PROTECTING SMALL BUSINESS, PROMOTING ENTREPRENEURSHIP

Do You Know an Independent Contractor When You See One?

By at 29 February, 2024, 11:16 am

By Barbara Weltman –

Supreme Court Justice Potter Stewart, when asked in a case to explain his test for obscenity, said “I know it when I see it.” The same question can be raised with respect to an independent contractor: what’s the test? Unfortunately, the answer is more complicated than the one for obscenity. There are a number of different worker classification tests for different purposes. Here’s a survey of those tests:

Federal test for minimum wage and overtime rules

Federal minimum wage and overtime rules apply to employees, but not to independent contractors. In January, the U.S. Department of Labor (DoL) issued a final rule that rescinded the rule in effect since 2021 and replaced it with a new rule for determining whether a worker is an employee or independent contractor. The new rule uses a 6-factor test:

1.) Opportunity for profit or loss depending on managerial skill

2.) Investments by the worker and the potential employer

3.) Degree of permanence of the work relationship

4.) Nature and degree of control

5.) Extent to which the work performed is an integral part of the potential employer’s business

6.) Skill and initiative

There’s a small entity compliance guide on the new rule. The guide explains each of the factors and provides examples to illustrate them.

The new rule is scheduled to take effect on March 11. That is, unless Congress invalidates the rule or if a judge delays or throws out the rule prior to March 11 (several lawsuits have been filed challenging the rule’s legitimacy.)  Stay tuned, as some type of action is expected.

State test for various purposes

States use worker classification for various purposes, including state minimum wage rules, worker compensation, unemployment insurance, and employee benefit laws (e.g., sick leave). The majority of states use an ABC test, or some variation of it, to determine whether a worker is an employee.

Under the ABC test as codified in California, a worker is considered an employee, and not an independent contractor, unless all three tests are met:

A.) The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;

B.) The worker performs work that is outside the usual course of the hiring entity’s business; and

C.) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

However, states have created various exemptions for certain workers, such as some professionals, who can continue to be viewed as independent contractors even if the ABC test indicates otherwise. For example, in California, those who create, market, promote, or distribute sound recordings or musical compositions are exempt from the ABC test, although they may still be employees using old factors.

States may use different tests for different purposes. California uses the same ABC test for all labor-related matters.

IRS test for employment tax purposes

If a worker is an employee, the employer is subject to a myriad of federal employment tax rules and may also have to provide various fringe benefits, such as health coverage and retirement plan contributions. If a worker is an independent contractor, the only obligation of the business is to issue Form 1099-NEC, Nonemployee Compensation, if payments for the year are $600 or more.

The IRS uses common law rules that explore the degree of control over or independence of the worker. These rules fall into 3 general categories:

Behavioral: Does the company control, or have the right to control, what the worker does and how the worker does the work? “Control” is a broad term that essentially covers when, where, and how the work is done.

Financial: Who controls the financial aspects of the work, such as whether expenses are reimbursed, who provides tools/supplies, etc., and whether there is any opportunity for profit (or risk of loss) from the work.

Type of relationship: Are there written contracts describing the relationship. Are any employee-type benefits, such as a retirement plan, insurance, vacation pay, etc., provided? Will the relationship continue beyond a set date?

The IRS says there’s no magic number or bright line to make a determination of worker classification; you have to weigh all the factors. The fact that someone is working remotely doesn’t change the determination process. If the business controls what will be done, when it will be done, and how it will be done, the remote worker is an employee.

NLRB test for union organizing

Employees have a right to unionize under the National Labor Relation Act; independent contractors do not. Worker classification for NLRB purposes is based on case law and administrative rulings. The Supreme Court back in 1968 used a common-law agency test, taking into account 10 factors reflecting “economic and policy considerations within the labor field.”

Since then, the NLRB has, from time to time, expanded, clarified, or eliminated the factors used to make a determination. In an NRLB ruling in 2014, it added entrepreneurial activity when assessing the status of FedEx home drivers. Last year, an NLRB ruling concerning The Atlanta Opera, Inc. distinguished between theoretical entrepreneurial opportunity and genuine entrepreneurial opportunity to find that make-up artists at the opera company could be viewed as employees and join a union.

Conclusion

The stakes are high for misclassification: fines, back pay and penalties, and more. Companies must use care in classifying their workers. Keep in mind that based on the facts of a situation, a worker may be an employee for certain purposes but an independent contractor for others. For example, the IRS recognizes that a worker may be a W-2 employee for a company while also performing 1099 activities through the same company as long as these activities are different from the duties of an employee.

Good luck!

Barbara Weltman is a member of SBE Council’s advisory board, and has been a leading consultant for small businesses of every kind for over twenty years. She’s the founder of Big Ideas for Small Business® and has written numerous books on small business operations, including J.K. Lasser’s Small Business Taxes, Complete Idiot’s Guide to Starting a Home-Based Business, and The Rational Guide to Building Small Business Credit. Follow Barbara on Twitter @BigIdeas4SB.

 

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