Worker classification 101 and the risks of misclassification

Daniel Moore, CPA, Owner — D.T. Moore and Company, LLC, discusses the recent Department of Labor rule on determining the classification of workers as either employees or independent contractors under the Fair Labor Standards Act. He also highlights the potential legal and financial risks associated with worker misclassification.

The rule, effective on March 11, 2024, aims to align with judicial precedents, reduce misclassification risks and offer more flexibility for businesses engaging with independent contractors.

Factors for worker classification under this rule are:

• Opportunity for profit or loss that a worker might have
• Investments of resources by the worker and potential employer
• Degree of permanence of the work relationship
• Nature and degree of control an employer has over the work
• Extent to which the work is integral to the employer's business
• Skill and initiative of the worker

Dan highlights the importance of considering both IRS and Department of Labor rules when advising clients on worker classification and how to best communicate this change to clients.

AICPA resources

· Tax season resource center — Access the AICPA's central hub for guidance, tools and developments throughout the tax filing season.

· Employee or independent contractor? DOL issues new guidance, Journal of Accountancy, Jan. 10, 2024

Other resources

· RIN 1235-AA43 published in the Federal Register — Department of Labor (DOL) rule

Transcript

April Walker: On today's podcast, listen to hear more about a recent Department of Labor rule that talks about independent contractors and employees.

Hello, everyone, and welcome to the AICPA's Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, lead manager from the Tax Section, and I'm here today with Dan Moore.

Dan is an owner of D. T. Moore and Company in Ohio, and he is another great volunteer friend of mine. And he's been on this podcast before, so welcome back, Dan.

Dan Moore: Thank you.

Walker: Today I thought we could spend a few minutes letting our listeners know about a new rule that the U.S. Department of Labor recently published in January. We're still in January when we're recording this, so very recent. It revises guidance on determining who is an employee and who is an independent contractor under the Fair Labor Standards [Act].

Just to set the stage a little bit, I'm not and Dan's not, an employment attorney, nor do we pretend to be one on TV or on this podcast.

We're going to approach this discussion as CPA tax practitioners and communicating this change to your clients. Because I'm sure you'll know and I'm sure as you're listening, you have clients who have struggled with this issue. It's not a new issue. It's just, it's a hard one to wrap our heads around.

So, we're going to talk a little bit about that. I will provide a link to the rule in the show notes. If you want to read more, it's very long, but we're not going to cover all the aspects and background about that rule. But just a quick little background on it.

In January 2021, the Department of Labor released a rule that was subsequently rescinded. This recent rule that was announced on January the 9th of this year, 2024. It replaces that guidance. It maintains that it's doing is [being] is more consistent with the judicial precedent. The rules that have been challenged in court and how the courts have come down on it. It also will reduce the risk that employees are misclassified as independent contractors, but also more flexibility, for businesses that still do engage with people who are in business for themselves and consider themselves independent contractors.

Let's start with an easy question, Dan. I'm sure it's easy. Maybe it's not easy. What's the definition of an independent contractor?

Moore: Thank you, April. It's always great to do these podcasts with you and I always enjoy the topics that you pick for me.

This one's a little bit challenging because independent contractor — it just depends to me where you're standing in the conversation. And although you can maybe reconcile and come to some conclusion under one aspect of the definition of an independent contractor, say, in the world of tax, when you step over to Department of Labor and you look at the Fair Labor Standards Act, you're standing in a different conversation.

And so, I may have figured it out on the tax side, but now I'm looking at it from the Fair Labor Standards Act. And now I've got to re-reconcile this whole concept as to whether or not someone is an independent contractor.

Independent contractors fall under a bunch of different names. You could call yourself an independent contractor. You could consider yourself to be self-employed. You could be doing freelance work. You could be involved in the much broader gig economy that is very popular and talked about frequently now. The tax aspect is going to be a little bit different about the Fair Labor Standards Act.

And first, before I define an independent contractor to the best of my ability based on the new announcement, I do want to touch on what the Fair Labor Standards Act is.

The Fair Labor Standards Act establishes a minimum wage for employees. It establishes the qualification or the right to pay overtime, record keeping. It discusses child labor law. It covers nursing mothers, 40-hour work weeks, breaks, how tips are to be paid to employees that are in an industry in which they receive tips as part of their compensation, and it prevents retaliation by an employer against an employee. There's a lot of things that the Fair Labor Standard Act covers, and the Fair Labor Standards Act covers employees, but it doesn't cover independent contractors.

So now we have to define — what is an independent contractor? — to see whether or not these set of rules do apply to independent contractors? And what we'll see as we go through this conversation today is although someone may seem like they're an independent contractor, once you apply the rules, for Fair Labor Standard Act purposes, they may be considered an employee in which you now have to apply all the Fair Labor Standard Act rules — an overtime payment would be one big one…a time and a half paid over 40 hours worked in a work week. A lot of these things are now going to apply to someone who may be sitting in the seat as an independent contractor, but fair labor standards are going to still apply to them.

So the easiest way — not necessarily easy — is we need to define what is an independent contractor. And that really isn't an easy question, and we have lots and lots of court cases to define it. [What] it really comes down to, is whether or not there is a matter of economic reality, and that the worker is economically dependent on the employer for work, thus an employee, or are they in business for himself and therefore potentially an independent contractor?

Like I said, there's a lot of different names, but also think of this too on the employer side with the Fair Labor Standards Act. The Fair Labor Standards Act is also there to protect the employer. Because if all employers are playing on the same level playing ground, then —your competition — it creates fair competition.

By establishing a 40-hour work week and overtime rules, that all plays a standard playing ground for all employers in which we're all going to play by the same rules in the sandbox. So now we have to look at who does this apply to? It implies to employees.

But how do we handle independent contractors and are independent contractors considered to be an employee?

And that's the big question of the day that this announcement in January (lovely time for new announcements to come out) This new announcement sets into play of, okay, independent contractor, are they subject to the Fair Labor Standards Act?

Walker: Gotcha. I was not trying to give you a trick question to start off with. I did know it was not a super easy question, but yeah, that's clear as mud for me.

However, thank you for that — doing a good job of setting the stage for us.

Now we know where we're going, how would one determine whether someone is an employee or an independent contractor under the Fair Labor Standards Act — once this rule is effective, which, noting that it is March 11th when the rule is effective.

Moore: Yes. First, we have to determine if an employee is a worker or an independent contractor. The rule came out with these six factors that you need to consider in determining whether or not someone is going to fall under employee versus independent contractor.

Now, this is not a true-false question. This is not, select A, B, C, or D as your answer. These are all subjective interpretations of these rules. And really, not one factor is weighted against the other. You have to just look at the rules [as a] stand alone. Try to apply them to your situation.

In my opinion, it almost comes down to, we have six factors. Do we have four to two, yay or nay, in determining whether or not someone should be really considered an employee for purposes of the Fair Labor Standards Act? So, you have to analyze them all on their own. This is going to lead back to court cases and precedents that is from the past, but also looking at the future at all of these tests.

So there's 6 factors I'm going to just go through real quick — each 1 of the 6 factors — and then I'm going to go back to each 1 and just add a little bit more detail to each one.

So, as you're sitting there, and from my standpoint as a practitioner, when I'm sitting there talking to my client, I'm going to say, okay, let's look at the six factors.

• The first 1 being the opportunity for profit or loss depending on managerial skill.

• Factor 2 is the investments by the worker and the potential employer.

• Factor 3 is the degree of permanence of the work relationship.

• Factor 4 [is] the nature and degree of control.

• Factor 5 is the extent to which the work performed is an integral part of the potential employer's business.

• Factor 6 [is the] skill and initiative [of the employee].

Now, again, subjective and many factors. Subjective on both the independent contractor, employee side versus the employer side. To what level of skill or the ability to profit? It's going to be dependent on a facts and circumstances test, and it's going to be dependent for each employee.

Lots to think about as I'm talking to someone, [to determine] whether or not they're an independent contractor for the Fair Labor Standards Act.

Factor 1 — I have to look at, okay, rule number one, what is the opportunity for profit or loss depending on managerial skill? I almost think of this as, are you punching a time clock and getting paid based on the number of hours worked? That's probably going to be an employee situation.

Or are you approached by a company to provide a service in which you, as the contractor, evaluate that project? You look at what, you think, the amount of time is going to be, the materials, the labor…do you determine what your profit margin is going to be on that job, what level of profit margin you're going to bid out that job for? There's a lot of factors in which you're looking at the actual profit and loss of that project, in which you probably would be sitting more in an independent contractor situation.

The common industries — not to beat up on the construction industry — would be typical, whether or not someone is sitting as an independent contractor. In this case, if you're really just showing up and doing the job as you're instructed by the company that you're doing the work for, you're probably going to fall under the employee test.

But if you're bidding out the job and you're determining how quickly you can [do] the job, determining how much profit you want to make on that job, you're using your managerial skill, then you would probably fall under independent contract. So again, that's just one of six tests that you're looking at.

[Factor 2] Now you have to move on to the next test, which is investment by the worker and the potential employer. And in this scenario, if you're showing up and the employer is providing mostly all of the tools and materials that you need to do the job…You're showing up and they're providing you, say they're providing you software, they're providing you office space, computer equipment, supplies, all of that's provided. You're just showing up and doing the work. You're probably going to be sitting in the employee side of things.

Whereas, on the flip side of it, you have your own equipment, you have your own tools, you're purchasing better equipment to make you more efficient as you're doing these jobs. In this scenario, you would be sitting more on the independent contractor side of the conversation. So again, the amount of investment and the type of investment you're making in that job would determine whether you're an [independent contractor] or an employee.

[Factor 3] After investment of the worker and the potential employer, let's take a look at the degree of permanence of the work relationship. This is the third prong of the question.

And you're looking at if you're going to the same work location day after day and it seems to be more permanent. That is almost as if you're going to work like anyone else, it's as you're looking at it as your job, and you're really not going out to work with another company. Your priority is given to this one company.

You're going to have a degree of permanence with that relationship that's going to lean towards more of an employee relationship. The flip side would be, you know what, I'm going to work maybe Monday, Tuesday this week, and Wednesday. I'm going to go do some work for another contractor on another project. Thursday/Friday, I might go work for someone else on a different project. The following week the makeup of that work could be completely different. And so there isn't a degree of permanence. And so that would lead more towards an independent contractor relationship. Again, that's factor three.

[Factor 4] Which then leads us into factor four, which is the nature and the degree of control. And when you're looking at the degree of control of the employer, the company that the individual is doing work for, are they setting the schedule?

Are they, having the independent contractor/employee show up every day to the same location at which they are given their duties for the day…sent out to various projects? Throughout the day, they're being monitored. They're doing check-ins with the company to see where they are on the project.

That level of control is really going to lead towards more of an employee status versus an independent contractor. Where an independent contractor may say, okay, I'm going to work on this project for you for the first part of the day. Then I'm going to go work on different projects for another contractor and switch it up. Or maybe they have their own project that they're working on.

[Factor 5] Now we move into the fifth factor is the extent to which the work is an integral part of the employer's business. If the individual is showing up to work and the work that they are doing is very integrated into the overall process. Maybe it's manufacturing and they're coming in every day and they're doing a very integrated part of the overall product development or what they're creating. That integrated part really is part of that process in which that would lead to, in most cases, the individual being treated as an employee, unless it's a very skilled process that is very infrequently used.

If someone's coming in and stepping in, integrated into the process, they're most likely going to step into an employee versus the independent contractor side of things where they're doing work for the company. Your accountant that is doing bookkeeping work for you that's not integrated into the overall process of what the business is in making money doing, then that individual would be sitting in an independent contractor standpoint because they're not integrated into the process of the overall product that the company is making.

[Factor 6] Then finally, we're looking at that sixth factor, and that is the skill and initiative. So again, skill and initiative, that's very subjective. What level of skill is the individual providing for the job?

If you have an independent contractor coming in to do something that is very technical, that very few people do…it's an integrated part of the job, but it's something very technical, and you may only need them on an infrequent basis to complete a project, that situation would generally lead to someone being independent contractor.

However, if they're coming in, they don't require specialized skills in performing the work. They don't necessarily require training in doing the work. They're being supervised. They're being trained on the job. That really could lead to being an employee relationship. So again, very subjective to the level of skill that the individual is doing.

And you have to look at it…and I think by industry. I'm just thinking, looking at my clients, I have some clients that are independent contractors. The work that they do is very specialized. And in some cases, there are very few, maybe in the region, individuals that are doing that type of work.

They pick and choose who they're going to work for and they freelance, they go out, they do that job, it is an integrated part, but they're very specialized, and they're not frequently used. They sit in an independent contractor position versus an employee position. Somewhat clear as mud.

Six factors that we're looking at, trying to say thumbs up, thumbs down. I don't think it's still an easy answer to that question.

Really, at the end of the day, I'm looking at this [and saying] — do I need to apply these rules? Do I need to make sure that if someone comes in and bids a job for me, [do] I need to do some record keeping to see how many hours they're working for me? And if they go over 40 hours, I'm going to have to renegotiate maybe that bid or that contract or figure out what the hourly rate is for that job to determine whether or not you paid them a minimum wage and whether or not they've been paid time and a half for that project. If they're sitting in the independent contractor seat, but really when you look at the factors, they would be considered an employee for the Fair Labor Standards Act.

And this is a very broad definition.

Walker: Great. just to recap a little bit, for our listeners. You have to think about this from your perspective as you're hiring people. Obviously, we're going to talk more about why do you care about this? Why are you spending time talking about this? And we'll delve a little bit into that, in a second.

Dan did a great job of going through all the six things, but it's each six things could be their own probably 30-minute conversations about what they mean, but that was great.

Something I, as I was preparing for this, I'm not sure that I necessarily understood this, and I think we alluded to it a little bit, but I want to make sure we're clear.

This six-factor test, this new rule that's effective March 11, does it override, or does it change the way the IRS determines worker classification, or other federal, state, or local laws that may provide standards for employee classification? How am I thinking about this?

Moore: This is an answer that we don't [know] often in the world of tax. Our answer is usually — maybe, or it depends, we need more information. When the Department of Labor comes out to answer this question, the question of whether or not does this override, does this change IRS determination of worker classification, when the Department of Labor comes out and says no, that is a pretty stern answer.

It's not an "it depends" situation. It doesn't override or change IRS classification because IRS uses its own classification. [It's] own standalone set of standards, the Common Law Test, which is completely different than the Fair Labor Standards Act and the rule that just came out. When we're looking at the Common Law Test, and just real quick on the Common Law Test as IRS looks at it, you're looking at relationship considerations, behavioral considerations and financial consideration.

We may determine that someone is an independent contractor from a tax standpoint, from an IRS standpoint, but that doesn't mean they're not considered an employee for Fair Labor Standards Act when we apply those six tests that we just went over. So, a hard no on the IRS standards. Does that make things any easier for us?

Absolutely not. It does not. And then you have to look at federal law, there's state law, there's local law, and all these laws apply to employees. The best rule to follow and the rules that you should follow, again we're not labor law attorneys, but you want to apply the law that has the most protections for the employee.

So certain laws may have higher standards than others, and you're going to follow the law that protects the employee the most in this situation. And so again, still confusing. We've got two bodies of law, when we're looking at IRS and Department of Labor. There's so many other factors and other things to consider when you're looking at employee versus independent contractor, but this is not changing the IRS law.

Walker: Okay, that's helpful. Let's talk about why as a tax practitioner, you care about this classification enough to spend time talking about it with your clients.

Moore: I get this question all the time. I work with a lot of startups, in particular. The startups that are like, I have this person, they're coming in, they're helping me out. They make their own schedule. I'm just, I'm scared. I'm not ready to put them on payroll. They're fine with being an independent contractor.

But that doesn't work. And a lot of times I find, particularly small businesses that are starting out, I look at them and I say, the first thing is that person could change their mind when it comes time for them to file their tax return and you may have had this wonderful agreement that they're an independent contractor and they go to file their tax return, guess what? They may not think they're an independent contractor any longer when they realize the impact of the self-employment tax. I have that conversation [that] you need to put your individuals that are working for you on payroll. They need to be part of payroll.

And then as the business grows, I have the discussion that, you know what, you started out, you had a friend helping you out. You have this independent contract relationship. That relationship has grown into something. more than what it originally was, and now it really seems to me like this independent contractor person is really an employee, and now you've hired more people, and you put them on payroll, but you have someone else doing really the same work that you're paying as an independent contractor, and I really think you can't have two people sitting in the same position doing the same work, treating one as an independent contractor and one as an employee.

These are all challenges that startup businesses have. We particularly have these conversations with our clients that are in the construction industry. [There] really [are] no bright line test here on who should be an employee versus an independent contractor? And you have to look again, these six factors, you have to look at the IRS rules to determine whether or not they're considered an employee versus an independent contractor.

Walker: Very good. When you get those red flags that arise as you're having those conversations, and you think that there's an issue, you talked about that — that you're having the conversation — but how do you put them on notice? What are your recommendations? Do you refer them somewhere? What are your next steps?

Moore: You try not to scare your clients into compliance, but we have a lot of stories that we can tell that are very scary that have turned companies upside down. They have turned small family-owned businesses upside down.

In a recent case, I had a construction company that had really what seems to be an independent contractor relationship with someone that was doing work for them. This individual had their own LLC — their own construction company. They came together to work on a job and that independent contractor fell, was severely injured and passed away. Now this construction company is having to deal with the fact that there were workers comp issues and are being sued over this issue from the family — the surviving family of the individual that passed away.

Maybe at the end of the day they'll rule and say, you know what, you did have this, independent contractor relationship with this individual. They [won't] fall under workers comp laws and there won't need to be a payout under workers comp, but it's cost tens of thousands of dollars. There's a lot of legal fees involved with that time and stress of this is massive. And so those are just the war stories.

I say, you really need to sit down with someone that is skilled and understanding about labor law to find out what your real risk is in the worst-case scenario. Those are rare situations, but when they [happen], they affect your business. They affect your family and they affect your health. And you have to make a very hard decision, on making that relationship with an independent contractor.

There's so many factors. There's fair labor. There's IRS rules when it comes to independent contractors. You have to look at unemployment laws, workers comp laws, the list goes on and on. And to make sure that you're properly protected, you have to really think. I think a lot of companies need to think very hard about that independent contractor relationship. And many will probably discover, you know what, I want to sleep at night. I'm going to flip this individual to an employee.

Walker: Great. yeah, like you said, it's not about horror stories and it's not about scaring. But part of our job as trusted advisers are to let people know, hey, there's potential payroll tax obligations and liabilities, but then there could be also these [other consequences]. You don't want them to come back to you and say, hey, you never questioned this. You never said anything was wrong with this. I think that's important. And that's the point of why we're talking about this today. Any final thoughts as we're wrapping up, Dan.

Moore: Yeah, so I'll remove the gloom and doom. The scenario could arise that you have someone doing work for you as independent contractor, under these rules, the individual would be able to go to the Department of Labor and say, okay, I really, truly believe that I fall under Fair Labor Standards Act, and I was not paid overtime by this company that I was doing work for.

Department of Labor comes in, they do a ruling, you may have to hire an attorney to help you navigate this situation. Then you have to pay overtime, calculate that, look at your record keeping. That could be penalties assessed with it. So that's just a simple, someone said, you know what? I worked 45 hours, not 40 on that job and I didn't get paid time and a half. And so, a very minimal kind of situation that could eat up a lot of time within the company.

Walker: Thank you so much for walking us through this conversation today. It was not an easy, breezy conversation, but it was one that I think we needed to have as hopefully our listeners will take something away. In closing on these podcasts, as you know, since you're a repeat guest, I like to think of us taking a journey together. An Odyssey, if you will, towards a better profession. In doing so, I like to hear about our guests other journeys outside of tax. So, please share a page from your travel journal or bucket list or something you've got on the horizon, Dan.

Moore: So, I won't do a travel, but I will say just on my own personal journey and pursuit to mindfulness and clear mind. I love to collect audio books that I'm going to find the time to listen to and I never find the time to listen to them. This morning I did a swim and this morning I was pretty excited I finally got my new headset to work. That I can now listen to books while I'm swimming. This morning I got a 40-minute workout in and also got to listen to 40 minutes of a book that I would not otherwise have made time.

Walker: Tell us the name of the book.

Moore: it's on NLP, Neuro Linguistic Programming. I should probably listen to that definition a little closer, but it's just really looking at our reactions, the words we use and also listening to how your employees and your clients are speaking and the way they're speaking really can help you to better understand their thought processes that are going through something. I think it's a great tool to have this time of year when we are face-to-face with all of our clients.

Walker: Wonderful. You're improving your body, you're improving your mind, all at the same time, that seems like a win-win for everyone.

Thank you again so much, Dan. I'm sure we'll have you again. I'll try to pick an easier topic next time.

This is April Walker from the AICPA Tax Section. This community is your go to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA and CIMA together as the Association of International Certified Professional Accountants. You can find us wherever you listen to your podcasts, and we encourage you to follow us so you don't miss an episode. If you already follow us, thank you so much, and feel free to share with a like-minded friend. You can also find us on aicpa-cima.com/tax to listen to our other episodes as well as get access to resources mentioned. Thank you so much.

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