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What to Know About Potential Changes to the Independent Contractor Classification

The Department of Labor's proposed ruling could have a big impact on independent contractor classification. Are you ready?
Industry TrendsMay 15, 2023

The distinction between employee and independent contractor has significant implications for workers. Your status as one or the other directly impacts issues like your legal protections, access to benefits, and level of autonomy.

The Department of Labor’s latest proposed ruling alters the independent contractor classification guidelines for the Fair Labor Standards Act (FLSA). If you’re currently self-employed, your status may be changing soon.

Here’s what you need to know about the pending shift, including what it means, its pros and cons, and what you can do to prepare for it.

History of the FLSA Independent Contractor Classification

Back in 1938, the FLSA became a big deal. It created the Department of Labor (DOL) and brought in some game-changing protections for workers, like the minimum wage and overtime requirement of 150% base pay for hours worked beyond 40 per week.

But here’s the deal: those benefits only apply to workers who qualify as employees under the FLSA. Independent contractors are explicitly excluded. Unfortunately, the regulations don’t provide a way to tell the difference between the two.

As a result, the question of who qualifies as an employee for FLSA purposes fell to the court system. In the 1940s, the Supreme Court set a precedent for an “economic reality test.” It aims to determine whether a worker is economically dependent on the employer for work or in business for themself.

If you're economically dependent on the employer, you're an employee. But if you're in business for yourself, you're an independent contractor. The court laid out a bunch of factors to help make that call.

These factors have been around for ages, and the DOL sums them up like this:

  1. How essential are your services to the employer’s business?

  2. How much have you invested in the equipment and supplies you use?

  3. Do you have opportunities for profit and loss through your work?

  4. How much control does the employer have over how and when you work?

  5. Is your relationship with the employer indefinite or temporary?

  6. How much skill and initiative do your services require?

These factors are all considered together, with none carrying more weight than the others. The list is also nonexhaustive, leaving room for other variables when applicable. Pretty confusing, right?

What is the Proposed Department of Labor Ruling?

In January 2021, the DOL published a ruling titled Independent Contractor Status Under the FLSA, referred to as the 2021 IC Rule. It narrowed the scope of the factors used to establish economic dependence and increased emphasis on the following two:

  • How much control the employer has over the worker

  • The worker’s opportunity for profit or loss

Under the 2021 IC Rule, these two factors overshadowed everything else, going against years of established legal precedent. The DOL had second thoughts about that decision almost immediately. It tried to withdraw the 2021 IC Ruling before it could take effect, but the courts intervened, and the ruling went through.

The most recently proposed DOL ruling aims to turn things around. It wants to reverse the 2021 IC Ruling and bring back a more traditional version of the economic reality test. The new test pushes for a return to determining economic dependence by analyzing the six traditional factors with a “totality-of-the-circumstances” approach, giving all the contributing variables equal weight.

More importantly for self-employed folks, the proposal dives deeply into the modern applications of these factors. If passed, it’s going to make it tough for many employers to classify certain workers as independent contractors.

Here’s the silver lining: people traditionally excluded from FLSA protections may finally start to receive them in the coming years as employers, workers, and the courts adapt to the ruling.

Pros and Cons of the Proposed Ruling

The latest DOL proposal brings some much-needed clarity to the economic reality test. It puts the pressure on employers to think twice before misclassifying workers as independent contractors. That may help people wrongfully considered self-employed under the FLSA get employee treatment.

These workers will be entitled to all of the protections the Act provides, like fair minimum wages and proper overtime rates. That should help prevent dishonest employers from underpaying workers, reducing their competitive advantage over employers that comply with the law.

However, not all independent contractors are excited at the thought of becoming employees. When similar regulations took effect in California, protesting truckers took to the streets and shut down the Port of Oakland for five days. Why? It comes down to autonomy. They valued their freedom and independence, and they didn’t want to lose it.

There’s another thing to consider. Classifying workers as employees under the FLSA may prompt other regulators to change their classification. That could lead to many undesirable effects for self-employed people. Take, for instance, the Internal Revenue Service (IRS). If they suddenly view a 1099 contractor as an employee, that 1099 contractor would lose the ability to deduct their business expenses and reduce their taxable income.

Two Ways the Ruling Could Affect Self-Employed Workers

So far, we’ve covered pretty abstract ideas regarding the DOL ruling. To paint you a clearer picture of what self-employed workers might experience if it takes effect as proposed, here are two tangible changes that might occur.

Widespread disruption of the gig economy

The gig economy is one of the sectors that's most likely to be impacted by the DOL’s proposed ruling. With the new guidance, it’s easy to argue that rideshare and delivery workers should be considered employees under the FLSA.

In fact, the misclassification lawsuits have already started. On March 30, 2023, the U.S. District Court for the Northern District of California ruled that a Grubhub driver was an employee under the FLSA and entitled to its benefits, though not due to the DOL ruling.

If this trend continues, companies that rely heavily on drivers will be hit hard by skyrocketing labor costs. And guess what? As a result, the demand for driving work will drop, putting these businesses in jeopardy. Uber even mentioned this risk in its most recent 10-K, where it said its financial performance would be “materially adversely affected” by the reclassification of drivers as employees, especially if they become represented by labor unions.

Turbulent client relationships for professional service providers

The DOL’s proposed ruling will impact self-employed individuals who provide professional services like graphic design, social media management, and freelance bookkeeping in a less predictable way compared to gig workers.

There’s a lot more variation in the business models these independent contractors follow. Some are employees in everything but name, holding indefinite contracts with one client who has significant control over their work. In these cases, it may be fairly straightforward for employers to grant FLSA benefits. Because these workers are also likely to earn more than the minimum wage and work less than 40 hours per week for their clients, the employer’s burden may be minimal.

On the other hand, some service providers are well removed from employee status, such as those who work with a constant supply of new clients, only accepting one-off projects that aren’t integral to their business activities.

Professional service providers will likely experience turbulence in their client relationships as everyone adapts to the DOL ruling. Some may become closer with their would-be employers, while others grow more distant, depending on each side’s circumstances and preferences.

How to Navigate the Proposed Ruling

After issuing its Notice of Proposed Rulemaking, the DOL opened the floor for public comments for 45 days to help inform its final decision. That period ended on November 11, 2022.

Now, the DOL is in deliberation mode, carefully considering all the feedback they received, after which it’ll publish its final rule. It’s unclear when that will happen or what changes it’ll make to its proposal, if any. In the meantime, here are four things self-employed people can do to prepare for the impact.

  1. Understand the general implications of the ruling: Remember, it only applies to your employee or independent contractor classification under the FLSA for now. Agencies like the IRS have their own way of determining worker status.

  2. Consider the most likely effects of the ruling on your work: Examine your relationship with the businesses you work for and determine whether there’s an argument for you being an employee after the change. If you suspect you might no longer fall into the independent contractor classification under the FLSA, develop a strategy for managing the potential fallout of that transition or change your business model to distance yourself from employee status. You might diversify your client base or negotiate for more control over how you perform your services.

  3. Sign up for the DOL’s emails: You’ll receive notifications as the department releases new information, and you’ll know as soon as it issues its final rule so you can react immediately.

  4. Prepare your finances: If you’re worried the new ruling may throw a wrench in your business model, it’s time to build up cash reserves. Having extra financial runway gives you the power to ride out any storm that comes your way.

As we await the final ruling from the Department of Labor, it’s easy to feel like there’s nothing you can do. Despite the uncertainty, there are steps you can take to prepare for the potential impact.

The information on this website is not intended to provide, and should not be relied on, for tax advice.

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