Independent Contractor vs. Employee: New DOL Classification Rules

June 18, 2024

Businesses rely on a diverse range of workers, from full-time employees to independent contractors. Properly classifying these workers is crucial, impacting everything from wages and benefits to tax implications. Recent Department of Labor (DOL) changes have added a new layer of complexity to this landscape.

Understanding the new DOL classification rules is imperative for navigating the often-confusing world of independent contractors vs. employees.

The Importance of Classification

Understanding the difference between independent contractor status and employee status is crucial for businesses and workers. It impacts critical areas like:

Wages and Overtime: Under the Fair Labor Standards Act (FLSA), employees are entitled to minimum wage and overtime pay, while independent contractors are not.

Benefits: Businesses typically do not provide benefits like health insurance to independent contractors.

Taxes: Businesses withhold taxes from employee paychecks (W-2), while independent contractors receive a 1099 form and are responsible for paying self-employment taxes.

New DOL Rule on Independent Contractor Classification

The New DOLs rules regarding independent contractor classification were implemented on January 10th, 2024. This rule rescinds the two-factor test introduced in 2021 and reverts to a multi-factor “totality-of-the-circumstances” approach. It went into effect on March 11, 2024.

What is the New Test to Determine Status?

The new DOL rule focuses on several factors to assess the relationship between the business and the worker. These factors include:

Control Over Work: Does the business dictate work hours, location, and methods?

Opportunity for Profit or Loss: Can workers set their own rates, take on other clients, and incur business expenses?

Investment by Each Party: Does the business provide significant tools and equipment, or does the worker invest in their own resources?

Understanding the Landscape: IRS vs. FLSA vs. State Rules

IRS Classification: The Internal Revenue Service (IRS) uses a similar common law test for worker classification but primarily for tax purposes.

FLSA vs. IRS: The FLSA focuses on worker protections (wages, overtime), while the IRS focuses on tax withholding. Businesses must comply with both sets of regulations.

State ABC Test: Some states, like California, have stricter tests (ABC test) that supersede federal rules for unemployment insurance purposes.

Mitigating Risk: Addressing Misclassification

The IRS, DOL, and states are collaborating to identify misclassified workers. Here is how to navigate this landscape:

Form SS-8: Businesses can use the voluntary Form SS-8 to request the IRS’s determination of worker status.

W-2 vs. 1099: Understand the proper use of W-2 (employees) and 1099 (independent contractors) for tax reporting.

Avoiding Audits: Increased scrutiny of worker classification can trigger audits. Proper classification reduces this risk.

Penalties for Misclassification

Misclassifying an employee as an independent contractor can be costly for businesses. Here is a breakdown of potential penalties from both the IRS and DOL:

IRS Penalties

Back Taxes: The IRS may require you to pay back taxes on the employee’s Social Security and Medicare contributions that should have been withheld.

Employer Payroll Taxes: You may also be responsible for paying the employer portion of payroll taxes (Social Security and Medicare) that weren’t withheld.

Fines: The IRS can impose significant fines for intentional misclassification.

DOL Penalties

Back Wages: The Department of Labor may require you to pay the employee back wages for any minimum wage or overtime violations they may have incurred.

Liquidated Damages: In some cases, the DOL may also assess liquidated damages equal to the back wages owed.

Civil Penalties: The DOL can penalize businesses for misclassification violations.

These are just some of the potential penalties for misclassification. Specific consequences will vary depending on the situation. Penalties can add up quickly, making proper classification crucial. By understanding the new DOL rule, the legal landscape, and the potential penalties for misclassification, businesses can make informed decisions about worker classification and minimize legal and financial risks.

Resolving Misclassification

Here are some steps you can take if you discover you have a misclassified employee:

Consult with an employment law attorney. This is crucial to complying with all legal requirements and minimizing potential penalties.
Reclassify the Worker as an Employee (if applicable). If the worker meets the criteria for employee status under the DOL’s “totality-of-the-circumstances” test, you’ll need to reclassify them officially. This involves:
1. Updating their employment records.
2. Beginning to withhold taxes from their paychecks (switching from a 1099 to a W-2).
3. Providing any employee benefits they’re entitled to (health insurance, paid time off, retirement plan benefits, etc.).
Calculate Back Pay and Taxes Owed. You will likely need to calculate any back pay owed for minimum wage or overtime violations and any employer-side payroll taxes you should have paid.
File Amended Tax Returns (if necessary). Depending on the timeframe of the misclassification, you may need to file amended tax returns to reflect the correct employee status. Your tax advisor can help with this process.
Develop a Clear Classification System. Implement a clear classification system for workers moving forward to avoid future misclassification issues. This may involve creating standardized contracts or checklists to assess worker status based on the DOL’s guidelines.

It is always best to address misclassification proactively. If you are unsure about a worker’s status, consult a lawyer or utilize the IRS’s voluntary Form SS-8 to request a determination.

Ensuring Compliance and Minimizing Risk with Windes

By understanding the new DOL classification rules, the legal landscape, and the potential penalties for misclassification, businesses can make informed decisions and minimize legal and financial risks. However, navigating these complexities can be challenging.

Here at Windes, our team of Tax and Employee Benefits Services professionals can help you ensure compliance with all relevant regulations.