Although current worker classification issues have mostly focused on companies like Lyft and Uber, recent changes and proposed regulations have unique consequences for freelance professional service workers, such as accountants and consultants, and their employers. While “gig economy” professional service workers are less common than freelancers in other industries, this work arrangement continues to solve workers’ desire for flexibility and employers’ need for seasonal assistance and intermittent expertise. However, emerging tax legislation and guidelines at the federal and state levels affect whether these professionals are classified as independent contractors or employees.
According to a 2020 National Employment Law Project report, “10 to 30 percent of employers (or more) misclassify their employees as independent contractors.” Since misclassification can result in steep penalties for employers, companies should familiarize themselves with new employee classification laws.
Internal Revenue Service Rules
Worker classification relies on the degree of control and independence the worker retains; federal and state guidelines often differ, however. For example, in 2020, the Internal Revenue Service (IRS) began using the common law control test, which replaced the 20-factor test, to determine employment taxes. This test uses three factors to ascertain employment status: (1) the behavioral control of the employer over the worker, (2) the financial control of the employer over the worker, and (3) the type of relationship between the employer and the worker.
If there exists a high degree of behavioral and financial control or factors that indicate an employee/employer relationship (e.g., no written contract or vacation pay is available), then the worker’s classification may more closely align with employee status. No single factor is weighted more heavily. While the IRS employs these factors, the proposed U.S. Department of Labor (DOL) guidelines are more broadly defined.
Department of Labor Rules
In addition to changes to the IRS guidelines, wage and hour laws may be impacted by new classification guidelines that were proposed in October 2022 by the DOL. The proposed guidelines make classifying a worker as an independent contractor difficult under the Fair Labor Standards Act. The proposal uses a “totality-of-the-circumstances” approach and requires that workers be classified as employees if they’re “economically dependent” on a company based on a multifactor economic realities test with no prioritization of factors. Yet some of the factors include investment by the worker and the employer and the nature and degree of control, including whether the employer uses technological supervision. A worker with a significant financial investment and little employer supervision may have greater evidence that they’re an independent contractor than a worker with insignificant financial investment and who is closely monitored.
The DOL currently operates under the Independent Contractor Status Under the Fair Labor Standards Act (2021 IC) rule, which specifies two core factors—the nature and degree of control over work and the worker’s opportunity for profit and loss. Other noncore factors include the skill required for the job, the degree of permanence of the working relationship between the worker and employer, and whether the work is part of an integrated production unit. Under 2021 IC, a person who works under an employer’s supervision and receives an hourly wage for full-time assembly line work with an indefinite end is almost certainly an employee.
Differing State Laws
While some U.S. states use the same common law control test as the IRS, other states are increasingly adopting the ABC test or some version of it. The ABC test includes the following considerations in determining worker status:
- The worker is free from the control and direction of the employer.
- The worker performs work outside of the usual course of the employer’s business.
- The worker has established their own business in the same industry in which the work is being performed.
If the worker fits the above criteria, they’ll likely be classified as an independent contractor.
To complicate the issue of differing state laws, some states are enacting changes that may also affect employers in other states. Notably, California created Assembly Bill (AB) 5, which took effect beginning in 2020 and was designed to target app-based platform economies. This legislation applies to freelance professionals and makes it more difficult for companies to classify workers residing in California as independent contractors. AB 5 includes exemptions, however. For instance, an individual who holds an active license from California and is a lawyer, architect, engineer, private investigator, or accountant is exempt from AB 5 and may be classified as an independent contractor. Workers exempted from AB 5 must still comply with the Borello test, which uses a 13-factor test with each factor weighted equally.
AB 2257, passed in September 2020, created more exemptions from AB 5. In November 2020, California voters passed Proposition 22, which exempted most app-based platform economies from AB 5, effectively mitigating the effects of AB 5 on the industry initially targeted by the bill. In August 2021, a California district court ruled Proposition 22 unconstitutional. This ruling was subsequently overturned, and the case is now before the state’s Supreme Court. Notwithstanding, freelance unlicensed accountants or inactive Certified Public Accountants (CPAs) must still comply with AB 5 regardless of whether the employer is located in California, while active CPAs are exempt.
While California has acted to curtail misclassification issues, other states are also implementing changes influenced by California’s reclassification. For instance, in July 2021, New Jersey passed A-5890, which provides the state with greater power to deal with companies allegedly misclassifying workers, including stop-work orders. Moreover, in August 2022, the state’s Supreme Court provided further guidance on classifying a worker’s employment status by relying on the ABC test to reach its decision in East Bay Drywall, LLC v. Department of Labor and Workforce Development. East Bay Drywall classified four workers and 12 entities as independent contractors, but the court determined that the contractors weren’t likely to be able to continue to operate if their connection with East Bay Drywall ended.
Consequently, while East Bay satisfied the first two factors of the ABC test, the company failed the third factor, which requires sufficient evidence that workers are engaged in an independently established business or trade, regardless of a contractor’s corporate status. East Bay was required to pay interest, penalties, and more than $42,000 of unpaid disability and unemployment contributions. This ruling illustrates the burden that businesses may face when classifying workers as independent contractors and highlights the need to understand federal and individual state laws surrounding worker classification.
Given the recent increase in freelance workers, employers should familiarize themselves with worker classification legislation and guidelines. Understanding these laws may help employers avoid exorbitant fines—levied by state and federal governments—that can reach into the millions, such as fines for unpaid workers’ compensation premiums, unemployment insurance, payroll taxes, and civil and criminal charges for misclassifying workers.
© 2023 A.P. Curatola
November 2023
