A Contractor vs. An Employee

New government rules will affect the classification. And now is the time to get ready. 

If your business, like mine, uses independent contractors, then new rules in the works at the Department of Labor may change how we classify these workers. Many of us may be required to classify these contractors as employees.

A number of factors are considered when determining whether a worker is an independent contractor or an employee. 

These include the permanency of the relationship, the nature and degree of control you have over that worker, and the contractor's opportunities for profit and loss.

In an independent contractor relationship, the contractor is not entitled to any benefits of an employee, such as health insurance, and is responsible for directly paying taxes. The business pays the contractor directly and, if that amount is more than $600 during a year, the business reports these payments to the IRS on a 1099 tax form.

But last month, the Department of Labor formally announced its plan to issue new rules on how employers classify their employees and contractors. "The department now plans to engage in rule-making on determining employee or independent contractor status under the Fair Labor Standards Act," Jessica Looman, the acting administrator for the Department of Labor's Wage and Hour Division, wrote on the DOL's blog. "We remain committed to ensuring that employees are recognized correctly when they are, in fact, employees so that they receive the protections the FLSA provides."

ABC test

During his campaign, President Joe Biden voiced support for an "ABC test," like the one used in California, to determine worker classifications. The ABC test focuses on three factors:

A: The worker is free from the control and direction of the hirer in connection with the performance of the work.

B: The worker performs work that is outside of the usual course of the hiring entity's business.

C: The worker is customarily engaged in an independently established trade, occupation or business.

Parts A and C do not differ much from the previous rules. But Part B may give many business owners some pause.

Take my business, for example. When needed, I employ a handful of outside developers to perform tasks for clients and then bill my clients for their time. Under the ABC rule, I may be required to classify those developers as employees because they are not "performing work that is outside of the usual course" of my business. They are generating revenue for me, which means I would have to withhold taxes and potentially offer them participation in my company's benefit plans.

This would also be the case for small businesses that use independent drivers, content creators, technicians, trainers or specialists who perform billable services for their customers.

What's even more concerning is that the new rules could be applied retroactively.

"I would think that, if the government took a position that, even though the worker was properly an independent contractor prior to the adoption of the ABC test, now that the ABC test is the operative test, the government can go back to when the worker was originally retained," said Robert Bovarnick, a business lawyer based in Philadelphia.

Opponents, which include many business organizations and associations representing freelancers, say the rules inhibit entrepreneurship and their freedom to practice independently. They also argue that the new rules will raise costs for small businesses and make it easier for employees to unionize.

Supporters say it gives workers more protections and that, according to Looman from the DOL, "employers who comply with the law are at a competitive disadvantage when competing against employers who misclassify employees and pay them less than the law requires and fail to provide other employment-based worker protections."

How to get ready

For small-business owners, however, it's time to get ready.

"Regardless of whether the ABC test is adopted, it would be wise for business owners to review their existing independent contractor agreements with their attorney," Bovarnick said. "At the very least, it will cause Philadelphia area employers to familiarize themselves with the new ABC test to see if someone is considered an employee or an independent contractor."

So what else should you do to prepare your business?

Claude Schoenberg, a Bala Cynwyd labor lawyer who represents employers, is advising his clients to get their finances in order.

"You need to make sure you're prepared to pay more for payroll taxes and benefits," he said. "You may need to make adjustments to your contracts in order to cover the cost of these benefits and taxes."

Schoenberg is also advising his clients to revisit their insurance policies, particularly their workers' compensation coverage, and calculate how much more in premiums it would cost for each additional person who would be classified as an employee.

The Department of Labor held two open forums for employers and workers in June to get feedback and has now begun the formal rulemaking process. Although no date has been given for the final rule, I'm expecting this to happen by the end of the year.

However, even when the new rule is issued, there will be complications. That's because the rule will likely not affect how states determines their worker classifications and would likely not change how the IRS determines independent contractors for tax reporting purposes. Confused? You're not alone. That's why many lawyers such as Schoenberg say lawsuits will be inevitable.

"I expect legal challenges to the authority of the Department of Labor to implement these changes," he said. "And I hope those challenges succeed."

Are you looking for legal advice? RJ Fichera Law Firm can help with strategic business planning, including legal organization and business structuring. Call today for a free consultation. 610-768-9255

This article was provided by Gene Marks, a certified public accountant and the owner of the Marks Group, and brought to you by the Ronald J. Fichera Law  Firm, where our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!

This is not tax advice and should not be construed as such.  Please seek professional tax services for more information and advice that will apply to your specific tax situation.