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Economic Realities Test: Do You Truly Have an Independent Contractor?

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As we’ve written before, proper independent contractor classification is not easy. There are many different factors that must be considered, and no single factor provides a definitive answer. The task is made even more challenging because various federal and state agencies have elected to apply different definitions and standards in determining whether a flexible worker should be classified as an employee or independent contractor.

In our role as independent contractor compliance and engagement specialists, supporting enterprise clients across the country, the Synergy Services compliance team evaluates thousands of consultants a year. We must evaluate each worker, and the work they’ve been engaged to do, in the context of the applicable federal and state regulations. One significant worker classification standard that we must always consider is the US Department of Labor.

According to the recent DOL Administrators Interpretation, we have recently gained some additional clarity around the definition of what the DOL considers to be an employee. The DOL advocates that the Fair Labor Standards Act (FLSA or “the Act”) may be helpful to the regulated community in classifying workers and ultimately in curtailing misclassification. The FLSA’s definition of employ as “to suffer or permit to work” and the later-developed “economic realities” test provide a broader scope of employment than the more traditional common law control test.

When reviewing flexible workers, these definitions can often leave compliance practitioners in a bit of a grey area. When a company manager needs to hire workers, especially on what would be termed as hiring on a project basis, the line between independent contractor and W2 employee can quickly become blurry.

When dealing with construction workers and nurses, an employee relationship can often seem clear. But in a real-world example, when engaging a high-level software developer and the economic realities test is applied, an employer can be left in a challenging worker classification predicament. Let’s take a look at applying the economic realities test in this situation.

The economic realities test digs deeper into questioning how an employer pays a worker who been classified as an independent contractor. The key items that are identified and questioned are:

  • Is the work that is being performed integral to the employer’s business?
  • If the worker makes a decision, does that decision determine if the worker profits or suffers a loss?
  • Does the work that is being performed require a specialized skill?
  • Is the relationship between the worker and employer on-going?
  • What is the level of control the employer has over the worker and the work being performed?

The answers to these questions help to determine if a worker is truly an independent business or if the worker is economically dependent on the employer.

Is the worker an integral part of the employer’s business?

The Administrator’s example is for a construction company that frames homes using a carpenter. In this case that carpenter’s work is going to be integral to the business and should be considered a W2 employee.

It is not so clear when talking about the example of the high level software developer. Why? The work the developer is performing is important to the business, as without the software, the business cannot implement what it needs in order to innovate, and remain competitive and profitable. The work being performed is certainly seen as an important element to the business, but is it integral?

Does the worker’s managerial skill affect the worker’s opportunity for profit or loss?

The Administrator provides an example illustrating how a worker who provides a cleaning service to corporate clients only works when the cleaning company determines it, while also not having the ability to advertise or work for other clients, would be considered a W2 employee of the cleaning company. On the other hand, there could be a worker providing cleaning services for corporate clients that advertises, negotiates rates, has other clients, decides when to work, and has the ability to turn down jobs, which would be considered an independent contractor.

The software developer in our example is able to turn down other jobs, but is constrained by the fact that they are providing nearly full-time hours to the employer, meaning the developer does not have the ability to take on any other clients given the full-time hours, and the longevity of the project. Even though the developer negotiated his own rate to an extent, it was based on the rate for an employee performing similar work, on top of that, the developer had no marketing materials except some word of mouth and networking connections.

Does the work performed require special skill and initiative?

The Administrator takes this question further than just asking if the worker possesses a specialized skill, such as a highly skilled carpenter, but rather does that worker make independent judgments; including deciding the sequence of work, the ordering of materials, and pursuit of the next gig. A W2 employee would be provided the sequence of work, and is essentially told what and how to do the work.

The independent contractor would be making these decisions, and in our example of the high level developer, the developer draws out the sequence with the manager, as that is the skill set required, but the manager is still stating the deadline, and is providing a sequence of events that will most likely lead to the developer working on the next consecutive project for the employer as well. This makes the project seem like an on-going type of relationship.

Is the relationship between the worker and the employer permanent or indefinite?

The Administrator sees this as a straightforward question. If the work is indefinite or permanent, then the employer is suggesting a W2 employee relationship.

There are a couple of scenarios where this can be confusing, one is that a manager will use a worker, and even have an end date to the project scheduled, but due to the work, the end date and the project are continuously extended. It is perfectly normal for a project to be extended and for scope creep to affect the work and add requirements to the deliverables, but eventually that project should actually come to an end. Some work that an employer will need starts as a project with a stated end date that truly will end, but becomes far more core to the business as the work progresses, so much so that there is now no end date, and the worker becomes the only resource for the business that can provide the specific function, which turns what was originally correctly classified as an independent contractor into an employee relationship.

The other scenario is that the project will end, but then the manager will provide the worker with the next project, and direct the worker to their next task, or possibly the worker will be utilized for a different project under another department of the same business. This common scenario confuses many managers who incorrectly believe that by moving the worker from project to project they are protected from treating the worker like an employee.

In our example of the high level developer, the project has been continuously extended, and is planned to end, but given the nature of the project, the next consecutive part of the project will start, which the employer will most likely also want the developer to work on. In this case, the developer has the choice to take on the next project, but due to this and the fact that this developer had done this type of work for the same employer in the past as an independent contractor has raised some red flags. To complicate things further, in our example case, the developer did establish an LLC, but was in no way marketing themselves, had no other recent clients to prove he was a legitimate independent business, and in fact before this gig, had been an employee for another employer performing very similar work for some time. The developer did obtain business insurance, and from a high level glance, looked to be an actual independent business.

What is the nature and degree of the employer’s control?

The Administrator does not put as much weight on this question as has been understood in the past, at least when looking at it through an economic realities lens. Any control exercised over a worker indicates a W2 employee relationship. The Administrator views working from home as a very small indicator of a lack of employer control, and that the worker’s control over their own hours is not indicative of independent status either. This is a tricky question because to some extent, all managers who need to engage a worker for a job are going to be providing some sort of control so that their project is satisfactorily completed and the business continues to function.

In our example, the high level developer does work from home, and is not directly supervised. The developer does provide status reports, and does meet with the project team on a semi-regular basis. The developer is not directed, controlled, and is not provided any instruction or training on how to do the work, but this alone does not determine independent status. It’s important to note the Administrator makes it clear that no single factor, including control of the work should be over-emphasized, as the real key is if the worker truly is an independent business and is not economically dependent on the employer.

Again, from a high-level, this developer looks like an independent business, but due to the developer’s lack of any other clients, the longevity of the project indicating full-time status and permanence, and no real ability for loss, this developer should be considered a W2 employee based on the economic reality of the relationship between the employer and worker.

Hopefully you’ve found this real-life example helpful in understanding the complexity of conducting a comprehensive worker classification assessment. This is the world that TalentWave’s compliance experts operate in every day on behalf of our enterprise clients!

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