Employee or Independent Contractor? Employers Need to Know DOL’s Proposed Rule
This blog will be updated with relevant developments
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Misclassification of workers by employers is a big problem, according to the Department of Labor (DOL).
“The misclassification of employees as independent contractors remains one of the most serious problems facing workers, businesses, and the broader economy,” it says in a 10/13/2022 notice of proposed rulemaking (NPRM) from the Wage and Hour Division of the DOL, discussed below.
To combat worker misclassification, the NPRM proposes modifications to regulations regarding how workers should be classified. This is a big deal because if the proposal is adopted – which it almost certainly will be – it would make it more difficult for workers to be classified as independent contracts and easier to be classified as employees, compared to current regulations.
Further, the DOL and the Internal Revenue Service (IRS) entered into a Memorandum of Understanding (MOU) in mid-2022, replacing a similar MOU from 2011, that lays out how the two agencies will work together to combat worker misclassification. More on this below, too.
These developments are of great importance to employers in South Carolina and across the country. It could mean reclassifying some workers that are currently independent contractors as employees, with all that entails.
Here’s what to know.
Proposed Rule by the DOL on Worker Classification
On October 13, 2022, the Wage and Hour Division of the DOL published a notice of proposed rulemaking (NPRM), Employee or Independent Contractor Classification Under the Fair Labor Standards Act (FLSA). You can read the NPRM in its entirety here on the Federal Register.
The rule would provide clear guidance on how to classify workers, making it “more consistent with judicial precedent” and with the FLSA’s “text and purpose,” says the DOL. Workers classified as employees have protections and benefits at the federal level under the FLSA, such as minimum wage and overtime pay, which independent contractors do not have.
The practical effect would most likely be that many workers who are now currently classified as independent contractors would need to be reclassified as employees. An article from the Small Business Administration on the topic notes that “In its Initial Regulatory Analysis, DOL estimates that millions of small businesses could hire and/or be independent contractors,” so this rule could affect a large number of people.
The Six Factors of the Economic Reality Test for Worker Classification
Classification would involve a totality-of-the-circumstances analysis using a multifactor economic reality test comprised of six specific factors and one additional, nonspecific factor. They are:
- Opportunity for profit or loss depending on managerial skill
- Investments by the worker and the employer
- Degree of permanence of the work relationship
- Nature and degree of control
- Extent to which the work performed is an integral part of the employer’s business
- Skill and initiative
- Additional factors
In this blog we won’t go into too much detail about each of these factors, but here’s a little bit of explanation for each one. (For more discussion on the history and application of these tests, follow this link to go straight to factor #1 in the NPRM, which goes into great detail about all the factors.)
- Opportunity for profit or loss depending on managerial skill. This considers several factors such as whether the worker determines their own pay, can accept or decline jobs at will, engages in marketing or advertising to secure more work, and has an opportunity for loss.
- Investments by the worker and the employer. This should also consider how the worker’s investment (if any) compares to the employer’s investment in the business.
- Degree of permanence of the work relationship. This should also consider whether the worker works for the employer exclusively or works for others, too.
- Nature and degree of control. This considers factors such as scheduling, supervision over the performance of work, setting rates, and the worker’s ability to work for others.
- Extent to which the work performed is an integral part of the employer’s business. This is not the same as the degree of contribution a worker makes; for example, one person in a call center of hundreds is still performing work that is essential to the business, even if that individual worker’s contribution is minimal.
- Skill and initiative. Specialized skills and business-like initiative are factors that favor independent contractor status, while work that’s unskilled, requires no training, or requires training from the employer favors employee status.
- Additional factors. Other factors, not enumerated here, may be considered if relevant to determining a worker’s classification.
No one factor is more important than the other, and no single factor is determinative on its own. Rather, this is a totality-of-the-circumstances approach to determine worker classification.
How is this rule different from current rule?
If finalized, which is very likely, this rule would rescind and replace the 2021 Independent Contractor Rule (2021 IC Rule). That rule was finalized in January 2021 shortly before President Trump left office and President Biden was inaugurated, and it was scheduled to take effect in March 2021.
The 2021 IC Rule focuses on two core factors to determine classification: 1, the nature and degree of control over the work, and 2, the worker’s opportunity for profit or loss. Additional factors may be considered if the first two are not clearly determinative. The purpose of this streamlined approach is to “promote certainty for stakeholders, reduce litigation, and encourage innovation in the economy,” according to the final rule published by the DOL.
The current NPRM notes that the approach of the 2021 IR is not in keeping with past approaches, which have included multifactor economic reality tests that looked at the totality of the circumstances, it does not “fully comport” with the FLSA’s text and purpose, and it goes against long standing case law.
In practice, the 2021 IC Rule makes it easier for workers to be classified as independent contractors rather than employees. The rule that’s currently being proposed would make it harder for workers to be classified as independent contractors.
DOL and IRS working together to identify employers misclassifying workers
The interest in codifying and enforcing rules on worker classification is not new.
The DOL and the IRS entered into a Memorandum of Understanding (MOU) in 2022, replacing a similar one from 2011, in which the agencies agree to collaborate and share information. This is less in the pursuit of protecting workers and ensuring they are afforded the protections under the FLSA due to them and more about collecting revenue.
The point of the collaboration is to “promote employer compliance with obligations to properly pay employees and to pay employment taxes.” The MOU outlines, among other things, how the DOL can evaluate businesses to refer to the IRS to look into whether workers have been misclassified. In addition, in reference to whether the DOL should refer a particular case to the IRS, it says “Given scarce IRS resources, the focus is where there is a likely source of collection.”
In short, the IRS appears to be looking for sources of revenue. (Another recent initiative announced by the IRS is a “proposed revenue procedure” called the Service Industry Tip Compliance Agreement program, a voluntary program for employers that would improve reporting of tips to the IRS.)
What this means for employers
Employers need to pay attention to if and when the DOL finalizes the rule proposed in October 2022 and ensure that they are correctly classifying their workers under the new rule once it takes effect. Some employers may be able to easily reclassify existing independent contractors as employees, if needed. Others may not have the resources to do so, because of the associated costs of employment taxes, workers’ compensation insurance, additional benefits, and so forth for employees. Employers may have to significantly change their relationship with their workers in order to meet the qualifications of being an independent contractor, or possibly let these workers go entirely.
The DOL notes in its NPRM that businesses that are already in compliance and are correctly classifying workers will benefit from this new rule, as businesses that misclassify employees as independent contractors gain a competitive advantage. This advantage will be eliminated or reduced if and when the new rule is finalized.
Additionally, an increase in the number of employers could mean an increase in unions and labor organizing. Labor unions generally are not allowed to organize independent contractors, but they can organize employees. The connection between worker classification and the drive to increase organizing and unions was made explicit on Joe Biden’s campaign website page for “Strengthening worker organizing, collective bargaining, and unions.” One of the promises was to “drive an aggressive, all-hands-on-deck enforcement effort that will dramatically reduce worker misclassification.”
Employers should also be aware that even if/when this rule from the DOL is passed, this is not the one and only way to determine whether a worker is an employee. The IRS has its own guidance on determining whether to provide a 1099 or a W-2 (read more on that here), and individual states may have their own rules or precedents, too; in South Carolina, the four-factor model is the standard (read more on that here).
Contact Business Attorney Gem McDowell for Advice and Guidance
If you’re an employer in South Carolina and are seeking legal advice, call Gem McDowell. He has over thirty years of experience helping South Carolina business owners start, grow, and thrive in their businesses. Changing classifications of workers could have a large impact on your business, as could noncompliance, and Gem can advise you on how to navigate this change.
Call Gem and his team at the Gem McDowell Law Group at the Mount Pleasant office at 843-284-1021. In addition to an office in Mount Pleasant near Charleston, Gem also has an office in Myrtle Beach for your convenience.
Employee or Independent Contractor? A Closer Look at the Four-Factor Model
How do you know whether a worker in South Carolina should be classified as an employee or an independent contractor? The decision has big consequences for both employer and worker, as that classification impacts taxes, workers’ compensation, and more.
While the IRS has its own standard for determining whether a worker should receive a 1099 or a W-2 (which you can read about in this blog), right now we’ll focus on how the State of South Carolina approaches this question.
The Four-Factor Model to Determine Employment Status
For many decades, South Carolina courts have used what is called the four-factor model or four-factor test to determine whether a worker should be considered an employee or an independent contractor.
The four factors are:
- The right or exercise of control;
- Furnishing of equipment;
- Method of payment; and
- The right to fire.
Let’s look a closer look at all four.
The right or exercise of control. When an employer controls or directs the worker – or has the right to, even if that right is not exercised – that denotes an employer-employee relationship. An employee is told when to do their job, how to do it, and is typically supervised to some degree. In contrast, an independent contractor decides their own hours, determines how to do their work, and works without supervision.
Furnishing of equipment. When equipment is furnished by the employer to the worker to complete their job, that’s evidence in favor of an employee classification. An employee uses, for example, the computer and desk, or truck and tools, of the employer at the employer’s expense. An independent contractor uses their own materials and tools at their own expense.
Method of payment. Time-based payment tends to show an employee relationship while project-based payment tends to show an independent contractor relationship.
Right to fire. South Carolina is an at-will employment state meaning that an employer can fire an employee and end the relationship immediately with no further obligations or liabilities (assuming the termination was not unlawful). In contrast, many independent contracts include clauses in their contracts that require full or partial payment if a job is terminated unexpectedly before its conclusion.
When determining the status of a worker, no single factor is determinative, and South Carolina courts weigh all the evidence to come to a conclusion. The examples above are as black-and-white as possible, but when these types of cases reach the Court of Appeals or the Supreme Court of South Carolina, they are never as clear cut.
The Four-Factor Model Put to the Test in Ramirez v May River Roofing, Inc.
A case heard in the South Carolina Court of Appeals in November 2020, Ramirez v May River Roofing, Inc. (read the opinion here), shows the four-factor model in action and how SC courts approach the issue of determining a worker’s classification.
The Background
Francisco Cedano Ramirez started a business as a sole proprietor called Cedano Roofing. About a year later, he began working for a company called May River Roofing, Inc., and he worked “continuously and exclusively” with them for approximately three years.
In January 2016, Ramirez was on a roofing job when he fell to the ground, a fall of about 16 feet, and sustained “significant injuries to his back, neck, shoulders, chest, ribs, lungs, and upper extremities” as a result.
The Claims
Ramirez filed a claim for workers’ compensation on the basis that he was May River’s direct or statutory employee.
The Single Commissioner at the SC Workers’ Compensation Commission determined that Ramirez was neither a direct employee nor a statutory employee of May River, but an independent contractor, and therefore was not eligible for workers’ compensation benefits. Ramirez appealed and an appellate panel affirmed the decision.
This appeal followed in which the SC Court of Appeals looked at the evidence de novo to come to its own conclusion about whether Ramirez was an employee of May River and thus eligible for workers’ comp benefits.
Weighing the Evidence to Determine Employee or Independent Contractor Classification
Statutory employee: A statutory employee is worker whose income is treated as if they’re an independent contractor but whose taxes are treated as if they’re an employee. In South Carolina, “settled law commands” a sole proprietor may not be considered a statutory employee, so Ramirez’s claim that he was a statutory employee of May River was denied.
Direct employee: Here the court spends time looking at the evidence using the four-factor model.
- Right or Exercise of Control
Factors in favor of independent contractor classification:
- Ramirez had “a great deal of autonomy”
- Ramirez set his own schedule
- Ramirez did not punch a time clock
- Ramirez was free to negotiate for additional payment or decline the job
- Ramirez was free to hire additional help on a job without approval from May River
Factors in favor of employee classification:
- Ramirez was required to wear a May River branded t-shirt at the jobsite
- Ramirez was required to display a magnetic May River decal on his truck
- Ramirez worked exclusively with May River for three years, which suggested to the court that May River had the right to control Ramirez by withholding work
There was also conflicting testimony about the level of supervision, so that was not considered as a factor in favor of either party.
The court acknowledges that May River’s control over Ramirez’s appearance and their exclusive working relationship might seem “trivial” but thinks they are not. It concluded that May River’s control over Ramirez was more than that of a typical employer-independent contractor relationship and concluded that this factor weighed in favor of an employee relationship.
- Furnishing Equipment
Factors in favor of independent contractor classification:
- Ramirez provided his own tools
- Ramirez provided his own vehicle
Factors in favor of employee classification:
- May River provided Ramirez with all the materials used in the roofing jobs
- May River gave Ramirez a branded t-shirt and magnetic truck decal he was required to display
The court concluded that May River furnishing all the materials at its own expense showed “direct evidence of control” over Ramirez and found that this factor also weighed in favor of employee classification.
- Method of Payment
Factors in favor of independent contractor classification:
- Ramirez was paid “per roofing square” for roofing work (the majority of the work he did)
Factors in favor of employee classification:
- Ramirez was paid by the hour for repair work (a minority of the work he did)
Because the majority of Ramirez’s work was paid on a project or piecemeal basis and his payment did not depend on the amount of time he spent working, the court concluded that this favored an independent contractor relationship.
- Right to Fire
The court did not find any evidence that weighed in favor of either party.
Conclusion: Employee Relationship
The evidence in this case was a mix of factors in favor of both employee relationship and independent contractor relationship. However, after considering all the evidence the court concluded that May River and Ramirez did have an employer-employee relationship, meaning that Ramirez was eligible for workers’ compensation benefits.
Employers Take Note – South Carolina Courts Favor the Employee Classification
Even though Ramirez set his own schedule, had freedom to negotiate payment, could hire help without approval, was paid per roofing square the majority of the time, and used his own vehicle and tools, the SC Court of Appeals still found that the relationship he had with May River constituted an employer-employee relationship.
This reflects the tendency of South Carolina courts to strongly favor the employee classification over the independent contractor classification when it comes to cases involving benefits for injured workers. “The general rule is that workers’ compensation law is to be liberally construed in favor of coverage in order to serve the beneficent purpose of the [Workers’ Compensation] Act; only exceptions and restrictions on coverage are to be strictly construed,” the SC Court of Appeals states in this opinion. While this has long been a general rule, this bias towards employee classification has been even stronger since the Lewis v L. B. Dynasty (2015) case (covered briefly in the 1099/W-2 blog).
If you’re an employer, keep this in mind when hiring and classifying workers. You must treat independent contractors like independent contractors. Seemingly small things, like asking your worker to wear a branded t-shirt, can become evidence of an employer-employee relationship, as seen in this case. Otherwise, hire the worker as an employee so they have the protections they’re entitled to under South Carolina law.
Business Law and Strategic Advice
For help with starting, running, or ending a business, call attorney Gem McDowell of the Gem McDowell Law Group. He and his team help business owners in the Charleston area and across South Carolina with forming LCCs and corporations, drafting corporate governance documents like buy-sell agreements, handling commercial real estate transactions, and more. Gem is also a problem solver who can give you strategic advice so you can avoid problems and protect yourself and your assets. Call him at his Mt. Pleasant office today at 843-284-1021 to schedule a free consultation.
How to Determine 1099 or W-2 Status According to the IRS
Update, 02/15/2023: The Department of Labor’s Wage and Hour Division published a notice of proposed rulemaking on the subject of worker misclassification and how to correctly classify workers as employees or independent contractors; read more about this on our blog here. This rule would be in addition to the approach the IRS takes to worker classification described below.
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In business, the term “1099” usually refers to someone in an independent contractor position. The term comes from the IRS; at the end of the tax year, a 1099 worker receives a 1099 form from their employer rather than a W-2 that employees receive.
Employers may prefer to hire independent contractors rather than employees whenever possible for the main reason that they often cost less to employ. That’s because for employees, employers have to pay Social Security taxes, Medicare taxes, unemployment taxes, and withheld income taxes to the IRS, and carry workers’ compensation insurance to cover them. Also, employers often provide benefits such as health insurance and retirement plans to employees, but not to independent contractors.
How does an employer know how the worker they’re hiring should be classified? While in many cases it’s clear, in others it’s complicated. Here’s how to determine whether a worker in South Carolina is an employee who should receive a W-2 or an independent contractor who should receive a 1099.
Federal Versus State Definitions Of 1099 Independent Contractors
To illustrate the difference between a 1099 and W-2 workers, imagine two plumbing companies hire two plumbers, Jack and Jane. By the terms of employment, Jack must come to the office every day from 9-1, use the company’s truck and tools, and is told which jobs to do and when. By contract, Jill may show up at the office if and when she wants, drives her own truck and uses her own tools, and is told about jobs but not told when she must complete them or how. In this scenario, Jack would be classified as an employee, and Jill an independent contractor.
How workers are classified is of interest to both the federal and state government. The federal government – more specifically, the IRS – cares because it wants to know who will pay the withheld income taxes, Social Security taxes, Medicare taxes, and unemployment taxes for each worker. The state government cares because it runs the state’s workers’ compensation program and needs to know who is responsible for paying for a worker’s injury sustained on the job – the employer (for an injured employee) or the worker themselves (for an injured independent contractor)?
Because the federal and state government have different reasons for wanting to know a worker’s status, they use different standards to determine whether someone is an employee (W-2) or independent contractor (1099).
The IRS’s Definition of 1099 Independent Contractors
The IRS proposes three common law rules for employers to consider when classifying a worker:
- Behavioral: Does the employer control, or have the right to determine, how the worker does their job?
- Financial: Does the employer control the business aspects of the worker’s job? How is the work paid? Are expenses reimbursed? Does the worker provide their own tools, or do they use the employer’s?
- Type of Relationship: Are there written contracts or benefits? What is the nature of the relationship? Was the expectation upon hiring that the relationship would continue indefinitely?
If you’re still uncertain as to how to classify an employee, the IRS can make that determination for you. Fill out Form SS-8 (PDF) and the IRS will review it and make a determination in six months or more.
The Changing Definition of 1099 Independent Contractors in South Carolina
In South Carolina, the approach to worker classification relies on a four-factor model, which you can read more about on our blog here.
A 2015 South Carolina Supreme Court case, Lewis v. L. B. Dynasty (read it here), changed the standard for classifying a worker as an independent contractor, making it stricter in favor of the employee. As a result of this case, workers that previously had been classified as independent contractors may need to be reclassified as employees.
The background: An exotic dancer named LeAndra Lewis was injured when she was accidentally shot while working at the Boom Boom Room Studio 54 in Columbia, SC. She filed a claim for workers’ compensation for coverage of the medical costs of her injuries (which included the loss of a kidney) as well as temporary total disability.
Her claim was denied at first, as she was determined to be an independent contractor by both the single commissioner and the Workers’ Compensation Commission appellate panel. (Independent contractors do not have a right to workers’ comp benefits in South Carolina and employers do not need to carry workers’ comp insurance for them.) The Court of Appeals also affirmed this decision. The South Carolina Supreme Court, however, did not.
Taking the viewpoint that the law should be interpreted to be advantageous to the worker, the Court stated, “The question before the Court is a simple, fact-based consideration—did the Club exercise sufficient control over Lewis to create an employee relationship?” The Court looked at a variety of factors, including the right to, or exercise of, control; furnishing of equipment; method of payment; and right to fire to determine whether the worker should be an employee or independent contractor. Ultimately, the relationship was found to be of an employee nature. That meant Lewis was entitled to workers’ compensation for her injuries.
What The Supreme Court’s Decision Means For South Carolina Employers
South Carolina employers must be sure that their independent contractors meet the high standards the SC Supreme Court has set. The Court has said “we construe workers’ compensation law liberally in favor of coverage to further the beneficent purpose of the Workers’ Compensation Act.” In other words, it will tend to side with the worker and act in their favor rather than in the employer’s.
What happens if you’ve been treating a worker as a 1099 independent contractor when you should have been treating them as a W-2 employee? You may find an unwanted notice from the IRS stating that you owe back taxes for employees. Or your worker may become injured while on the job and sue you, leading to a long and expensive lawsuit. In short, it could cause a big headache and cost a lot of money. For many companies, either one of these scenarios could be devastating. It’s a good idea to review the nature of your independent contractors’ work and make sure they are truly independent contractors according to federal and state law.
Contact Mount Pleasant Corporate Attorney Gem McDowell for Advice
For advice on classifying employees, hiring and firing, contracts, and other aspects of starting or running a business, contact attorney Gem McDowell. He and his team at the Gem McDowell Law Group in Mount Pleasant, SC help businesses make smart and informed decisions in day-to-day and exceptional circumstances. Get in touch by calling (843) 284-1021 or by filling out this contact form online. Schedule your free initial consultation today.
