favor of classifying the worker as an independent contractor. Of course, even independent contractors will need to comply with simple terms of the working arrangement – like meeting deadlines, being available for meetings, or health and safety requirements – but if the worker can control the manner in which they complete the work, they are likely to be considered an independent contractor.
Core Factor #2: The worker’s opportunity for profit or loss based on initiative or investment.
If the worker’s amount of work and investment in the business correlate with their ability to make a profit, they are likely to be considered an independent contractor. Under these new guidelines, the DOL will no longer consider how the worker’s investment compares to the investment made by the business. Such side-by-side comparisons fail to consider that contracted individuals will have fewer access to resources and do not always need to make hefty investments (like maintaining corporate offices) that potential employers may be making.
Both core factors in the new guidelines were present in the DOL’s original list of seven determining factors, but by highlighting these two, the DOL has signaled that these are the factors they find most compelling. If both factors clearly point to the same classification, there is no need to investigate further. But if there is any uncertainty, businesses and the DOL should consider the three “guidepost factors.”
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Guidepost Factors
Guidepost Factor #1: The Skill Factor
The DOL will consider whether specialized training or skill is required to complete the work but that the business does not provide. If such skill is required, the determination favors independent contractor status because the worker could market themselves to other organizations.
Guidepost Factor #2: The Permanence Factor
The DOL will consider how permanent the working relationship is between the two parties. The more permanent and exclusive the relationship, the more likely the DOL is to classify the worker as an employee.
Guidepost Factor #3: The Integrated Unit Factor
The DOL will consider whether the work performed is integral to the production process. If so, the DOL is more likely to classify the worker as an employee.
The three guidepost factors are less relevant than the two core factors, but they may need to be referenced to determine employee classification in certain working relationships.
Why Employee Classification Matters
When classified as employees, workers are provided certain rights under the Fair Labor and Standards Act (FLSA); independent contractors are not. Businesses are also required to withhold income taxes on behalf of their employees. Independent contractors are responsible for remitting their own payroll taxes to the government.
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What to Expect Going Forward
These rules are seen as interpretations of the FLSA. While authoritative in their own right, these interpretations stand second to the statutory language written in the Act itself. Courts may turn to the statutory language in the FLSA if there is any misunderstanding with the employee classification rule as written.
The independent contractor/employee discussion is also a hot topic at the state level. For instance, in this most recent election cycle, California overwhelmingly approved Proposition 22 that allowed gig economy companies like Lyft and Uber to continue classifying their workers as independent contractors. This had been a contentious issue in California when the state passed its ABC doctrine in 2018. Businesses will need to track state legislation like this closely as it has the power to affect state payroll requirements.
If you have questions about how your state handles the new employee classification rule or want to discuss your independent contractor questions with an advisor, contact our Landmark CPAs today.