8723 / How is it determined whether a taxpayer is an independent contractor or a common law employee?

Editor’s Note: January 9, 2024, the Biden Department of Labor (DOL) announced that it had finalized a standard for determining whether a worker is an employee or an independent contractor under the Fair Labor Standards Act. The focus in determining independent contractor status under this rule hinges on the economic realities of the work relationship, including investment, opportunity for profit or risk of loss and whether the work is integral to the employer’s business. Under the rule, a six-factor "economic reality" test will consider: (1) the workers' opportunity for profit or loss depending on managerial skill, (2) investments by the worker and the employer, (3) the permanence of the work relationship, (4) the nature and degree of control exercised by the employer, (5) whether the work performed is integral to the employer’s business, and (6) the worker's skill and initiative. Additional factors may be considered as relevant to determining whether the worker is economically dependent on the employer or in business for themselves. States that use the so-called "ABC" test will not be impacted by the new rule, which is only used for FLSA purposes. The rule rescinded the 2021 standard entirely. In June of 2023, the National Labor Relations Board (NLRB) issued a ruling that follows this totality of the circumstances analysis.

On May 6, 2021, the DOL announced its intent to withdraw the most recent modifications to the independent contractor test. The Trump-era rule was designed to make it easier for employers to classify workers as independent contractors, rather than traditional employees, by focusing on whether workers are economically dependent upon an employer—or in business for themselves. The now-withdrawn rule prioritized two key factors, including (1) the worker’s degree of control over the work performed, and (2) the worker’s opportunity for profit or loss. The DOL’s 2021 announcement stated that prioritizing these factors in determining employment status under the Fair Labor Standards Act (FLSA) would have undermined the longstanding balancing approach of the economic realities test and court decisions requiring a review of the totality of the circumstances related to the employment relationship. The Trump DOL rule would have resulted in many workers’ losing FLSA protections, including minimum wage and overtime benefits. Shortly thereafter, a group of businesses filed a lawsuit in federal court. The Texas Court agreed with the business groups and reinstated the Trump-era test, with an effective date of March 8, 2021. The court found that the DOL's delay of the effective date for the Trump-era rule violated the Administrative Procedure Act by providing only a 19-day period for notice and comments (rather than the 30-day minimum). The court also found that the DOL limited the content of the responses to whether the effective date should be delayed (so unduly limited the scope of the comments received, making the decision to rescind the Trump-era rule "arbitrary and capricious").¹Generally speaking, an individual will be considered an employee under the common law rules if the person or organization for which the individual performs services has the right to control and direct the individual’s work, not only as to the result to be accomplished, but also as to the details and means by which that result is accomplished.² In other words, an individual will be classified as an employee if the employer has the right to control not only what will be done, but also how that work will be accomplished. On the other hand, if the individual performing the work is only under the control of another to the extent of the end result that must be delivered, that individual will be classified as an independent contractor.

It is important to note that the employer does not actually have to direct and control the manner of an individual’s work in order for that individual to be classified as an employee. The individual will be classified as an employee if an employer has the right to direct and control the manner in which that employee’s work is accomplished even if the employer does not actually exercise this right.³