Identity Crisis: Employee or Independent Contractor?

by Kristen Duffeler

Determining whether a given worker is an independent contractor or an employee is an important consideration for all businesses.

Classifying workers as independent contractors can be less expensive for employers, generally allowing them to avoid contributions towards workers’ compensation, unemployment insurance, Social Security, and Medicare, as well as removing the worker from eligibility for benefits such as health insurance.

However, the risks of misclassification (that is, incorrectly or impermissibly classifying a worker who should be an employee as an independent contractor) are high.  If you are audited by the IRS, for example, the IRS can find you liable for unpaid employment taxes and assess additional fines and penalties.  In addition, the Department of Labor (“DOL”) may find violations of the Fair Labor Standards Act (“FLSA”) regarding unpaid overtime. Repercussions exist at the state level as well – in Virginia fines begin at up to $1000 per misclassified worker.

Obviously, it is important to properly classify your employees, and the rules have not always been clearly defined, often relying on a hodge podge of opinion letters, proposed rules and court cases.  Moreover, different government agencies sometimes have differing standards for determining classification; for example, the IRS and the DOL have similar, but not identical, criteria.

Out with Old (Rules), in with the New

If you are confused, you are not alone!  Fortunately, some clarity has been provided, at least in regard to the DOL and its enforcement of the FLSA.  On January 10, 2024, the DOL issued a final rule, effective March 11, 2024, regarding worker classification.  This rule rescinds the prior rules, which focused primarily on just two factors (the nature and degree of the employer’s control over the work and the worker’s opportunity for profit or loss). The new rule focuses on the “economic reality” of the relationship between the worker and the employer.

In the new rule, there is no one factor that determines classification. Rather, classification depends on the “totality of the circumstances”.  The DOL clarifies, citing court interpretation of the FLSA, that the key to any classification analysis “is whether, as a matter of economic reality, the worker is economically dependent on the employer for work (and is thus an employee) or is in business for themselves (and is thus an independent contractor).”   Under the current rule, in making this determination, the DOL will consider six primary factors, although other factors may be considered.

The Six Factors for Distinguishing an Employee From a Contractor

The six primary factors are:

(1) whether, and the degree to which, the worker has opportunities for profit or loss based on the worker’s managerial skill;

(2) the relative investments by the worker and business (for example, with regard to tools and equipment);

(3) the degree of permanence of the work relationship, including any exclusivity of work;

(4) the nature and degree of control the business can exercise over the worker (for example, over scheduling, or how the work is performed);

(5) extent to which the work performed is an integral part of the potential employer’s business; and

(6) the skill and initiative of the worker.

As mentioned above, no one factor is determinative.  Rather, each worker relationship must be evaluated under the totality of the circumstances to determine the appropriate classification.

“Totality of the circumstances” based analyses can be difficult to plan for because there is no single factor, or even a few, to plan around. Instead, each little variation in the relationship between an employer and a worker, and how those vary from other employer worker relationships, could have a different impact on the outcome depending on how the variation interplays with the other five factors. This makes planning ahead much more important. It is also important to remember that a working relationship can change and evolve, potentially affecting classification.

Next steps for the small business owner? Review your worker classifications in light of the new test. Ask yourself where your employer-worker relationship lies in each of these six factors, and why. Consult with your attorney, and plan accordingly. Then review your worker classifications on an annual basis, if possible, as well as independent contractor agreements. These steps should help you stay ahead of the requirements of the new rule and the evolutions of your working relationships.