The U.S. Department of Labor (DOL) published its final rule on independent contractor classification consisting of a six-part “economic reality” test and formally repealed the 2021 “core factors” test. The final rule is to become effective on March 11, 2024.  The repealed core factors test prescribed a five-factor test to guide the analysis, two of which were designated as “core factors” carrying more weight in the inquiry: 1) nature and degree of control over the work, and 2) the worker’s opportunity for profit or loss.  The new six-factor economic reality test looks broadly to the “totality of the circumstances” to determine whether a worker is generally considered an independent contractor (IC) or employee (E) under the Fair Labor Standards Act (FLSA). 

While employers commonly use the terms “W2 Employees” and “1099 Employees” to distinguish between categories; this is simply wrong.  The distinction is between Employees and Independent Contractors, not between the method of reporting income to the IRS.  All employees have their incomes and tax withholdings reported on IRS Form W-2.  All Independent Contractors have the payments made to them by their various clients reported on IRS Form 1099, Miscellaneous Income.  Suggesting that either tax reporting method can be used for Employees or Independent Contractors independent of the nature of the actual relationship with the Employer is what has caused Employers to incur significant penalties from the Department of Labor and the IRS.

Fair Labor Standards Act (FLSA)

This final rule addresses how to determine whether a worker is properly classified as an employee (e.g., W-2 employee) or independent contractor under the Fair Labor Standards Act (FLSA).   FLSA generally requires covered employers to pay nonexempt employees at least the Federal minimum wage for all hours worked and at least one and one-half times the employee’s regular rate of pay for every hour worked over 40 in a workweek. The Act also requires covered employers to maintain certain records regarding employees and prohibits retaliation against employees who are discharged or discriminated against after, for example, filing a complaint regarding their pay. However, the FLSA’s protections do not apply to independent contractors.  As used in this rule, the term “independent contractor” refers to workers who, as a matter of economic reality, are not economically dependent on an employer for work and are in business for themselves and are commonly referred to by different names, including 1099 independent contractor, independent contractor, self-employed, and freelancer.   Although the FLSA does not define the term “independent contractor,” it contains expansive definitions of “employer,” “employee,” and “employ.”

Summary of the Major Provisions of the Final Rule

1. Opportunity for profit or loss depending on managerial skill – This factor considers whether the worker has opportunities for profit or loss based on managerial skill, whereas a worker who has no such opportunity is likely to be considered an employee.  
   • E: a worker has no opportunity for profit or loss
   • IC: worker has the ability to negotiate job pay and/or timing of work
2. Investments by the worker and the potential employer – This factor considers the relative investments of the worker and the potential employer. Investments that are “capital or entrepreneurial in nature” suggest contractor status.   
   • E: investments/costs imposed by a potential employer
   • IC: investments/costs increase a worker’s ability to do more or different types of work or extend a market
3. Degree of permanence of the work relationship – This factor considers whether the work relationship is indefinite, continuous, or exclusive in which case the worker is likely to be considered an employee. Whereas work that is nonexclusive, definite in duration, sporadic or project-based indicates that a worker is more likely an independent contractor in business for themselves. 
   • E: exclusive, indefinite, or continuous work relationships
   • IC: non-exclusive, sporadic, and project-based work
4. Nature and degree of control – The greater the ability of the Employer to control the actions of worker or the conditions under which the work is performed, the greater the likelihood that the worker is an employee.  It is important to note that it is the ability of the employer to exert the level of control, whether the employer chooses to exert the control is irrelevant. 
   • E: business maintains the ability to control performance and all economic aspects of the relationship, scheduling, supervision, and/or rates (Note: supervision may be imposed using tracking or remote monitoring technology) and need not be in-person.
   • IC:  controls the timing and means of performing the work, offers services to other potential clients, has established a business entity to perform the work.
5. Extent to which the work performed is an integral part of the employer’s business
   • E: when the work is critical, necessary, or central to the business
   • E: a worker is dependent on training from the business to perform the work
   • IC:  a worker is using his or her specialized skills and taking business-like, entrepreneurial initiative to advance his or her independent business.
   • IC:  a worker possesses specialized skills and demonstrates entrepreneurial judgment (Note: specialized skill alone is not sufficient, but must be used in connection with business-like initiative)

Employer Obligations for a W-2 Employee Versus Independent Contractors

Employers are responsible for determining whether a worker is an employee under the FLSA.  In addition to the protections under the FLSA, if an employer classifies a worker as a W-2 employee, the employer is required to offer Statutory Benefits which include:

• Withhold FICA taxes to fund Social Security and Medicare.
• Contribute to unemployment insurance through payroll taxes at both the state and federal levels.
• Maintain workers’ compensation insurance to provide financial support to employees unable to work due to a workplace injury or illness.
• Withhold any state income taxes for the benefit of the employee.
• Provide Family and Medical Leave Act (FMLA) to eligible employees of covered employers to take unpaid, job-protected leave for specified family and medical reasons.  
• Provide adequate and affordable healthcare coverage to eligibile full-time employees and dependents of covered employers pursuant to the Affordable Care Act (ACA
• Offer state specific disability Insurance and other benefits.

Independent contractors are generally brought onto a team for a short period to assist with a specific task or specialized project.  If you classify a worker as an independent contractor, the independent contractor is responsible for paying federal and state taxes themselves and for providing their own benefits.  Employers are not not able to provide independent contractors with benefits or add them to their payroll since they are not employed by the organization. .

Misclassification of Employees as Independent Contractors Under FLSA

The DOL enforces misclassification under the Fair Labor Standards Act (FLSA), while the IRS investigates misclassification under tax laws.  Employers are responsible for determining whether a worker is an employee under the FLSA.  Misclassification occurs when an employer treats a worker who is an employee under the FLSA as an independent contractor.   If an employer misclassifies an employee as an independent contractor , it could be held liable for:

• Wage law violations – failure to pay overtime and minimum wage under FLSA and applicable state wage laws. An individual can file a wage claim under the FLSA up to two years later for a non-willful violation and three years for a willful violation exposing the employer to both criminal penalties and liability for back wages.
• Unpaid employment taxes – Employers may face penalties for failing to withhold and remit state and federal payroll taxes, including failure to make social security and Medicare tax payments
• I-9 violations – Employers will have liability relating to employer verification requirements specifically, employers are obligated to keep properly completed Form I-9s on file for each of their employees. An employer could be subject to an audit of its Form I-9 records by the Department of Homeland Security, Immigration and Customs Enforcement (ICE), and the Department of Labor and subject to penalties that include civil fines, criminal penalties, debarment from government contracts, and court orders.
• Anti-discrimination violations – Misclassification may also result in failure to provide required protections to individuals under state and federal anti-discrimination laws. Those workers improperly classified as independent contractors could be entitled to certain notice obligations and enforcement protections relating to these laws. An employer’s violation of any of these rights could result in agency charges of discrimination or lawsuits for failure to provide these required protections.

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C2 is a Professional Employer Organization (“PEO”) that provides outsourced HR services to businesses across a variety of service industries with a focus on federal government contractors.  Utilizing our PEO model allows our clients to transfer the responsibilities and liability of payroll, benefits administration, employee onboarding, and employee relations to C2 and to focus their attention on satisfying their clients and growing their business.  C2 blog posts are intended for educational and information purposes only.

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