On October 11, 2022, the U.S. Department of Labor released proposed rules rescinding current worker classification rules (2020 final rule) and reverting to prior guidance based on historic court rulings on the matter.
2020 final rule
As the administration changed hands, the 2020 final rule was placed under scrutiny. First, implementation of the rule was postponed and then later the DOL attempted to withdraw the rule. The 2020 final rule established a new standard for determining a worker’s status based on two core factors. Those two core factors are: (1) the nature and degree of the worker’s control over the work, and (2) the worker’s opportunity for profit or loss based on initiative and/or investment.
Other factors would only be considered if the two core factors were not helpful in making a worker determination. The attempt to withdraw the rule was legally challenged and a federal court vacated the action on March 14, 2022, leaving the 2020 final rule in effect.
New proposed rules for worker classification
The DOL’s new proposed rules rescind the 2020 final rule, rejecting the use of two core factors, and opt for a multi-factor approach for worker classification. The proposed rule would return to a totality-of-the-circumstances analysis of the economic reality test in which the factors do not have a predetermined weight and are considered in view of the economic reality of the whole activity. The factors to be considered are:
- Whether the worker exercises managerial skills that affect the worker’s economic success or failure in performing the work.
- Whether any investments by a worker are capital or entrepreneurial in nature.
- Degree of permanence of the work relationship and weigh whether the work relationship is indefinite in duration or continuous (in favor of employee) or nonexclusive, project-based, or sporadic (in favor of independent contractor).
- Nature and degree of control, including reserved control, over the performance of the work and the economic aspects of the working relationship.
- Whether the work performed is an integral part of the employer’s business.
- Whether the worker uses specialized skills to perform the work and whether those skills contribute to business-like initiative.
- Any additional relevant factors may be considered.
Legal insights into the proposed rules
Payroll on Checkpoint discussed the proposed rules with Todd Lebowitz, a partner at BakerHostetler. He leads the firm’s Contingent Workforce Practice Team and runs the blog, WhoIsMyEmployee.com, which addresses issues of independent contractor misclassification and joint employment.
Additional relevant factors
While the DOL’s proposed rules permit the consideration of “additional relevant factors” in worker classification, Lebowitz noted that the “additional factors” language in the proposed rule is “disappointingly vague.” While the DOL did not provide any examples, he was able to shed some light on what might be considered “additional relevant factors.” Based upon large body of case law, Lebowitz noted that these additional factors may include:
- Whether there is a written contract that sets forth the parties’ expectations
- Acknowledgment by the worker that no workers’ compensation, unemployment, or employee benefits are being provided
- Amount of instructions or training provided
- Whether the worker is free to hire helpers
- Whether the worker decides when and where to work
- Whether full-time work is required
- Whether interim status reports are required
- Whether payment is by the project, month, day, or hour
- Whether expenses are reimbursed
- Whether the worker’s services are advertised to the public or if the worker has other clients
- Whether the relationship is for a contractually defined time period, not at-will
- Whether a court or agency has previously evaluated and approved the classification
IRS worker classification rules vs. DOL worker classification rules
The IRS examines three main categories when determining independent contractor status. Those three main categories are: (1) behavioral control; (2) financial control; and (3) relationship with a total of 13 factors to be considered (see IRS Publication 5520).
Lebowitz described the IRS test as a “Right to Control” test. He explained with a “Right to Control” test, the determination hinges on “whether the hiring party retains the right to control the manner and means by which the work is performed.” Unlike the IRS, the DOL uses an Economic Realities test where a determination is based on “whether the worker is economically dependent on the other party.”
The IRS and DOL define the term “employ” differently. Under the FLSA, 29 USC 203(g) defines “employ” as “to suffer or permit to work.” Lebowitz noted that the Supreme Court has held the definition is “intentionally broader than the common law definition.” As a result, Lebowitz clarified that the same relationship may result in different interpretations under the Economic Realities test (DOL) vs. the Right to Control test (IRS).
Impact of a DOL worker reclassification on withholding tax
We asked Lebowitz what impact, if any, on withholding tax, should the DOL classify an independent contractor as an employee under the FLSA. Lebowitz emphasized that the proposed rules only apply to FLSA requirements such as minimum wage, overtime requirements, and recordkeeping. Lebowitz explained that a DOL determination would have “no direct impact on tax withholding.”
Specifically, Lebowitz pointed out that it would be possible for a worker to be determined as an employee by one agency and independent contractor by the other. However, he stressed that the agencies do share information and a DOL worker classification may lead the IRS to examine that worker relationship more closely and trigger a classification audit.
Impact of the Memorandum of Understanding between the IRS and DOL
On December 14, 2022, the DOL and the IRS signed a Memorandum of Understanding (MOU) where the DOL agreed to refer classification cases as employment tax referrals to the IRS. The MOU specifies a list of conditions that must be met before the DOL makes an employment tax referral.
For example, one of the conditions is that the business has an average dollar-volume greater than $500,000. This helps limit which cases are referred as well as helps the IRS set priorities for review. Lebowitz noted that the MOU simplifies enforcement efforts, while the respective tests remain different. It will make it “easier for the agencies if they can start by investigating businesses that have already been found to have misclassified workers under a different statute.”
It is important to note that the DOL may also have a MOU in place with certain states. The DOL provides an interactive map on state enforcement and outreach.
Impact of state worker classification on DOL determinations
States also have laws regarding worker classification for withholding, wage and hour, unemployment, and even workers’ compensation purposes. In particular, California utilizes the ABC test for worker classification, which begins with the presumption that a worker is an employee, a higher standard that the DOL declined to employ in the proposed rules.
Lebowitz explained, however, like the IRS, a worker determination by the state has no bearing on how the DOL would determine. Particularly, he noted that states may have differing laws on worker classification that impact different areas from tax to unemployment to wage and hour. It is important that businesses comply with both federal laws and the state laws where workers are located.
Standard ABC test vs. strict ABC test vs. common law test
Worker classification is a complex topic. The differences from agency to agency and from federal to state laws further complicate things for employers. Lebowitz explained that the ABC test comes in two varieties, standard and strict.
In general, the ABC test starts with the presumption that the worker is an employee unless the hiring party can prove three items (A, B, C). However, the ABC diverges at the second prong of the test (Prong B) into a strict version versus a standard version. The strict version of the ABC test presumes an employee status unless:
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
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.
Lebowitz explained that the standard test is “a bit more forgiving.” Prong B can be satisfied if the work is performed outside all the places of business of the enterprise for which the service is performed. For example, he noted that California uses a strict ABC test while New Jersey and most states use a standard ABC test. Lebowitz cautioned “No matter where your business operates, determining a worker’s classification is no simple task!”
Keep up to date on the latest developments in worker classification with Checkpoint Edge Payroll.
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