FLSA vs IRS Independent Contractor Rules

They serve different purposes and therefore have some differences in their standards

Published June 13, 2024 | Revised November 30, 2024

WHAT'S IN THIS ARTICLE
Introduction | Why Misclassification Matters? | DOL's 2024 Final Rule | DOL's 2021 Final Rule | IRS Common Law Rules | Compare & Contrast FLSA vs IRS Rules | Avoid These Pitfalls | How Does Final Rule Affect FLSA? | **NEW**Significant Changes to Independent Contractor Rules and Related Areas in 2024

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FLSA vs IRS Independent Contractor Rules

The Department of Labor (DOL) and the Internal Revenue Service (IRS) have frameworks to determine whether an individual is an employee or an independent contractor, but they serve different purposes and therefore have some differences in their standards.

Businesses must be careful to consider both the DOL's interpretation (Final Rule) of the FLSA and IRS guidelines when determining how to classify and manage workers to ensure compliance with both tax and labor regulations, especially when they are odds with each other.

Help getting all your ducks in a row

Misclassifying workers, whether intentionally or by mistake has consequences. Understanding why it matters to get this classification right is necessary for both workers and employers.

Businesses may misclassify workers as independent workers in order to avoid their payroll obligations as well as basic employee rights and protections. Here's why proper classification is crucial:

• Worker Protections
  Employee classification carries important implications for worker protections under laws like the Fair Labor Standards Act (FLSA), which mandates minimum wage, overtime pay, and other protections.
  
  Employees are also covered under state and federal labor laws that provide additional benefits such as workers' compensation, unemployment insurance, and family leave protections.
  
  Misclassification matters to businesses because independent contractors do not receive these protections and benefits, which can significantly impact their financial and personal health security. 
  
  
•  Access to Benefits
  
  Employees often have access to benefits such as health insurance, retirement plans, paid vacations, and sick leave.
  
  Independent contractors, meanwhile, must provide their own benefits, which can be prohibitively expensive and less comprehensive.
  
  Misclassification matters to businesses because it can deny employee benefits to workers, impacting their financial well-being and job satisfaction.
  
  
• Tax Implications
  Tax obligations differ significantly between employees and independent contractors. Employers withhold income tax, Social Security tax, and Medicare tax from employees' wages.
  
  Independent contractors must handle these obligations themselves, often resulting in higher tax complexity and burden. This means they must pay both the employer and employee portion of SST and Medicare tax.
  
  Misclassification matters to businesses because it can lead to incorrect filing of taxes, possible underpayment of taxes, and the potential of an audit which may result in penalties from the IRS, DOL, or your state.
  
  
• Legal Compliance and Penalties
  The government enforces strict rules about how businesses classify their workers to ensure everyone pays their fair share of taxes and receives appropriate legal and financial protections.
  
  Misclassification matters to businesses because it can lead to penalties, interest, and back taxes.

• Possible Impact on Business Reputation
  Consider that misclassifying workers (especially as independent contractors) might initially save businesses on costs such as benefits and taxes.  However, it might lead to decreased employee morale, distrust in management, not to mention possibly making it harder to recruit high-quality talent.
  
  Misclassification matters to businesses because it can damage a company’s reputation.

The 2024 Final Rule is Employee Friendly

Effective March 11, 2024, the 2024 Final Rule went back to using the "economic realities" test under the Fair Labor Standards Act (FLSA) to classify workers. It will make it more difficult to classify a worker as independent contractor.

This test is primarily concerned with whether the worker is economically dependent on the employer or is truly in business for themselves. Unlike the 2021 Final Rule, none of the six factors are given any predetermined weight. The 2024 Final Rule returns to looking at the totality of the circumstances.

The FLSA protects workers who are dependent on a business. The more dependent the worker is on the business, the more likely it is that the worker should be classified as an employee.

Key factors in the DOL's economic reality test typically include:

1. The worker's opportunity for profit or loss depending on managerial skill / business acumen. It is not considered entrepreneurial if the worker can earn more money by working more hours.
   
2. The worker's investment in equipment or materials required for their task. The relative (not absolute) investment made by the worker and the employer will be taken into consideration.
3. The permanence of the relationship between the worker and the employer.
   
4. The degree of control the employer has over the work.
5. The extent to which the work is an integral part of the employer’s business.
6. The degree of skill and independent "business like" initiative required to perform the work. (This is a departure from the 2021 "integrated unit of production" standard.)

These factors help determine the economic dependence of the worker. It is important to keep up-to-date as the standard seems to change with each new administration.

It's not only the FLSA vs IRS independent contractor rules you have to consider. I haven't mentioned yet that each state may have their DOL classification regulations. They are sometimes even stricter than federal guidelines; California's "ABC test" comes to mind.

2021 DOL Final Rule Was Business Friendly

The 2021 rule introduced by the DOL under the Trump administration emphasized an “economic reality” test to determine whether an individual is an employee or an independent contractor under the FLSA. This test primarily focused on two core factors:

1. The nature and degree of control over the work.
2. The worker’s opportunity for profit or loss based on initiative and/or investment.

These factors were considered more important than others in the determination process. Additional elements could also play a role but were given less weight:

• The amount of skill required for the work.
• The degree of permanence of the working relationship.
• Whether the work is part of an integrated unit of production.

This 2021 rule was seen as making it easier to classify workers as independent contractors, which is beneficial for businesses looking to reduce labor costs but controversial in terms of worker protections.

The IRS, on the other hand, uses the "common law rules" focusing on the degree of control and independence in the relationship. The IRS rules are primarily used for tax purposes, determining how a worker should be classified for federal tax obligations.

The key factors according to the IRS include:

1. Behavioral control - Does the company control or have the right to control what the worker does and how the worker does the job?
2. Financial control - Does the payer control the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.
3. Type of relationship - Are there written contracts or employee-type benefits such as a pension plan, insurance, vacation pay, etc.; will the relationship continue; is the work performed a key aspect of the business?

If your business isn't sure how to classify a worker, send IRS form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding for a ruling.

Although FLSA and IRS sets of standards both assess the nature of the relationship between worker and employer, there are nuanced differences:

• Purpose: IRS standards are tailored for tax status and implications, while the FLSA's standards focus on labor laws and protections.
• Approach: The IRS places a strong emphasis on financial and behavioral aspects, whereas the DOL also considers the economic dependence of the worker in substantial detail.

While the criteria overlap to some extent, they can lead to different determinations in specific situations. This can result in a situation where a worker might be classified as an independent contractor under the IRS's set of rules and an employee under the DOL's set of rules.

Therefore, organizations must be careful to consider both DOL and IRS guidelines when determining how to classify and manage workers to ensure compliance with both tax and labor regulations.

Benefit plans are governed by the Internal Revenue Code and the regulation of "IRS Rules".

Due the differences between the 2024 Final Rule and the IRS Rules, Linklater's January 29, 2024 article titled The DOL Publishes its Long-Awaited Final Independent Contractor Rule suggests you be mindful of avoiding these employee benefit plan pitfalls:

1. Retroactive coverage - a misclassified employee could lead to retroactive benefit entitlement and penalties under the Affordable Care Act.
2. Plan testing - a misclassified employee could affect your retirement plan's annual non-discrimination testing.
3. Coverage for independent contractors - most employer-sponsored benefit plans prohibit participation of independent contractors.

No. It should be noted that the Final Rules serve to revise the DOL's interpretation of the FLSA.

The DOL's website says "It [the final rule] has no effect on other laws—federal, state, or local—that use different standards for employee classification. For example, the Internal Revenue Code and the National Labor Relations Act have different statutory language and judicial precedent governing the distinction between employees and independent contractors, and those laws are interpreted and enforced by different federal agencies. Similarly, this rule has no effect on those state wage-and-hour laws which use an “ABC” test, such as California or New Jersey. The FLSA does not preempt any other laws that protect workers, so businesses must comply with all federal, state, and local laws that apply and ensure that they are meeting whichever standard provides workers with the greatest protection.[my emphasis] See 29 U.S.C. 218."

There have been significant changes to independent contractor rules and related areas in 2024. These changes will affect small business owners like yourself. Let me provide some context and details about these changes:

1. New Independent Contractor Rules (March 11, 2024):
   The Department of Labor (DOL) has finalized new rules for classifying workers as independent contractors known officially as the 2024 Final Rule. These rules are designed to provide more clarity and consistency in determining worker status. The new guidelines emphasize the "economic reality" test, which looks at the worker's economic dependence on the employer. This may make it more challenging for businesses to classify workers as independent contractors.
   
   
2. New Overtime Rules (April 23, 2024):
   The DOL has updated the overtime pay rules, which could affect how you compensate your employees. This likely includes an increase in the salary threshold for exempt employees, meaning more workers may be eligible for overtime pay. As a small business owner, you'll need to review your current employee classifications and pay structures to ensure compliance.
   
   
3. FTC Rules on Noncompete Agreements (April 23, 2024):
   While not directly related to independent contractor classification, these new rules from the Federal Trade Commission (FTC) may impact how you structure agreements with both employees and independent contractors. The rules likely place restrictions on the use of noncompete clauses, which could affect your business practices.
   
   
4. Worker Categorization Audit Issues:
   The IRS and DOL continue to scrutinize worker classification. With the new rules in place, it's more important than ever to ensure that your worker classifications are accurate and defensible.

Given these significant changes, I strongly recommend the following actions:

1. Review your current worker classifications in light of the new DOL rules.
2. Assess your overtime pay practices and ensure they align with the updated regulations.
3. Examine any noncompete agreements you have in place and consider how the new FTC rules might affect them.
4. Consider seeking professional assistance to ensure full compliance with these new regulations.

Takeaway
When looking at FLSA vs IRS independent contractor rules, it's important to understand they serve different purposes and therefore have some differences in their standards.

These 2024 changes discussed are complex and can have significant implications for your business. Work with your CPA to review your current practices to help you implement any necessary changes to ensure compliance with these new rules. Your circumstances might lend itself to also consulting with an employment law attorney to fully understand the legal implications of these changes for your business.

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