New DOL Guidance on Employee Classification

The U.S. Department of Labor (DOL) has issued new guidance on employee classification and a new rule clarifying the distinction between employees and independent contractors under the Fair Labor Standards Act (FLSA). This new regulation reinstates the “economic reality test” as the primary method for determining a worker’s status under the FLSA. It is slated to take effect on March 11, 2024.

The Importance of Proper Classification

The correct classification of workers as either employees or independent contractors is not just a procedural formality; it’s a legal requirement with far-reaching implications.

Legal and financial repercussions of misclassification include:

• Violations of wage and hour laws: employers that misclassify employees as independent contractors could have to pay unpaid wages and overtime, along with additional damages and penalties.

• Tax consequences: for employees, employers are obligated to withhold federal and state income taxes, along with Social Security and Medicare taxes (FICA). Misclassification can result in employers owing back taxes, including their share of FICA taxes, along with penalties and interest. Employers are also required to pay Federal Unemployment Tax Act (FUTA) taxes for their employees. Misclassification can result in employers owing back FUTA taxes with additional penalties.

• Unemployment and workers’ compensation penalties: employers must contribute to state unemployment insurance and workers’ compensation funds for employees. Failure to contribute can lead to penalties and interest. Additionally, if a misclassified independent contractor gets injured, the employer might have to cover their medical bills and disability benefits.

Given these implications, it’s vital to review worker roles and responsibilities regularly. This proactive approach not only helps with compliance but also safeguards businesses against potential financial and legal fallout.

Background and Context

Employee classification requires a careful, case-by-case analysis, considering the specific details of the work arrangement. It’s also a dynamic assessment and should be re-evaluated as working relationships and regulations evolve.

Generally, an employee is someone who works in a more structured environment under the direct control of an employer. They typically have set work hours, receive a regular salary or hourly wage, and are entitled to employment benefits.

Independent contractors tend to operate with greater autonomy. They are often self-employed, manage their own schedules, and may work on a project or contract basis.

In 2021, the DOL issued an employee classification rule that emphasized two core factors: the nature and degree of control over the work and the worker’s opportunity for profit or loss. While other factors were at play, these factors were given greater weight in determining whether a worker was an employee or an independent contractor. The idea was that more control by the employer and less opportunity for the worker to influence profit or loss pointed toward employee status.

The new DOL rule rescinds the 2021 regulation and adopts a “totality of the circumstances” approach.

2024 Rule: a Shift to a Totality of Circumstances Analysis

The 2024 rule restores an analysis that has been used by courts for decades. A “totality of the circumstances” approach is a legalistic way of saying that employers should examine all relevant factors equally when determining a worker’s classification.

The centerpiece of the new rule is the revised “economic reality test.” This test is designed to answer the question: are workers dependent economically on the employer, or are they operating their own independent business? The answer to this question is central to distinguishing between employees and independent contractors.

The DOL has articulated six key factors to be evaluated when classifying workers. Importantly, no single factor is given weight over the others. These factors include:

• Profit or loss opportunities: the extent to which the worker can earn profits or incur losses can be indicative of an independent business.

• Nature of financial investment: if the worker primarily purchases their own tools, equipment, and other resources, it can signify an independent contractor relationship.

• Permanency of the work relationship: longer and more stable relationships suggest employee status.

• Degree of control: if the employer has significant control over the worker’s tasks, it typically points to an employer-employee relationship.

• Importance of the worker’s role: if the worker’s role is critical and central to the business’s core operations, it often indicates employee status.

• Worker’s skill and initiative: the level of skill and initiative the worker brings to the role in terms of business operations may suggest independent contractor status.

While the DOL provided insight into these six factors, it’s important to note that these factors are not exhaustive. Employers are encouraged to consider any and all relevant factors that might impact a worker’s status. For instance, does the worker provide services for several unrelated companies? This may help an employer determine the extent to which a worker is economically dependent on the employer.

What if You are Unsure of a Worker’s Status?

The new guidance has sparked a flurry of questions among employers, with some expressing concern that the rule raises more questions than it answers. Unfortunately, the classification process is highly nuanced, and the distinction is not always clear-cut.

If you’re unsure about a worker’s classification, there’s still a way to avoid potential legal and financial issues. The IRS provides Form SS-8 to request a determination on the worker’s status. Either the employer or the worker can file Form SS-8, but it will require detailed information about the nature of the work, the working relationship, and the control exercised by the employer over the worker.

Additionally, employers should consult with their state’s Department of Labor for insights into local criteria and guidelines regarding worker classification. This step is important as state laws may have different or additional requirements.

Steps for Employers to Take

In response to the new rule, employers must take proactive and strategic steps to ensure their employee classifications align with the updated guidelines. Here are some key steps to take:

1. Comprehensively review all workers, especially those under a 1099 tax arrangement.

2. Conduct training sessions and workshops to ensure management teams can correctly apply the revised guidelines.

3. Establish regular review protocols, as worker classifications can evolve over time.

4. Given the legal nuances of employee classifications, it is advisable to seek expert guidance from legal and accounting professionals. These experts can provide tailored advice, ensuring that a business’s classification process aligns with all relevant laws.

While this article provides a broad and general overview of the new DOL rule, it’s crucial to note that employee classification is highly fact-specific. Each employment situation carries its own unique set of circumstances, so the application of this rule can vary considerably from one case to another.

This article is not intended to serve as legal advice. The complexities inherent in employment law require professional interpretation and guidance. For customized advice regarding your unique situation for employee classification, consult with our business tax specialists.