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:

1. Opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the employer
3. Degree of permanence of the work relationship
4. Nature and degree of control
5. Extent to which the work performed is an integral part of the employer’s business
6. Skill and initiative
7. 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.)

1. 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.
2. 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.
3. Degree of permanence of the work relationship. This should also consider whether the worker works for the employer exclusively or works for others, too.
4. 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.
5. 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.
6. 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.
7. 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.