Recognizing massive growth in the use of independent contractors — “Gig work has taken the workforce by storm,” as one human resources writer put it — the Department of Labor (DOL) released updated worker classification guidelines that are intended to provide a clear determinations standard but add new layers of complexity.

The determination whether a worker is an employee or contractor governs whether they are granted protection under many labor laws, including those relating to minimum wage and overtime.

Fueling the gig economy is the increasing availability of workers who prefer the autonomy and control that comes with contracting work. Various commentators have suggested this trend constitutes a “seismic shift” and noted that gig economy statistics, while available, are difficult to gather.

The new DOL rule, published in the Federal Register on January 10, took effect March 11, 2024.

Employee or Independent Contractor Classification Test

The new rule applies a six-factor equally weighted “economic reality” test built upon the federal courts’ historical application of the multi-factor, totality-of-the-circumstances economic reality test first litigated in the 1947 U.S. Supreme Court cases United States v. Silk and Rutherford Food Corp. v. McComb.

In 2021, the DOL adopted a streamlined economic reality test in an attempt to clarify prior articulations of the independent contractor versus employee standard. It ultimately withdrew the guidance after receiving thousands of critical comments. This is reminiscent of the Treasury’s withdrawal of I.R.C. §385 regulations it had promulgated in an attempt to control the debt versus equity classification for federal income tax purposes. Like payroll tax classification, the inquiry is inherently factual, and, therefore, it is extremely difficult to articulate a standard that properly resolves all issues.

On a subsequent notice of proposed rulemaking on worker classification, the DOL received more than 50,000 comments that similarly sent it back to the drawing board.

The new rule returns to the totality of the circumstances of economic reality, and the factors do not have a pre-determined weight. The six factors are:

1. Opportunity for profit or loss depending on managerial skill
2. Nature and degree of control
3. Degree of permanence of the work relationship
4. Nature of work — is it “integral” to the employer’s business?
5. Specialized skill and initiative
6. Relative amount of investment of capital or entrepreneurial effort by the worker compared to investment by potential employer

Under this economic reality test, the “investment” factor is separately considered. The rule addresses how remote supervision, the right to work for others, scheduling, and price setting are analyzed under the control test. It also considers exclusivity in the permanency factor and initiative in the skill factor. The rule specifically doesn’t apply extra weight to factors 1 and 2, which had been “core factors” in the withdrawn rule.

For mergers and acquisitions in particular, this will place another layer of uncertainty on proper worker classification, which will increase legal, HR, and tax due diligence efforts, and perhaps increased interest in representations and warranties insurance policies to cover the risk.

Given the risk of misclassification and both the legal and tax liabilities that may remain with target companies after M&A transactions, buyers should consider the magnitude of risk when looking to acquire target businesses that rely heavily on contractor work. Even if both the company and the worker are in a mutually beneficial relationship, the government may not see it the same way.

Worker Classification and Payroll Tax

Worker payroll tax classification has always been a favorite IRS audit topic and has often been included in the IRS’ annual list of “Dirty Dozen” tax abuses. The IRS has applied its three-category analysis in determining payroll tax classification: behavioral control, financial control, and the relationship of the parties.

For both employees and independent contractors, Social Security taxes are 12.4% of income and Medicare 2.9%. But for employees, the company pays its half, and withholds and pays the employees’ half on their behalf. Independent contractors must pay the full amount of Social Security and Medicare taxes as part of their self-employment taxes. The annual filing is done on Form 1040 Schedule SE (Self-Employment Tax) as explained in IRS Publication 334 (Tax Guide for Small Businesses).

Given that the IRS collects the same amount of Social Security and Medicare taxes from employees and independent contractors, perhaps its vigilance on unemployment taxes — which independent contractors do not pay at the federal or state level — is misguided.

Litigation Concerning Worker Classification

Many are aware of litigation involving Doordash, FedEx, Grubhub, Lyft, and Uber over the proper classification of their drivers. This is the 21st century version of a long history of litigation of the proper classification of truckers.

In 2015, FedEx paid $228 million in a settlement to more than 2,000 California drivers after the Ninth Circuit Court of Appeals ruled that they were employees rather than independent contractors for California labor law purposes.

Just the next year, FedEx paid an additional $240 million in a settlement to drivers from more than 20 states in a similar class action lawsuit. As a result, FedEx stopped working directly with independent contractors in 2011 and now contracts with businesses that employ their drivers. At issue in the litigation was whether the drivers were entitled to healthcare, workers’ compensation, paid sick and vacation, overtime, and retirement benefits.

FedEx also tangoed with the IRS. After assessing $319 million of payroll taxes and penalties against FedEx for its 2002 year (with the 2004 to 2008 years pending), the IRS eventually walked away from the issue. The IRS decision came after the D.C. Court of Appeals determined in a 2009 case that FedEx drivers are independent contractors operating as small business owners, not employees, and therefore are not subject to the National Labor Relations Board. The IRS had argued that the drivers ought to be classified as employees under the then-popular 20-factor test. The drivers drove FedEx trucks, wore FedEx unforms, and worked full-time for FedEx based on set schedules. Perhaps the IRS was right to assert that the drivers were employees.

21st Century Economic Realities

In its war on independent contractors, the IRS often overlooks the economic realities of the 21st century. For example, consultants (e.g., management consultants, IT consultants, security-clearance level government consultants) are often hired by consulting firms to supplement their employee-base. These contractors may be hired because of their extensive experience and deep expertise in a niche area and are often hired for a specific project.

Often, consulting firms cannot afford to hire these consultants full time because they don’t have a revenue stream that requires their expertise on a full-time basis. The “right” answer in this case is that the consultants should be respected as such. This is consistent with the fact that, given their expertise and experience, the consulting firm does not have sufficient behavioral control to be considered the employer. It is also consistent with the economic reality that the consultant is often hired for a single project, which may last for a month or for more than a year. The consultant is available to others for hire but may be so involved in one project that it is not feasible to work for others. This should not change their classification.

Is the Worker Integral to Business?

One of the troubling considerations is whether the worker is integral to the business. A worker seems much more like an employee when they perform work for an employer’s client (e.g., providing IT consulting to a client) rather than performing work for the employer (e.g., providing IT consulting to support the employer’s internal systems). In that case, they perform the same or similar work as employees but do so without the same employee benefits and protections. This is frequently the case for truckers and consultants.

However, this is an industry standard. For both truckers and consultants (as well as other professions including cyclical businesses), businesses cannot financially afford to employ all the talent they need, which is why they supplement the employee base with contractors. Accordingly, industry standards ought to be considered in the determination, but they are not in the new DOL rule.

Several states have adopted their own specific worker classification rules. California, Illinois, Massachusetts, and New Jersey have adopted the so-called “ABC” test, under which a worker may be classified as an employee unless all of the following three conditions apply:

1. The employer does not control or direct the worker’s performance
2. The work is performed outside the regular course of a business
3. The worker has an independent business, or occupation of the same nature as the work being performed (e.g., a landscaper hired by a company to do landscaping)

The ABC test tends to weigh in favor of employee status.

While California’s ABC test applies to most professions, CA Labor Law §§2775 to 2787 explains that the “Borello” test, referring to a state Supreme Court decision, applies to certain licensed and registered professions. Illinois’s Employee Classification Act, at IL 820 ILCS 185, is one of the most stringent contractor classification rules in the nation. See also Massachusetts’s MGL c. 149, §148B and the New Jersey Unemployment Compensation Act, NJSA §43:21-19(i)(6)(A) to (C).

While protecting workers’ rights and ensuring they are properly paid are admirable goals and consistent with government’s paternalistic role, adopting strict standards that tilts the balance toward workers being employees takes away the freedom of employers and workers to elect the classification of their choice. Although this may surprise some, a fair number of workers choose to be independent contractors and should generally be free to do so.

How to Classify Workers Is Still Not a Resolved Matter

Ultimately, the determination of a worker’s classification as independent contractor or employee is highly factual. Given that, it seems there will also be continued government scrutiny and litigation, which will not be resolved or improved by the DOL’s new standard. We acknowledge the difficult challenge of the IRS and federal and state Departments of Labor in proper collection of payroll taxes and protecting worker’s rights. That being said, we also acknowledge that the economics of the 21st century call for an updated view of the employer-worker relationship.

Originally published in Bloomberg Tax.