The DOL has released a proposed rule that adopts an “economic reality” test to make it easier for employers to classify workers as independent contractors.
The United States Department of Labor proposed new guidelines for distinguishing independent contractors from employees in September. The proposal is the latest in a series of rules that aim to simplify the classification process. It emerges as more businesses look to reduce their employment costs through temporary hiring.
Independent contractors — including freelancers, consultants, and on-demand workers — are driving a burgeoning gig economy that could give small and medium-sized struggling with employment costs more hiring options. The 55 million gig workers who make up 1/3 of the U.S. workforce could increase their numbers to 43% this year.
With the steady rise in gig workers, economic slowdown, and spike in unemployment fueled by the pandemic, more SMBs can fulfill their need for skilled labor without relying solely on permanent, full- and part-time employees. But since working with contractors is different from hiring and managing employees, SMBs must know the rules that apply and the consequences for noncompliance.
The 55 million gig workers who make up 1/3 of the U.S. workforce could increase their numbers to 43% this year.
The basic difference between workers is that employees are on a company’s payroll and independent contractors are not. However, both the Fair Labor Standards Act and the IRS dive deeper into that distinction with their own set of guidelines.
The FLSA currently has a 6-point economic realities test (ERT) for classifying workers based on a past U.S. Supreme Court ruling. The criteria (in italics) suggest that workers:
- Are most likely employees if their work is an integral part of the employer’s business.
- Are most likely independent contractors if their managerial skills create opportunities for profit or loss.
- Fit the classification of independent contractors if they invest in the employer’s facilities and equipment.
- Could be either employees or independent contractors if their work requires special abilities and initiative.
- Are likely employees they and an employer have a relatively permanent relationship.
- Are likely employees If the employer has or maintains much control over how the work is performed.
The IRS has a more extensive, 20-point list of considerations for classifying employees. It’s summed up in 3 groups of questions:
Behavioral: Does the business owner control or have the authority to control what workers do and how they perform their jobs?
Financial: Does the business owner control the business facet of workers’ jobs, including:
- How they’re paid
- Whether they’re reimbursed for expenses that the payer controls
- Who provides their tools, supplies, and other job-related necessities
Type of relationship: Is the employer/worker relationship based on a written contract? Other questions to ask:
- Does it involve employee benefits — such as vacation pay, insurance coverage, and a pension plan?
- Is the relationship continuous?
- is the work a core aspect of the business?
Central to the DOL’s proposal is whether workers are in business for themselves (i.e., independent contractors) or economically reliant on an employer for work (i.e., employees). In an email interview for Workest, Richard Nowak, a partner at the international law firm of Mayer Brown, called the proposal a practical approach to classifying workers that stems from legal challenges.
“If implemented, the rule should help streamline both the DOL’s and courts’ review of classification status under the FLSA by focusing on actual, rather than theoretical, facts,” Nowak commented. He added that the proposal addresses only the FLSA’s wage and hour requirements — such as the minimum wage, overtime, and employee record requirements. It wouldn’t impact or change the standards that other federal, state, and local agencies use to classify independent contractors.
“If implemented, the rule should help streamline both the DOL’s and courts’ review of classification status under the FLSA by focusing on actual, rather than theoretical, facts.”
While the proposal addresses the same employment factors as the current rules and uses ERT as a “yardstick” for classification, it pares down the 6-point checklist into 2 core paradigms:
Control over key aspects of the work
Workers are likely to be independent contractors if they have substantial control over the nature and degree of the work they perform. They may, for example:
- Set their own work schedule
- Choose assignments
- Work with little or no supervision
- Work for other businesses, even an entity’s competitors
Although the control factor weighs more heavily towards the “employee” category if people lack control over key aspects of their work, the DOL makes clear that an assumption of control over a worker doesn’t necessarily define an employer/employee relationship under the FLSA.
For example, assuming that workers are employees if they’re required to comply with employment laws, health, safety, and quality-control standards, or contract-driven agreements such as project completion deadlines, won’t necessarily hold up under FLSA guidelines.
Also, the FLSA doesn’t guarantee that workers will be contractors just because they:
- Received a 1099
- Signed an independent contract agreement
- Have identification or paperwork declaring their services a business entity
- Are classified as contractors under state or tax laws
“For small business owners in states that do not have their own guidelines, identifying who is a contractor will be easier.SMBs must be as aware of their own state’s rules as the federal provisions. Rania Sedhom, managing partner at Sedhom Law Group, PLLC, told Workest that the proposal will streamline and clarify the classification process, but will be more complicated for employers in states with their own classification rules.
“For small business owners in states that do not have their own guidelines, identifying who is a contractor will be easier,” Sedhom said via email. “For small business owners in states like NY, the proposed federal rule will have less effect [because] business owners must conduct separate analyses under both state and federal law.”
Profit or loss opportunity
The proposal suggests that workers are independent contractors if they have an opportunity for profit or loss resulting from an investment or initiative. The worker gains a profit or loss by either:
- Exercising a personal initiative, including business expertise or a managerial skill, or
- Managing investments or capital expenditure in — for instance — personnel, materials, or equipment
Other factors the proposal considers are:
Skills. Since having control over the work performed is an inconclusive means of classifying workers, the proposal gives greater weight to the level of skills required to perform a job over the degree of control over the work.
Permanence. Workers with a long-term or continuous relationship with an employer are likely to be employees. An independent contractor’s working relationship with an employer is likely finite or random.
Integrated unit. This factor weighs in favor of employees who are part of an employer’s integrated production process for goods or services. The proposal doesn’t require an assembly-line procedure. However, the employee’s work must be interdependent on others in the production process. It must also contribute to what DOL describes as a “specific unified purpose.”
Marty Young, CEO and co-founder of Buckle, Inc., a tech-enabled financial services company, told Workest that the proposal isn’t much different from the current rules on both the federal and state levels. “It’s a clarification, not a complication,” Young commented via email. “To us, it’s just restating what folks are already reporting in their Schedule C tax returns. The IRS implemented the ‘economic reality test’ years ago.” He attributed any possible confusion over the proposal as instigation from “big labor” influences.
Penalties for noncompliance
The list of penalties for misclassifying workers is long and often substantial. Wage violations may require compensation for back pay, overtime, and minimum wages. A penalty can be as high as $1,000 per impacted worker and up to a year in jail. Also, employers may owe state and federal payroll taxes. These taxes include Social Security and Medicare taxes under the Federal Insurance Contributions Act for each misclassified contractor.
Also, workers whom the courts rule as eligible for reclassification can claim benefits, such as:
- Health coverage
- Paid time off
- 401(k) plan participation
- Stock purchases
- Break times
Microsoft settled a $96.9 million misclassification lawsuit against freelancers more than 2 decades ago. In Vizcaino vs. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997, the court ruled that the freelancers were treated like employees while being denied benefits and wrongly classified in signed agreements as independent contractors. The company also had avoided paying payroll taxes. The massive settlement required the tech giant to pay the plaintiffs back pay, benefits, and other forms of restitution.
Impact on SMBs
Young thinks the DOL is very likely to adopt the proposal. “The gig economy is here to stay, and gig workers have to be part of the human capital plan of any SMB, especially during COVID-19,” Young commented. “This proposal will make it easier for SMBs to adapt their human capital requirements to market conditions with lower risk.”
Sedhom also thinks the proposal is very likely to pass; it has a noncontroversial nature and SMBs’ assurance that gig workers will meet ERT requirements. But she cautions against hiring typically short-term gig workers for full-time, lengthy periods. Doing so creates a risk of misclassifying gig workers as employees.