When looking to cut costs, some business owners consider paying workers as contractors to avoid employer payroll taxes. Not only is this practice illegal, it can actually cost the business more.
Misclassifying a worker as an independent contractor instead of an employee can expose a business to lawsuits, back payroll taxes, penalties, and other negative consequences.
On Jan. 10, 2024, the U.S. Department of Labor published the issuance of the final rule, Employee or Independent Contractor Classification Under the Fair Labor Standards Act, effective March 11, 2024. This final rule revises the department’s guidance on analyzing how to classify workers under the Fair Labor Standards Act.
When determining worker classification, first consider the duties to be performed and then how much control you have over those duties.
Independent contractors typically offer an agreed-upon service for a specific project and perform the job without oversight. When the job is complete, they issue a bill. They can work for other businesses, and they provide their own tools, materials, and equipment.
Employees are typically paid hourly or a salary over a period of time and perform duties assigned by someone in the company. They use the tools, materials, and equipment of the business to perform tasks related to the primary purpose of the business.
Even if the job is part-time or seasonal, someone doing work central to the company’s business activity is most likely an employee.
6 Classification Factors
When classifying a worker, the final rule helps to clarify the distinction between contractor and employee by issuing these six factors to analyze their status.
- Opportunity for profit or loss depending on managerial skill. In other words, can the person lose money on the job they do for the business if they improperly bid it? Contractors operate their own businesses, negotiate their own jobs, hire their own crews to perform the job, and file their own tax returns based on a book of business throughout the year. Employees do not encounter such risk of loss.
- Worker investment of own funds. Money spent to start and operate a business (entrepreneurial in nature) to perform work for you and others points to the possibility that the worker could be an independent contractor. However, a mechanic working in your repair shop who has his own tools does not necessarily demonstrate evidence of entrepreneurial investment.
- Degree of permanence of the work relationship. Contractors typically provide non-exclusive, project-based work that is sporadic because they also work for others. Employees typically come to work on a more regular basis over a period of time.
- Nature and degree of control. Contractors usually work projects into their schedule and don’t need supervision to perform the job. Employees usually follow the company’s work schedule, are supervised on the job, and are limited from working for other companies.
- Extent to which the work performed is an integral part of the potential employer’s business. Contractors customarily do not perform work that is principal to the business. The work they perform work is usually ancillary in nature, such as performing repair work at a retail establishment.
- Skill and initiative. Although contractors may need minimal instruction on the specific job at hand, employees are usually trained to do the job by someone within the company.
The final rule provides detailed guidance regarding the application of each of these six factors. No factor or set of factors among this list of six has a predetermined weight, and additional factors may be relevant if such factors in some way indicate whether the worker is self-employed (i.e., an independent contractor), as opposed to being economically dependent on the employer for work (i.e., an employee under the FLSA).
Before deciding whether someone should be issued a 1099 or a W-2 for their work at year end, consider these six standards set forth in the final rule.
To learn more about the final rule, see the U.S. Department of Labor’s FAQ page.