New Rule by the DOL – Correctly Classifying Independent Contractors
by Allison Hosgood and Nicole Bennett
The US Department of Labor (DOL) has changed the rule regarding classification of employees and contractors.
The DOL has stated that this new rule, which took effect on March 11, 2024, is more consistent with court decisions, will help reduce the risk of misclassifying employees as independent contractors, and allows businesses to become more confident working with individuals in business for themselves. However, the new rule generally makes it more difficult to classify workers as independent contractors rather than employees.
This is important to take note of because a large number of employers hire people as contractors and often do so to avoid taxes or because they want to “try” workers out before making a commitment to hire them as employees.
Further, with the ever-changing business environment, hiring challenges, and the expense of doing business – ranging from increased benefit and business insurance costs, higher compensation demands, increased regulations with employees, challenges with retention, and the list goes on – many employers, including many of APW’s clients, are considering engaging domestic and/or foreign contractors. Consequently, the number of service providers available to help with this has grown as well.
As the employment market changes before our eyes, we’re seeing more gig workers, freelancers, and self-employed people with specific and unique skill sets and experience than in years past. Hence, engaging contractors has become even more attractive to companies that are desperate to find quality talent.
The bottom line is that it’s more important than ever to be sure you’re correctly classifying workers, and here’s what you need to know…
Fair Labor Standards Act
Let’s first start with the Fair Labor Standards Act (FLSA), its purpose, and some definitions. The FLSA is a federal law that establishes minimum wage, overtime pay, recordkeeping, and child labor standards. These laws are applicable to full-time and part-time employees in the private and public sector.
While the FLSA does not define “independent contractor,” the DOL does provide the definition and the rules for determining whether an individual is an independent contractor or an employee for the purposes of FLSA – how they are paid, how much they need to be paid, etc.
An Employee is defined as “any individual employed by an employer.” An employee completes an IRS W-4 Form for the employer to withhold federal income tax from paychecks and receives an IRS W-2 Form (Wage and Tax Statement) from the employer reporting the employee’s income and tax that was withheld.
A Contractor is defined by the DOL as a worker who is in business for themselves. A contractor typically has a signed contractor agreement that specifically addresses the work to be performed and the relationship with the company engaging them. The contractor completes a Form W-9 (Request for Taxpayer Identification Number and Certification) and submits an invoice to the company for services rendered and money owed. The contractor also understands they take on the risk of not being paid for poor performance or unsatisfactory deliverables.
It’s important to point out that even though payroll systems allow you to pay contractors, paying them through the payroll process is one more action on a company’s part of treating a contractor like an employee. Therefore, it’s recommended that contractors be paid through the company’s accounts payable process instead. Paying contractors through accounts payable helps to further distinguish that the company is paying an invoice for services rendered, not hours worked.
Contractors are required to pay their own employment taxes and, depending on earnings, typically make estimated tax payments directly to the IRS throughout the year. Contractors receive 1099 statements by the end of January each year from the company to file with their tax returns.
The DOL Rule Change
The DOL’s previous rule (adopted in 2021) used a multi-factor test to determine whether a worker was economically dependent on an employer but gave greater weight to two “core elements”: the nature and degree of control over the work and the individual’s opportunity for profit and loss. The prior rule did not consider a worker’s investment or whether the work was integral to the employer’s business as separate factors.
Effective March 11, 2024, the DOL’s new rule imposes a new six-factor “economic reality test” to determine if an individual is an independent contractor or an employee, framed and determined by, “when analyzing the economic realities of the working relationship” as stated by the DOL’s Wage and Hour Division webpage in the “Small Entity Compliance Guide.”
The new rule assigns equal weight to each of these six factors, and no one factor is determinative, which means that all these factors need to be considered. The purpose of the test is to determine whether, as a matter of “economic reality,” a worker is economically dependent on a company for work or in business for themselves based on the “totality of the circumstances” of each individual case. If they are economically dependent, they are an employee.
Six-Factor Economic Reality Test
Below are our quick interpretations of the six factors in the new rule along with prompt questions that can aid in determining worker classification. You can find the DOL’s exact wording of these six factors and explanations for each in items 13-18 under Substance of the Final Rule here.
1. The worker’s opportunity for profit or loss, depending on managerial skill.
Question: Can a worker increase their own profits through their efforts and negotiations with the company?
Example: Can the worker determine or negotiate their charge or pay for the work they provide? Can they choose the time it takes to do the job and, in some cases, when the work gets done?
Answer: If yes, the worker can increase their profits through their efforts and negotiations with the company, this factor weighs in favor of independent contractor status.
2. Investments by the worker and the company.
Question: Is the worker making similar types of capital and entrepreneurial investments to their own benefit when working for the company?
Example: Does the worker invest in tools and equipment that allow them to work for multiple companies?
Answer: If yes, the worker is making similar types of capital and entrepreneurial investments in their work that benefits them in the work they provide the company, this factor weighs in favor of independent contractor status.
Additional Notes: If the company requires a worker to purchase tools and equipment that have little use in other jobs, this is not considered an investment in their business as a contractor.
3. The degree of permanence of the relationship.
Question: Is the worker engaged in a more permanent, continuous role with the company or a more open-ended relationship?
The worker is more likely to be an independent contractor when the work relationship is non-exclusive and project or sporadic based, allowing the worker to be in business for themself and marketing their services or labor to multiple employers. The worker may have regularly occurring fixed periods of work, but the worker must have some say in the matter – if they wish to take on a project or not.
Answer: If the answer is no, the worker is not engaged in a more permanent and continuous relationship with the employer, then this factor weighs in favor of independent contractor status.
4. The nature and degree of the company’s control over the work.
Question: Does the company have actual and “reserved” control over the worker?
“Reserved” control means control the company could exert control and direction, even if it never does. The greater the degree of control, the more likely the worker is an employee. Example: Does the company set the worker’s schedule? Does the company supervise the performance of the work? Does the company limit the worker’s ability to work for others? The rule also considers whether the company “controls economic aspects of the working relationship,” including price and rates for service, and allows worker the ability to market themselves for other contracted services, etc.
Answer: If the answer is no, the company does not have actual and “reserved” control over the worker, the factor weighs in favor of independent contractor status.
5. The extent to which the work performed is an integral part of the company’s business.
Question: Is the work being performed “critical, necessary, or central” to the company’s principal business?
If the company’s primary business is to make a product or provide a service, the workers involved in making the product or providing the service are performing work that’s integral to the company’s business. Contractors typically provide expertise in their work but aren’t performing the day-to-day work of the company. Companies may have difficulty establishing that a worker does not provide services that are integral to their business.
Answer: If no, the work being performed is not “critical, necessary, or central” to the company’s principal business, this factor weighs in favor of independent contractor status.
6. The worker’s skill and initiative.
Question: Are the worker’s skills specialized, unique, or advanced?
If a worker is not using specialized skills, or they depend on training from the company to perform the work, they are more likely an employee versus a contractor.
Answer: If yes, the worker’s skills are specialized (and are not dependent on training from the company), this factor weighs in favor of independent contractor status.
Keep in mind that there likely will be variables and different circumstances from case to case, so the new rule is designed to consider all six factors for each classification review. Also keep in mind that this list of six factors is not exhaustive. If questioned, other “additional factors” may be considered and auditors will be looking to see what factors indicate whether the worker is in business for themself, as opposed to being economically dependent” on the company for work.
The Risk of Misclassification
As you can see, through this new six-factor test, it becomes more difficult for companies to justify classifying workers as independent contractors. Therefore, it’s important to carefully evaluate each worker providing independent contractor services by applying all six factors to ensure the worker has been properly classified. You may also want to ensure your company has a vetted independent contractor agreement consistent with DOL’s guidelines and speaks to the various six factors of the new rule.
Risks of misclassification will take into account minimum wage and overtime as well as benefits not paid, workers’ compensation not accounted for, employment tax not paid, and more. It could result in being responsible for paying liquidated damages such as back pay and civil penalties. Further, the company may be exposed to an audit that may reveal other infractions.
Resources to Aid in Making Determinations
While the questions for the Six-Factor Economic Reality Test are intended to help make proper classification easier, there are many terms or phrases used by the DOL that may not be as clear as we would like. Again, the DOL provides further definition, explanation, and examples here.
Due to the complexity and interpretation of the factors and the financial risks involved in misclassifying workers, you may want to seek counsel to assist with the evaluation of your independent contractors. APW is also a convenient resource to help you review your company’s roles and the work individuals are performing and provide guidance on appropriate classification. We’d be happy to help.
Citations:
Small Entity Compliance Guide | U.S. Department of Labor (dol.gov)
Frequently Asked Questions – Final Rule: Employee or Independent Contractor Classification Under the FLSA | U.S. Department of Labor (dol.gov)
U.S. Department of Labor Issues New Final Rule for Classifying Independent Contractors, Effective March 11, 2024 | Snell & Wilmer (swlaw.com)
Employee or Independent Contractor Classification Under the Fair Labor Standards Act | Federal Register: The Daily Journal of the United States Government (federalregister.gov)
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