In an effort to clarify whether a worker is an independent contractor or an employee under the Fair Labor Standards Act (FLSA), the U.S. Department of Labor (DOL) recently announced a proposed rule to adopt a five-factor “economic reality” test. This test considers whether a worker is in business for themselves — that is, acting as an independent contractor — or is economically dependent on an employer for work and is therefore an employee.
This rule clarifies a few longstanding standards currently used by the DOL for Social Security purposes and to determine a company’s compliance with federal labor law. Like the “IRS test” used by the IRS to determine this same question for tax purposes, the rule employs a scale of degrees, in which the extent to which each factor is true or not can be judged on a spectrum, rather than the simple yes/no questions of the ABC test used in California’s AB-5 legislation. The proposed DOL rule asks many of the same questions as the IRS test, streamlined to five factors vs. 20, with an emphasis on the financial aspect of the worker-client relationship.
It is important for all freelancers to understand the regulations that may affect their ability to work in their chosen professions. In addition, if you are a freelancer who subcontracts work to other self-employed individuals, it is especially important to understand this proposed rule to avoid potentially exploiting the client-freelancer relationship. This is especially true if you have one or two independent contractors who do significant amounts of work for you and they are providing services that are an integral part of your freelance business functions.
According to the proposed rule, there are two “core factors” that can help to determine the degree of economic dependence a freelancer has on someone else’s business versus their own business.
1) The nature and degree of the worker’s control over the work being performed. For example, any freelancer is likely to be legally classified as an employee if the client exercises substantial control over key aspects of how they do work. However, if they are setting their own work schedule, selecting from assignments, working with little or no supervision, and able to work for others, including competitors, they are more likely to be classified as an independent contractor.
2) The worker’s opportunity for profit or loss based on initiative and/or investment in their work. The DOL’s proposed new rule also requires an analysis of a worker’s investment in their work as it relates to the opportunity for profit or loss as well as the degree to which personal initiative, managerial skills and business acumen are exercised. The more opportunity for personal gain through independent action an individual has, the more it weighs toward them being considered an independent contractor.
Another component of this core factor is the extent to which an individual is able to affect their earnings through initiative or investment — say, a freelance writer who becomes skilled in SEO and is able to charge more for that additional service — in contrast to an employee who is only able to do so by working more hours or by working more efficiently for your business.
These two core factors above are what the DOL’s proposed rule gives the most weight to in determining if a worker is economically dependent on someone else’s business or is in business for themselves. However, the proposed rule also identifies three other factors for consideration in the analysis of legal employment classification:
3) The amount of skill required to do the work performed. If the work you do as a freelancer requires specialized skills, this will weigh in favor of classification as an independent contractor. Alternatively, if the work in question requires no specialized training or skills outside of those provided by the potential employer, this factor would weigh in favor of an employee classification.
4) The degree of permanence of the relationship between the worker and potential employer. If there is an ongoing relationship of an indefinite duration between your freelance business and another freelancer you hire, this factor would weigh in favor of their classification as an employee. If your work relationship with a particular individual is more sporadic, the classification of an independent contractor is more likely.
5) Whether the work is considered part of an integrated unit of production. If an individual works for a business and is fulfilling a required part of a process that is fundamental and analogous to another required function with integrated parts that lead toward a common goal, then that person would be more likely to be considered an employee. If the opposite is true, then classification of the individual as an independent contractor would be favored.
From the DOL’s viewpoint, these five factors provide the framework for “the ultimate inquiry” as to whether, “as a matter of economic reality, the worker is dependent on a particular individual, business or organization for work (and is thus an employee) or is in business for him — or herself (and is thus an independent contractor).”
In addition to the federal DOL, your state DOL may use additional criteria. It is important to understand those rules as well.
Per the DOL’s statement on the release of this proposed new rule, this is a response to the fact that over the years, many business owners have shown a propensity to reduce their expenses by classifying workers as independent contractors, absolving themselves of the legal obligation to provide a minimum wage, overtime, and company benefits, or to keep employment records for these individuals. The DOL says this rule is an attempt “to promote certainty for stakeholders, reduce litigation, and encourage innovation in our economy.”
The proposed rule is open for comment through October 21, 2020. Any interested party may submit a comment in support of or against this proposed rule or any of its parts. Any comments submitted will become part of the public record.
Jonathan Medows is a New York City–based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He provides tax, accounting, and business articles for freelancers on his website, http://www.cpaforfreelancers.com, which also features a blog and a comprehensive freelance tax guide. Please note, due to the high volume of inquiries in regard to COVID-19, Jonathan is not able to respond to individual requests for information at this time.