Understanding the New Rules of Independent Contractor Classification Law

There are few areas in employment law that remain in a greater state of flux than the question of who a business can properly classify as an independent contractor.  The differences between federal and state law can make the question even more complex.  With federal and state governments increasingly focused on independent contractor misclassification as well as the advent of a new federal test, now is the time for Virginia and North Carolina businesses to re-examine their practices to avoid costly monetary and other penalties.

The Department of Labor Rule: Out with the Old and In with the New

In January 2024, the DOL issued its final rule establishing a new “economic reality test” to determine whether a person can properly be characterized as an independent contractor.  This test replaces the prior test put in place during the Trump Administration.  Unlike the prior test that focused on two primary factors, the new test examines the “totality of the circumstances” and does not give primary or pre-determined weight to any of the factors.  This means that unless all the factors support an independent contractor finding, it will be difficult to determine in advance which factor or collection of factors on which the DOL will rely on.  The DOL states that this test will provide the Agency with flexibility.  It is this same lack of certainty, however, that will create challenges for many businesses seeking to understand and quantify their risks.

Under this new multi-factor test, the DOL will determine whether an individual is an independent contractor by analyzing:

• The individual’s opportunity for profit or loss, depending on managerial skill

Think “business owner.”  An independent contractor will normally make or lose money based on how successfully they perform their duties.  An employee’s pay is normally less dependent on the ebbs and flows of profitability.

• Investments by the worker in their own equipment or material

Employees normally have equipment provided for them, whereas independent contractors are responsible for the purchase and upkeep of own equipment.  This also includes expense and benefits reimbursement since an independent contractor is normally responsible for their own cost of operation.

• The degree of permanence and exclusivity of the work relationship

An independent contractor is normally not a person who has been working with a company for a long time.  Rather, they normally perform specific jobs and tasks.  Likewise, an independent contractor is usually someone who is free to work for anyone they wish, whereas an employee is often restricted from working for competitors.

• The degree of control the business exerts over the worker

It is expected that an employer will supervise and manage their employees. Independent contractor work should have a more “set it and forget it” approach, with a business telling the individual what it wants done and the independent contractor deciding how to perform the work.

• The extent to which the work performed is integral to the business

How integral to the business is the work at issue? If, for example, you have a painting business, the DOL will likely expect that you employ painters.  One good question for a business analyzing this factor is: Would a customer assume that a worker was an employee based on the work being performed?  If the answer is “definitely yes” but the person is classified as an independent contractor, then the business may need to rethink its approach.

• The degree of skill required for the work.

The more skill or expertise required for a job, the more likely this factor will weigh in factor of independent contractor status.

Damages and Penalties for Misclassification: What Will This Cost My Business?

Misclassification can prove very costly for businesses. Under federal law, civil penalties for misclassification can include:

• liability and penalties for unpaid state and federal taxes;
• liquidated, or double, amounts unpaid wages and overtime to misclassified employees for up to a three-year period and attorney’s fees; and
• the value of any benefits from which they were improperly excluded, such as health and retirement benefits.

The Virginia Rule: The Deck is Stacked Against You. 

Virginia follows the “Twenty Factor Test” used by the IRS that is familiar to many employers.  Under Virginia law, however, workers are presumed to be employees. Businesses have the burden to prove that a person is properly classified as an independent contractor.  This means that any investigation or audit by the Commonwealth will not be a neutral fact-finding inquiry.  An investigator will treat a complaint of misclassification as valid unless the business is able to demonstrate otherwise through evidence and documentation.

The North Carolina Rule: Look at the Whole Picture

In North Carolina, an independent contractor is someone who, among other things, is engaged in an independent business, has control over when he or she works, independently uses special skills, does specific work at a fixed price, cannot get fired because he or she chooses one method over another to do the work, can use assistants if the person wants, and has full control over his or her assistants. In addition to these factors, North Carolina courts will review the circumstances of the arrangement in their totality.  This approach requires businesses to carefully analyze questions of proper classification on an individualized basis.

Practical Tips for Understanding Independent Contractor Classification.

1. Come to terms with the fact that the Government does not like it when businesses classify employees as independent contractors. Businesses and industry groups point to the value and flexibility that independent contractor classification provides.  The Government (at least the current Administration and its Agencies) sees it differently.  It believes that businesses often use independent contractor classification to avoid tax liability and circumvent myriad of workplace protections, including Civil Rights Laws, Workers’ Compensation, and Unemployment Compensation.  In a press release, the DOL summed up its position stating that“[t]he final rule will help the Wage and Hour Division to continue addressing misclassification and prioritizing the most vulnerable workers who are being misclassified – because that’s what we must do.”  The important thing here, however, is to understand that the Government does not take a neutral approach to whether an independent contractor is a misclassified employee.

2. Avoid the easy mistakes. Although not a guarantee of proper classification, businesses should make sure they steer clear of avoidable mistakes.  Never, for example, use an agreement that refers to a person as a “1099 Employee” this is not a thing.  It is simply evidence of potential misclassification.  Businesses should avoid referring to a contractor as an employee altogether.  Another avoidable mistake is asking an independent contractor to sign a noncompete agreement.  Independent contractors (as independent businesspeople) are normally expected to be able to advertise and work for whomever they choose.

3. Remember your mother’s advice. Growing up, many of us heard a parent say, “Just because your friends are doing it does not mean that you should too.”  This adage also applies to independent contractor status.  Often businesses feel a sense of protection if others in their industry are classifying workers as independent contractors.  Industry practice is not a safe harbor, however.  We have seen this time and again when the DOL engages in targeted enforcement of industries for misclassification such as with the health care and retail industries.  Businesses should likewise take note of any audits or enforcement activity in their industry.

4. Changes in your business practices can result in misclassification. Operating a business often requires an owner to adapt to change in a fast-paced environment. This can also create risks when the business does not examine the impact on personnel decisions and policy changes to independent contractor status.  For example, during a labor shortage, a business may be tempted to offer incentives such as travel reimbursement, money to assist with health insurance, paying worker’s compensation insurance, or purchasing equipment.  While understandable, these decisions can lead to a properly classified independent contractor becoming a misclassified employee.

5. It does not matter what your worker wants. In many instances, workers themselves request (or even demand) that businesses classify them as independent contractors.  They may want the perceived flexibility of not being an employee, or desire more control over their taxes.  It is not up to them.  Federal and state agencies readily assess liability for misclassification even where clear evidence exist that a worker got exactly what they wanted.  The lesson here is to classify correctly regardless of worker preference.         

The laws governing independent contractor status are complex. Simply trying to treat workers fairly is often insufficient to ensure that a business satisfies the rules and tests designed to uncover misclassification. Time and money can be saved by involving competent employment counsel in the process. Likewise, if a problem arises, do not avoid it.  A business should promptly bring in legal counsel when faced with an audit or investigation to help find workable solutions.