Think Twice Because Your Freelancer Might Legally be an Employee

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It used to be that the IRS regulations regarding worker status for tax purposes was the gold standard in determining whether to issue a W-2 or a 1099 at the end of the year.

However, since the raise of the freelance economy there has been a lot of confusion on how to interpret the regulations. The Department of Labor (DOL) issued an administrative memo for the purpose of providing, “additional guidance regarding the application of the standards for determining who is an employee under the Fair Labor Standards Act.”

The new guidelines focus on a set of economic reality criteria to determine if the worker is economically dependent on the employer.

A worker who is economically dependent on an employer is suffered or permitted to work by the employer, and is, by the definition of the Fair Labor Standards Act, considered to be an employee rather than an independent contractor regardless of whether the employer, worker or both consider the worker to be a contractor.

Even if a worker willingly received a 1099, the broadly interpreted wording of the Fair Labor Standards Act may still put the worker squarely in the “employee” status if the worker cannot demonstrate that he is in business for himself.

According to the Department of Labor’s interpretation of the Fair Labor Standards Act, most workers are employees.

By issuing this the Department of Labor is signaling to folks that it intends to aggressively pursue enforcement action against companies that employ independent contractors.

How is economic dependence determined?

Under the Act, common-law definitions, or employer-worker agreements, are insufficient to determine if a worker is economically dependent on the employers.

As a result, the courts have developed a six-part economic realities test to determine if an employer “suffers or allows” an employee or if the worker is in business for himself. Here's the six parts.

1. Is the work performed an integral part of the employer’s business?

The key word here is integral. Courts are applying this concept broadly. Any work, which a company does or has done that is necessary for the company to provide its finished product or service, may be deemed integral to the company.

The graphic designer, who designs brochures for a print design company, is integral to the graphic design company’s business and therefore could be deemed an employee of the design shop. But an accounting company, which provides payroll services to that same design company, would not be considered integral.

Related: Everything You Need to Know About Hiring a Freelancer

2. Does the worker’s managerial skills affect his ability to gain profits or suffer losses?

This is a broader consideration than the financial focus under common law. Here, the focus is not on who pays for what, per se, but on who makes the decisions. Does the worker have the managerial authority of a business owner to create efficiencies or cost savings, or can he only choose to do more work? The courts look at the ability to exercise managerial skill as opposed to simply agreeing to do work as assigned or available.

3. What is the worker’s investment level in the work he or she does?

Freelancers who work with multiple clients typically invest in their business. They purchase business equipment with the intent on doing many more jobs past the current one. Someone who is economically dependent, on the other hand, makes relatively minor investments in the work being done.

Related: We're Turning Into a Freelance Nation. Here's What This Looks Like.

4. Does the worker demonstrate business skills and initiative?

Courts will ignore the job-specific technical skills, and focus on whether the worker shows any business acumen and initiative such as ordering materials, bidding new jobs and/or managing workflow.

5. Is the worker’s relationship with the employer permanent or indefinite?

Contractors are employed for a particular project. A worker whose work is not project-oriented or of a fixed term will likely be ruled an employee, regardless of the length of employment.

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

Under common law it was often enough to demonstrate that a worker had the theoretical ability to control how work was done. Under the Fair Labor Standards Act, it must be demonstrated that the worker actually exercises such control on a regular basis.

What does this mean for employers?

Although the DOL’s administrative memo carries no legal authority in and of itself, courts tend to lean heavily on their interpretation of the Fair Labor Standards Act, when making binding legal decisions. And the current legal trend is to favor DOL enforcement against companies, who hire independent contractors.

Therefore, if your business model makes use of freelancers or contractors, it would be wise to review your hiring process to ensure you are in compliance with the current interpretation of the labor laws.

Related: 3 Legal Precautions in Hiring Freelancers

Companies should update their onboarding processes to include substantiating that the worker is operating an independent business.

The worker needs to be incorporated, and ideally, they need to have a business bank account, a website, marketing materials and provide services to many other customers.

If a worker operates a business related to the services being provided to the employer, it is less likely that the worker will be misclassified as a contractor.

Employers should also avoid paying by time, reimbursing expenses or providing tools and equipment because freelancers, if they are truly operating as businesses, should have their own tools.

As freelancers and contingent workers continue to grow in importance, new freelancer management software platforms are being developed to assist with the recruitment, selection, onboarding and compliance assurance of this new segment of the workforce.

Freelance Management Systems (FMS) provide employers with a real-time reporting on their freelance and contingent workforce.

For example, at Shortlist we work with employers of all sizes to manage their contractors and freelancers. It’s not a surprise that one of the biggest issues our customers are facing is compliance, which is why our technology is designed to monitor contractor misclassification and provide our customers with reports to prevent costly missteps.