Full employees and independent contractors are treated very differently by legal guidelines, so it is important for small businesses to understand the implications of each kind of classification. The most recent rule published by the U.S. Department of Labor revises the guidelines, so it is especially important to understand the implications given that it went into effect March 11, 2024. Take a look at what this rule means for W2 vs 1099 employees for small businesses.
The final rule on the independent contractor classification standard is a six-factor test that focuses on the economic realities of the worker/employer relationship. Understanding how to properly classify employees is key to remaining compliant with the Fair Labor Standards Act (FLSA), which dictates that W2 employees are entitled to minimum wage and overtime pay protections. A business must also abide by recordkeeping obligations. These same standards, however, do not apply to independent contractors.
The six-factor test used to determine employee status is as follows:
To begin with, the test considers what the worker's opportunities for profit or loss are based on how their entrepreneurial capabilities impact economic success or failure in how they perform the work. Essentially, a worker who is able to negotiate compensation, accept or decline work, determine their schedule, market additional work, and make work-related purchases is likely an independent contractor. Each of these examples could result in wide fluctuations in the worker’s take-home earnings depending upon their actions.
Investments that are capital or entrepreneurial in nature are made by business owners. In determining if the business’s workers are W2 employees or 1099 contractors, the question becomes — who’s the one making investments in the business? Is it the potential employer (the boss) or the worker? When it’s the boss, the workers are generally W2 employees. When the workers themselves are investing in their own business growth and opportunities, they’re more likely to be considered independent contractors.
What is the worker buying? The DOL does make a distinction between any costs that a potential employer “imposes” on its worker and costs that the worker is investing in their own business. For example, if workers are personally investing in individual marketing initiatives or in tools and equipment that allow them to work for multiple companies, they are more likely to be seen as independent 1099 contractors. However, if a company were to require its workers to purchase any unique tools and equipment that aren’t applicable to a wider market, this is unlikely to be seen as an investment in the worker’s individual business capabilities — even though the worker is the one paying for it. Those workers would be more likely to be seen as W2 employees.
This factor considers whether the work relationship is indefinite, exclusive to other work, or continuous. In any of these cases, the worker is likely an employee. Meanwhile, work that is finite in duration, project-based, or sporadic is likely done by an independent contractor.
When considering the nature and degree of control, the test considers how impactful the potential employer is regarding the worker's schedule and how their work is being managed. If the company is hands-on with its workers or has disciplinary authority, the worker is probably an employee. Independent contractors control their own schedule and workload.
Workers who perform critical tasks essential for the basic functioning of the business are likely employees. Specifically, the final rule update considers whether or not the employer would be able to function without the work of the worker in question.
The final factor is the consideration of a business-like initiative. Both employees and independent contractors can have special skills, but only independent contractors use those skills in conjunction with a business-like initiative to market their own services.
Businesses need to consider both the benefits and drawbacks of W2 and 1099 employees when finding the workers needed for operations. W2 employees are subject to all legal protections regarding minimum wage and overtime while also being eligible for employer-provided benefits. 1099 workers, on the other hand, just have to be paid for their work and that's it. They are responsible for their own taxes, health care, etc. In most cases, W2 employees perform essential business functions, while 1099 workers are used for specific projects.
The DOL final rule change regarding W2 employees could impact many businesses that are currently re-evaluating their payroll processes. One of the best places to get help with managing payroll for your W2 employees is a qualified and experienced PEO partner. At SPLI, we specialize in services that keep payroll processing, benefits management, workers’ compensation insurance coverage, and insurance claim management simple. Get in touch with us today to get administrative burdens off of your plate so that you can focus on growing your business.
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