Independent Contractor Classification
Final Rule: Under the Fair Labor Standards Act - Effective March 11th
Many of our clients have both W2 employees and independent contractors working for them. Sometimes the lines can seem to be blurred and perhaps conflicting. Hopefully this article will assist you in determining if you have properly classified your workforce as employees or independent contractors to avoid liability under the Final Rule.
If you currently have independent contractors that work for your organization or you are thinking about hiring them, what does this Final Rule mean for you? The answer depends on an evaluation of the 6 factors that are discussed in the Final Rule. The most important thing to remember is that the outcome of the evaluation will be largely determined by the person’s “economic dependence” on the company. Therefore, any of your contractors who perform substantially all of their work for your company are most likely “economically dependent” on your company, and you may have misclassified them as contractors.
If any of these questions have you continue to believe your workers may be misclassified, keep reading.
Following is a brief summary that should help guide you through the evaluation process:
The Final Rule:
The Final Rule became effective on March 11, 2024. This rule rescinds the 5-factor test which was more employer friendly and was replaced with a 6 factor economical test that is more employee friendly.
The previous 5 factor test emphasized the nature and degree of the worker’s control over the work and the worker’s opportunity for profit and loss. All of the factors were weighted equally. The new 2024 rule considers all 6 factors to determine the overall question of economic dependence. Ask yourself this question:
1. Does the person rely on the employer for economic dependence or do they generate business for themselves? The 6 factors define whether or not the worker is economically dependent on an employer for work or if they are in business for themselves.
o An employee is economically dependent on an employer for work.
o An Independent Contractor is a worker who is in business for themselves.
The DOL’s final rule is an economic reality test that focuses more broadly on a worker’s economic dependence on an employer, considering the totality of the circumstances.
Here are the 6 factors to determine economic dependance:
1. Opportunity for profit or loss depending on managerial skill.
This test allows the employer to understand if a worker can earn profits or suffer losses through their own independent effort and decision making. For example, does the worker negotiate pay? Do they decide when to accept and decline work? Do they hire their own workers, purchase their own equipment, or engage in efforts to expand the business (marketing, advertising, etc.)? Having a real opportunity to take actions and make a business decision on rather or not to earn more or less profit indicates the worker is an independent contractor as opposed to not taking such actions and having to get approval to advertise, purchase equipment, etc. indicates the worker as an employee.
By truly understanding if the worker can earn profits or suffer losses through their own decision making (taking on more or less work, securing more clients, making efforts to grow or reduce business, etc.) this will help determine the status of the worker.
If you have a contractor who does not exercise their own independent effort when making a decision, it is recommended that you consider re-evaluating their status.
2. Investments by the Worker and Employer
· This factor focuses on capital and entrepreneurial investments. Ask yourself – are you the employer dependent on the worker to support the growth of the business or does the worker have to depend on their own investments in equipment, business, marketing, etc. to grow? Investments by a worker that support the growth of a business, increasing number of clients, etc. tend to weigh in favor of an independent contractor classification. If there are no capital or entrepreneurial investments, it is more likely that the person should be classified as an employee.
· For example, if a worker purchases their own software, rents their own space, purchases advertising, finds new clients, this indicates independent contractor status. If the worker uses an employer’s software, works at the employer location, and relies on the supplies to be provided by the employer, the worker is likely to be considered an employee.
3. Degree of Performance of the work relationship
The degree of performance factor primarily looks at the nature and length of the workers’ relationship to your business. When the work relationship is continuous, indefinite, or the person is not permitted to work for any other employer without permission, this factor weighs in favor as the worker being classified as an employee. When work is nonexclusive (the worker can work for anyone), project-based, definite in duration (a start and end date is clear), this weighs in favor of the worker being classified as a contractor.
For example, if the worker creates trainings as specifically directed by the employer, has a regularly scheduled training time each week, is evaluated based on the outcome of the training, and the training is continuous, this would favor more toward employee status. On the other hand, if the worker has multiple different clients they present trainings for, creates their own content, is not evaluated, and is called whenever the employer needs the specific training for a specific period of time, this would favor more toward independent contractor.
4. Nature and Degree of Control over the work
Ask yourself - What level of control do you have over the worker? What are the economic aspects of the working relationship? The more control you have over the worker, the more likely the worker is to be considered an employee. “Control” is evaluated by looking at performance, setting the work schedule, supervising the work, hiring, firing, pay rates, etc. When you maintain more control over these aspects of the working relationship, this factor weighs in favor of the person being more properly classified as an employee.
For example, if a chef is making food for an event at a venue and the venue sets the schedule with input from the staff regarding schedule, what food they want, evaluates how good the food is, whether or not the chef is on time, what the pay rate is, etc. this may indicate employee status under the control factor. However, if the chef has their own rate, sets the days/time they are available, can hire their own staff, this indicates less control by the employer and more control of the worker making the worker more in favor as an independent contractor.
5. Extent to which the work performed is an integral part of your business
Ask yourself these questions:
1. what is the importance of the work that is being done
2. Is this work an important part of your business?
3. Is this work an integral part of the business?
If yes, this is a good indicator that the person would be classified as an employee. If no, meaning that the work performed by the worker is not critical, necessary, or central to your business, this is a good indicator that the worker should be classified as an independent contractor.
Here is an example: if a payroll employee has been terminated and you decide to hire a contractor to perform the job, this would raise a red flag because payroll is an integral part of your operations and now the worker doing it is considered an independent contractor. This would most likely be considered a misclassification. Alternatively, if you decide to pay an accounting firm to file your annual taxes, since the accounting support is not critical or an integral part of the business, this firm and the worker at the firm would be considered an independent contractor.
6. Skill and initiative.
· Does the worker use their own specialized skills in connection with business initiative or does the worker rely on you to provide training for the job? If the worker does not rely on you to perform the work, support, or grow the business this is a strong indicator of independent contractor status. If they do rely on you to provide the training, this is a strong indicator of employee status.
· For example, if you have an electrician providing services to your manufacturing company, if the electrician does not make any independent decisions at the job site beyond what they are asked to do, if they do not determine their schedule, what materials they need, and if they are told what to do and where to go, these facts would be a strong indicator of employee status. On the other hand, if the electrician services a number of different clients with their specialized skill, uses their skills for marketing purposes, etc. these facts tend to indicate independent contractor status.
The Department of Labor will consider anything else they believe shows the contractor was an employee or an independent contractor.
If any of the answers above seem to indicate that your contractor might be misclassified, it is recommended that you re-evaluate their employment classification and seek guidance for how to proceed moving forward. To ensure you are in compliance with the Final Rule it is recommended that you engage in the following actions:
· Take inventory of all the classifications for workers with 1099 status
· Conduct an internal audit by evaluating the 6 factors
· Make sure that when you decide to hire an independent contractor, you understand how the person will be engaged and what the agreements are.
· Conduct routine checks on your contractors. It is important to ensure independent contractors have not become employees over time due to a shift in the nature of their work.
· Remember - Even if a worker has requested to be classified as an independent contractor, this is not a valid defense to a misclassification claim.
Misclassification Penalties
· Misclassification penalties depend on several factors, such as the size of your business size and the amount of time you avoided paying employment benefits and taxes. Keep in mind that the penalties can be more severe if the misclassification is intentional.
Penalties include, but are not limited to:
· Tax violation fines
· Federal Law violation fines
· Harmed reputation and loss of business
Feel free to reach out to us here at Advisor HR to provide you with support and assistance.