1099 Classification Just Became More Difficult

Hiring independent contractors has long been a favored strategy for businesses looking to reduce costs and maintain flexibility. Unlike employees, independent contractors are not protected by most federal and state labor laws, including the Fair Labor Standards Act (FLSA), which establishes national minimum wage and overtime standards. However, recent changes by the U.S. Department of Labor (DOL) have made it more challenging to classify workers as independent contractors, potentially increasing costs and legal risks for businesses.

Why Hire Independent Contractors?

One of the main advantages of hiring independent contractors instead of employees is that contractors are not covered by most labor laws. This means businesses don't have to provide benefits, pay overtime, or contribute to unemployment insurance for these workers. However, with the DOL's recent efforts to redefine worker classification, businesses may find it increasingly difficult to maintain these advantages.

The Fair Labor Standards Act (FLSA) Overview

The FLSA requires employers to pay all non-exempt employees one and a half times their regular pay rate for any hours worked over 40 in a week. Businesses with $500,000 or more in annual sales or those engaged in interstate commerce must comply with the FLSA, covering nearly all workplaces due to the broad interpretation of what constitutes interstate commerce.

Employers who fail to comply with the FLSA may face liability for back overtime pay for two years (or three years if the violation is intentional) and could be subject to liquidated damages. Both the DOL and workers themselves enforce the FLSA, with the latter having the right to sue for violations.

Certain workers, such as bona fide executive, administrative, and professional employees, are exempt from the FLSA's overtime and minimum wage requirements, provided they earn over a minimum amount. As of July 1, 2024, this minimum was increased to $43,888 per year, with another increase to $58,656 scheduled for 2025. This change is expected to bring an additional 3.5 million employees under FLSA coverage.

Exempt Employees: Definition: Workers who are not entitled to overtime pay or minimum wage protections under the FLSA due to their job duties, salary level, and method of payment.

Exemption Criteria: To qualify as exempt, employees generally must:

1. Perform specific job duties that fit into one of the exemption categories outlined by the FLSA (such as executive, administrative, professional, computer-related, or outside sales).
2. Be paid on a salary basis rather than hourly.
3. Earn above a minimum salary threshold set by the DOL. As of July 1, 2024, this threshold is $43,888 per year, and it will increase to $58,656 in 2025.

Types of Exempt Employees:

• Executive Exemption: Employees whose primary duty is managing the enterprise or a recognized department, who regularly direct the work of two or more employees, and who have authority or significant influence in hiring and firing decisions.
• Administrative Exemption: Employees performing office or non-manual work directly related to management or general business operations and who exercise discretion and independent judgment on significant matters.
• Professional Exemption: Employees performing work requiring advanced knowledge in a field of science or learning, typically acquired through prolonged education. This includes lawyers, doctors, engineers, and others with specialized academic training.
• Computer Exemption: Applies to certain computer professionals (systems analysts, programmers, software engineers, etc.) who perform specific job functions.
• Outside Sales Exemption: Employees whose primary duty is making sales or obtaining orders or contracts and who are customarily and regularly engaged away from the employer’s place of business.

The New DOL Independent Contractor Rule

Under the FLSA, independent contractors are not covered, meaning they do not have to be paid overtime or even the minimum wage. However, determining who qualifies as an independent contractor is complex. Courts have held that for FLSA purposes, the key question is whether workers are "economically dependent" on the hiring firm or are "in business for themselves."

The DOL's new rule, effective March 11, 2024, replaces a more business-friendly standard and introduces a six-factor test to determine worker classification. No single factor is determinative; all factors must be considered together:

1. Opportunity for Profit or Loss: Independent contractors have the potential to earn a profit or incur a loss through their efforts and decision-making. Lack of such opportunity suggests employee status. Relevant considerations include whether the worker negotiates pay, decides to accept or decline work, hires their workers, purchases materials, or engages in marketing efforts.

2. Investment in Facilities and Equipment: Independent contractors typically invest in their tools, equipment, and workspaces. A lack of such investment points toward employee status.

3. Permanency of the Relationship: Independent contractors usually work on a sporadic or project basis. Long-term or continuous relationships may indicate employee status.

4. Nature and Degree of Control: An independent contractor operates with a high degree of autonomy, while employees are subject to the hiring firm's control over their work. If a firm controls hiring, firing, scheduling, or other aspects of the work, it suggests employee status.

5. Integration into the Employer’s Business: If the work performed by a worker is central to the hiring firm's core business, the worker is likely an employee. If the worker’s tasks are integral to the goods or services offered by the company, they are more likely to be seen as employees.

6. Skill and Initiative Required: This factor assesses whether the worker uses their specialized skills and business acumen to perform the work and grow their business. Workers who rely on the hiring firm for training and lack independent business skills are likely employees.

Challenges with the New Test

The new DOL rule is complex and challenging to apply. The DOL has not provided specific guidance on how to weigh each factor or how to balance them against each other. Additional factors may also be considered if they help determine whether a worker is in business for themselves or dependent on the hiring firm.

This ambiguity has led some commentators to describe the rule as an "impenetrable fog," making it difficult for businesses to confidently classify their workers.

Worker Classification Tests: A Complex Landscape

The DOL's new test is just one of many used by different government agencies to determine worker classification.

• IRS Test: The IRS uses a more business-friendly "common law" test focusing on the hiring firm's right to control the worker's performance, both in terms of final results and the details of when, where, and how the work is done.

• State ABC Tests: Many states, including California, Massachusetts, and New Jersey, use the stricter ABC test for state unemployment, workers' compensation, and wage and hour laws. Under this test, a worker can only be classified as an independent contractor if they:

  • Are free from the company's control or direction,
  • Perform work outside the hiring firm’s usual business, and
  • Are engaged in an independent trade, occupation, or business.

Given these different standards, a worker might qualify as an independent contractor under the IRS test but be classified as an employee under the DOL or state ABC tests.

What Does This Mean for Businesses?

The evolving rules make it increasingly difficult for businesses to classify workers as independent contractors confidently. To determine the proper classification, companies should consider the following questions:

• Does the company control when, where, and how long the contractor works?
• Does the company provide detailed instructions or supervise the worker’s performance?
• Does the company control the economic aspects of the relationship, such as rates and payment terms?
• Does the company supply equipment or materials?
• Is the work critical to the company’s principal business?
• Is the worker dependent on the company for training or other support?

If the answer is "yes" to any of these questions, the worker is more likely to be classified as an employee.

Protecting Your Business

To mitigate risks, businesses that employ independent contractors should consider the following:

• Independent Contractor Agreements: Have contractors sign agreements that include a clause waiving the right to participate in class action suits for misclassification. The U.S. Supreme Court has upheld the validity of such waivers.
• Incorporated Workers: Hiring workers who operate as corporations or LLCs can increase the likelihood they will be considered independent contractors. However, this does not guarantee they will avoid misclassification claims.

The Future of the DOL's New Test

The DOL's new test faces legal challenges and potential changes depending on future presidential administrations. These challenges could alter or invalidate the test entirely, adding another layer of uncertainty for businesses.

The rules for classifying workers as employees or independent contractors have become more complex with the new DOL regulations. Businesses must navigate these changes carefully to avoid costly legal disputes and penalties. Staying informed about the evolving legal landscape and seeking professional guidance can help companies make the right decisions regarding worker classification.

By understanding the new rules and taking proactive steps, businesses can better protect themselves and continue to benefit from the flexibility and cost savings of hiring independent contractors—where appropriate.