What Are the Tax Implications?
Classifying workers as employees or independent contractors is vital for tax purposes. Generally, a potential employer would prefer to treat workers as independent contractors. For employees, an employer must withhold income and payroll taxes, pay its share of payroll taxes and keep detailed records. Plus, employers must provide benefits for eligible employees.
As stated in the main article, the determination of a worker’s status under the final rule published by the U.S. Department of Labor (DOL) doesn’t extend beyond the Fair Labor Standards Act (FLSA). However, for consistency, the IRS and courts may follow the same basic approach. Thus, employers should examine the six key factors based of their circumstances.
Important: In some cases, an individual may be an independent contractor for tax purposes even though he or she is an employee for FLSA purposes. In a series of Q&As, the DOL explained that the IRS applies its version of the common law control test to analyze if a worker is an employee or independent contractor for tax purposes. While the DOL considers many of the same factors as the IRS, it added that “the economic reality test for FLSA purposes is based on a specific definition of ’employ’ in the FLSA, which provides that employers ’employ’ workers if they ‘suffer or permit’ them to work.”
In court cases, this language has been interpreted to be broader than the common law control test. Therefore, some workers who may be classified as contractors for tax purposes may be employees for FLSA purposes because, as a matter of economic reality, they’re economically dependent on the employers for work.
March 28, 2024
In January 2024, the U.S. Department of Labor (DOL) issued its long-awaited final rule related to employment status under the Fair Labor Standards Act (FLSA). The new rule carves out six key factors to be analyzed in determining whether a particular worker should be treated as an independent contractor or an employee.
Background
For instance, the current minimum wage under the FLSA is $7.25, although individual states may impose higher requirements, and many do. The federal limit usually applies to non-professional workers who are paid an hourly rate as opposed to an annual salary.
Furthermore, employees must receive overtime pay at a rate of no less than time-and-a-half if they’re nonexempt and work more than 40 hours a week. Workers are generally considered to be exempt if they:
- Are paid an annual salary,
- Earn at least $684 a week ($35,568 for the year), and
- Perform professional, executive or administrative duties.
In addition, employees who earn $107,432 or more for the year aren’t entitled to overtime pay.
However, these rules are only applicable for workers who are employees. Independent contractors are in business for themselves and aren’t subject to the FLSA minimum wage and overtime standards.
The classification between employee vs. independent contractor has significant consequences relating to FLSA rights and responsibilities as well as having implications in other areas, including taxes. (See “What Are the Tax Implications?” at right.)
6 General Factors
The FLSA doesn’t provide any bright line test to distinguish employees from independent contractors. These matters have been left to the courts. Over the years, courts have often relied on six factors established by the U.S. Supreme Court in 1947 (United States v. Silk, 331 U.S. 704; Rutherford Food Corp. v. McComb, 331 U.S. 722). The six factors are:
- Opportunity for profit or loss depending on managerial skill,
- Investments by the worker and the potential employer,
- Degree of permanence of the work relationship,
- Nature and degree of control,
- Extent to which the work performed is an integral part of the potential employer’s business, and
- Skill and initiative.
Although courts have consistently cited these factors for over 75 years, they haven’t been weighted evenly and have resulted in seemingly conflicting determinations on comparable facts. Thus, the DOL sought to rectify the situation.
Core Factors
In 2021, the DOL formally adopted a rule based on two core factors for worker status:
- The nature and degree of control over work, and
- The opportunity for profit or loss.
These two factors were considered the most probative in value. But the rule drew widespread criticism from some parties, so the DOL has repealed it.
New Final Rule
In January 2024, the DOL replaced the 2021 rule with one that essentially reinstates the six key factors set forth by the Supreme Court — along with some modifications based on court rulings over the years. The new final rule focuses on the totality of the circumstances presented in each case.
The DOL summarizes the six factors as follows:
1. Opportunity for profit or loss depending on managerial skill. A worker is more likely to be classified as an independent contractor if he or she provides managerial skills, including business acumen and judgment affecting the failure or success of the work being performed. Conversely, a lack of such opportunity generally indicates employee status.
2. Investments by the worker and the potential employer. Investments of capital and similar entrepreneurial activities support a designation of independent contractor status. In addition, the worker’s investments should be compared to the potential employer’s investments in its overall business. Even a relatively small amount of investment by workers may indicate that they’re operating independently.
3. Degree of permanence of the work relationship. This factor weighs in favor of the worker being an employee if the work is indefinite in duration, continuous or performed exclusively for a particular employer. On the other hand, a worker is more likely to be an independent contractor if the work is finite in duration, nonexclusive or project based. Note: The fact that work is seasonal in nature is not controlling.
4. Nature and degree of control. This factor remains critical to the determination of worker status under the final rule. Some of the relevant questions to be asked are as follows:
- Does the potential employer set the worker’s schedule?
- Does the potential employer supervise the worker’s activities?
- Is the work technological in nature?
- Does the potential employer restrict the worker’s ability to work for others?
- Does the potential employer reserve the right to supervise or discipline the worker?
- Does the potential employer control economic aspects of the work relationship? What about pricing and fees for services and marketing activities provided by the worker?
Positive answers favor a determination that the worker is an employee. Negative answers indicate independent contractor status.
5. Extent to which the work performed is an integral part of the potential employer’s business. If the function isn’t found to be necessary or central to the potential employer’s business, or even critical, the relationship favors a determination that the worker is an independent contractor.
6. Skill and initiative. Workers are more likely to be treated as employees if their work doesn’t require specialized skills or if they rely on training from their potential employers. However, if workers display certain specialized skills, there’s no conclusion that they should be treated as independent contractors, unless the work is connected to a business-based initiative.
Flexibility is the key when determining whether a worker is an employee or independent contractor. No factor is conclusive nor does any factor carry more weight than another. In addition, courts may consider other factors that aren’t on this list. Finally, the DOL clarifies that one or more factors may be more probative than others, while a particular factor (or factors) may be irrelevant.
Bottom Line
It remains to be seen if the new final rule will have a significant effect on businesses. Clearly, it provides more clarity, but courts may still adhere to their precedents. Moreover, the final rule could face legal challenges from the business community, especially those that promote use of independent contractors.
Although the final rule is technically only applicable to FLSA matters, the DOL’s pronouncement marks a historic watershed in the ongoing struggle to distinguish between employees and independent contractors. Contact your financial advisors for the latest developments.
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