Independent Contractor vs. Employee: In Tax vs. Labor Law
“Independent Contractor vs. Employee: In Tax vs. Labor Law,” that’s the subject of today’s ACTEC Trust and Estate Talk.”
Transcript/Show Notes
Introduction: Independent Contractor vs. Employee in Tax and Labor Law
This is Travis Hayes, ACTEC Fellow from Naples, Florida.
36% of the United States workforce are independent contractors as of March 2024. What happens when a worker classified as an independent contractor is reclassified as an employee? What risks and laws do employees and hiring managers need to keep in mind?
ACTEC Fellow Lee Stautberg of Cincinnati, Ohio joins us today to discuss the new Fair Labor Standards Act: Six Factor Test versus the IRS and ERISA standards for classifying independent contractors and employees. Welcome, Lee.
Background on the Fair Labor Standards Act
Thank you, Travis. I appreciate the opportunity to be on this podcast. The Fair Labor Standards Act, or FLSA, is a federal law that establishes minimum wage, overtime pay, and child labor standards. On March 11, 2024, the Department of Labor published a final rule revising the DOL’s guidance on what constitutes an independent contractor versus an employee. In the next few minutes, I will discuss the intersection of the FLSA’s six-factor test, state and federal characterization, and touch on ERISA characterizations of employees versus independent contractors.
Misclassification Risks
Before doing so, let’s consider some things that can go wrong if a worker is mischaracterized as an independent contractor. FLSA minimum wage and overtime – unless an exemption applies, FLSA requires that workers classified as employees be paid minimum wage- currently $7.25/hour, and overtime at not less than time and one-half for all hours worked over 40 hours. Also, misclassifying workers can expose employers to class action lawsuits.
For example, in 2015, FedEx settled a class action lawsuit for $228 million after the Ninth Circuit found, in the case Alexander v. FedEx, that FedEx had mistakenly classified 2,300 truck drivers as independent contractors. And also, there is employer liability for payroll taxes, Social Security, and Medicare taxes. The IRS imposes a failure to deposit penalty, ranging from 2 to 10% of the unpaid deposit with interest. There are back payments to workers for missed benefits, like 401(k), healthcare, equity compensation, paid time off, and family and medical leave.
Failure to keep I-9s – employers must complete and retain I-9 documentation with respect to all workers who are classified as employees for as long as the employee continues to work for the employer and for some time thereafter. A failure to complete and retain I-9 documentation for misclassified employees may lead to civil fines for the employer and at the worker level, there is a denial of trade or business deduction. So, it is important to get the right classification of a worker as an employee versus an independent contractor. Getting this right.
Historical Perspective on Classification Tests
Now, let’s step back and think about history a bit. In 1947, the Supreme Court looked at the case, U.S. v. Silk. In this case, the court employed an economic reality test to hold that coal uploaders were employees. In determining whether these particular workers were independent contractors or employees within the meaning of the Social Security Act, the court applied the same rules as the National Labor Relations Act and Labor Board v. Hearst Publications. In Silk, the U.S. Supreme Court noted that coal uploaders had no opportunity to gain or lose except from the work of their hands and simple picks and shovels that the workers provided. This economic reality test is basically the same as what has been used to effectuate the FLSA.
The FLSA Six Factor Test
Now, let’s get to this new FLSA Six Factor Test.
#1 Opportunity for profit or loss depending on managerial skill
The first factor, factor number one, is the opportunity for profit or loss based on managerial skills. Basically, this factor looks at whether the worker can do things like negotiate pay, accept or decline jobs, choose the order in which the work is performed, and hire others.
#2 Investments by the worker and the employer
Factor number two is investments by the worker and potential employer. If the investment is minor, this is an indication of an employee.
#3 Permanence of the work relationship
Factor number three is the degree of permanence and work relationship. Is the working relationship continuous or exclusive? This would indicate an employee.
#4 Nature and degree of control
Factor number four is nature and degree of control. Can the worker set their own schedule? Is the work supervised by others? Is the work limited in the work he or she can do for others?
#5 Whether the work performed is integral to the employer’s business
Factor number five is the extent to which the work is performed is an integral part of the potential employer’s business. Is the work critical, necessary, or central to the potential employer’s principal business?
For example, a large farm grows tomatoes that it sells to distributors. The farm pays workers to pick tomatoes during the harvest season. Because a necessary part of the tomato farm is picking tomatoes. The tomato pickers are integral to the company’s business. These facts indicate status under the integral factor.
#6 Skill and initiative
Factor six is skill and initiative. Does the worker use specialized skills and do these skills contribute to a business-like initiative? This factor indicates employee status if the worker does not use specialized skills in performing the work or where the worker is dependent on training from the potential worker to perform the work. It is not only the technical skills, but also the use of the skills that connects to the business-like initiative.
For example, a welder who markets specialized skills for multiple customers has a characteristic of an independent contractor.
IRS 20 – Factor Test and Rules on Classification
Okay, so now that we have this new six-factor FLSA test down, let’s think about the IRS rules on characterizing employees versus independent contractors. The FLSA and IRS can arrive at different conclusions as to what is an employee or an independent contractor. The Department of Labor’s FAQs specifically state that the IRS applies its test based on a common law test. The economic reality six-factor test used by the FLSA is broader because as a matter of economic reality, the worker is economically dependent on an employer for work.
In Rev Rule 87-41, the IRS put forward 20 factors that it identified as indicating whether sufficient control is established to represent an employer-employee relationship. These factors included level of instruction, amount of training, degree of business integration, extent of assistance, continuity of relationship, flexibility of schedule, demands for full-time week, need for onsite services, sequence of work, requirements for reports, and so on.
The IRS has acknowledged that these are not the only factors that are important. The IRS divides these types of factors into three categories of evidence.
- behavioral control;
- financial control; and
- relationships of the parties
While these evidence categories some of the old evidence factors have been prioritized with certain factors being of lesser importance.
ERISA Classification Standards
ERISA has its own common law employee test. In Nationwide v. Darden, the Supreme Court adopted a common law test using general agency principles for determining who qualifies as an employee under ERISA considering the following 13 factors. The hiring party’s right to control the manner and by means by which work is done and the skill of the worker are two of these 13 factors.
Does this sound familiar? As with similar tests, all of the incidents of the relationship must be assessed and weighed with no factor being decisive.
Comparison of Classification Tests
The commonalities among the FLSA new six-factor test, the IRS 20-factor test, and the ERISA common law test include workers’ opportunity for and realization of profits and losses, workers’ investment in facilities and equipment, a continuing permanent relationship between the worker and the employee, and employee integration of the worker’s services to the activities of the company, nature, and degree of control.
These areas of overlap can be especially important to consider when analyzing whether to classify the worker as an employee or an independent contractor.
Where do these tests diverge? The answer to this question may have more to do with how the factors are weighed and interpreted than with the factors themselves. The FLSA definition of employment, suffer or permit to work, is recognized as potentially encompassing a broader group of workers than those who might qualify as employees under traditional agency or common law tests, an interpretation that favors finding employee status may be more appropriate when applying the FLSA test. Per the Department of Labor, economic dependence rather than control is the ultimate inquiry for purposes of the FLSA, is a worker as a matter of economic reality in business for themselves.
Conclusion: Thoughts on Proactive Classification
Although classification for FLSA tax and benefits purposes should be independent considerations as a practical matter, reclassification under the FLSA may prompt reclassification analysis for other purposes as well. Employers proactively looking to properly classify workers for FLSA purposes may voluntarily choose to treat more workers as employees for all purposes, Travis.
Travis Hayes: Thank you, Lee, for discussing with us the distinctions in labor and tax law when classifying independent contractors and employees.
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