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Will the DOL’s Proposed 5-Factor Worker Classification Rule Impact Freelancers?

CPA for Freelancers Advice for Self-Employed

In an effort to further clarify whether a worker is an employee or an independent contractor under the Fair Labor Standards Act (FLSA), the U.S. Department of Labor (DOL) recently announced a proposed rule to adopt a five-factor an “economic reality” test. This test considers whether a worker is in business for themselves, acting as an independent contractor, or is economically dependent on an employer for work and, therefore, is an employee.

If you are a freelancer who subcontracts work to other self-employed individuals, it is important to understand this proposed rule and to avoid potential exploitation of the client-freelancer relationship.This is especially true if you have one or two independent contractors who do significant amounts of work for you and they are providing services that are an integral part of your freelance business functions.

According to the proposed rule, there are two “core factors” which can help to determine the degree of economic dependence a freelancer has on someone else’s business versus their own business.

  • The nature and degree of the worker’s control over the work being performed. For example, any freelancer you hire is likely to be legally classified as an employee if you exercise substantial control over key aspects of how they do work. However, if they are setting their own work schedule, selecting from assignments, working with little or no supervision, and able to work for others, including your competitors, they are more likely to be classified as an independent contractor.
  • The worker’s opportunity for profit or loss based on initiative and/or investment in their work. The DOL’s proposed new rule also requires an analysis of a worker’s investment in their work as it relates to the opportunity for profit or loss as well as the degree to which personal initiative, managerial skills and business acumen are exercised. The more opportunity for personal gain through independent action an individual has, the more it weighs toward you being considered an independent contractor.

Another component of this core factor is the extent to which an individual you hire to do work for your freelance business is able to affect their earnings through initiative or investment—in contrast to an employee who is only able to do so by working more hours or by working more efficiently for your business.

The two core factors above are what the DOL’s proposed rule gives the most weight to in determining if a worker is economically dependent on someone else’s business or is in business for themselves. However, the proposed rule also identifies three other factors for consideration in the analysis of legal employment classification:

  • The amount of skill required to do the work performed. If the work you ask a freelancer to do requires specialized skills this will weigh in favor of classification of an individual as an independent contractor. Alternatively, if the work in question requires no specialized training or skills outside of those provided by you as a potential employer, this factor would weigh in favor of an employee classification.
  • The degree of permanence of the worker and potential employer relationship. If there is an ongoing relationship of an indefinite duration between your freelance business and another freelancer you hire, this factor would weigh in favor of classification as an employee. If your work relationship with a particular individual is more sporadic the classification of an independent contractor is more likely.
  • Whether the work is considered part of an integrated unit of production. If an individual works for your freelance business and is fulfilling a required part of a process that is fundamental and analogous to another required function with integrated parts that lead toward a common goal, then the freelancer would be considered an employee. If the opposite is true, then classification of the individual as an independent contractor would be favored.

From the DOL’s viewpoint, these five factors provide the framework for “the ultimate inquiry” as to whether, “as a matter of economic reality, the worker is dependent on a particular individual, business or organization for work (and is thus an employee) or is in business for him — or herself (and is thus an independent contractor).”

In addition to the Federal DOL, your state DOL may have additional criteria so please consult those rules as well.

Given that over the years many business owners (including freelancers) have shown a propensity to reduce expenses by classifying workers as independent contractors, absolving themselves of the legal obligation to provide a minimum wage, overtime, and company benefits, or to keep employment records for these individuals, this recent move by the DOL is, according to the agency an attempt, “to promote certainty for stakeholders, reduce litigation, and encourage innovation in our economy.” Whether it will serve its intended purpose will remain to be seen as the proposed rule is finalized.

It is clear from the DOL that in order to avoid taking advantage of contractors that you use to perform functions of your business, issues of employment law or the potential assessment of fines or payroll taxes all freelance business owners should remain vigilant about evaluating the working relationships they establish and maintain with other freelancers.

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Jonathan Medows, CPA

Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.

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