New Guidelines: Employee vs. Independent Contractor Classification

Joe Young

Good afternoon and welcome HR friends. Welcome to the 18th episode of the GovCon HR Round-Up podcast. This is, after a month off. We did take June off. I am sure our legion of listeners and fans out there just did not know what to do with themselves last month. I'll let everybody interpret what legion means on their own.

But, welcome back. My name is Joe Young. I am the President of GovConPay. We are the only outsourced payroll and HR provider focused exclusively on serving the government contracting marketplace. I am coming to you live from the studios here of BLC Digital Strategies, the media affiliate of Berenzweig Leonard LLP. And as always, thank you for the support of our great producer, Mr. Todd Castleberry.

Before we get started, I also always want to recognize our sponsor, our friends from Berkshire and Associates. Berkshire are compliance experts with over 50 years of experience in providing compliance services technology for organizations looking to build their ideal workforce through a compliant non-discrimination services, workforce analytics, and pay equity expertise. So special welcome to any Berkshire clients that are joining us today.

And for our subject matter experts, again here with the leaders of Berenzweig Leonard. Managing partner and founder, Seth Berenzweig. And welcome back for an encore appearance, partner Nick Johnson. Would you guys take a second and introduce yourselves?

Seth Berenzweig

Nick, you want to go first?

Nick Johnson

Yeah. Thanks for having me, Joe. I guess I didn't mess up too much the first time.

Joe Young

Well, you replaced Seth the first time, and now Declan, so, you know, now we have some decisions to make.

Nick Johnson

That's right, that's right.

Seth Berenzweig

Well, it was kind of like a Taylor Swift situation. We had so many protesters demanding your return.

Joe Young

Yes.

Seth Berenzweig

We had to accede to public demand.

Joe Young

Yes.

Nick Johnson

But no. Good to be back. Nick Johnson. I'm a partner here at Berenzweig Leonard. I work in our firm's employment group. And, looking forward to a good discussion today.

Joe Young

Absolutely.

Seth Berenzweig

Yeah. I'm Seth Berenzweig. I handle employment matters and also, corporate matters here at Berenzweig Leonard. Good to be back.

Joe Young

Well, guys, it's great to be back together. After a month off, I think we have a great topic today. I think it's an interesting topic that has always been an interesting topic and kind of driven conversation, but with a lot of the topics we talk about, we always do it under the umbrella of “How is this different under the second Trump administration?”

Everything seems to come with that caveat of how maybe that is going to be interpreted differently. So, you know, Nick, let's start with you.

What has changed in the Trump administration from the Biden administration regarding the business use of independent contractors and employees?

Nick Johnson

Yeah. I mean, I think similar to what you're seeing in a number of other employment aspects, there's been some significant changes. And I think in terms of what's changed under the new administration, there's a short answer and a long answer. And I think the short answer is, the Department of Labor is no longer enforcing a rule that was implemented under the Biden administration that made it more difficult for businesses to classify workers as independent contractors.

And so, in a nutshell, it's easier to classify workers as independent contractors under new enforcement guidance under the Department of Labor. And so, some backstory: Under President Trump's first administration, his Department of Labor, they implemented a rule that made it a little bit more lenient, a little bit more lax, easier for a business to classify an individual as an independent contractor.

President Biden came in, implemented a rule that actually went the other way, in kind of the game of ping pong, which you'll see that that goes on here. And so, implemented a rule that made it a little bit more rigorous, a little bit more demanding on businesses to actually properly classify a worker as an independent contractor.

And as part of that, the Biden administration rescinded the prior Trump rule that was implemented under his first term. No shocker. President Trump assumes office for a second term, and, effective May 1st, the Department of Labor issued guidance essentially saying that we are no longer going to be enforcing the 2024 rule that was implemented under President Biden.

And so, it's important to note that the 2024 rule has not been rescinded. So it's still on the books. It's available for private litigation. It still sits out there. We'll talk about next steps. I think if I were to bet there might be a chance that this administration implements a new rule that formally puts the nail in the coffin there.

But, for purposes of the Department of Labor's enforcement priorities, they are no longer enforcing that prior 2024 rule. Okay, what does that mean? So, you know, we've got many different tests. You've got the IRS test, you've got DoL test. So, what's the current status of the law? The current status of the law is they follow what's called the Economic Realities Test.

And essentially, I think a way to kind of look at that is okay, when you're looking at an individual worker, when you think about someone who's working for you. Are they in business for themselves, or are they – here's the phrase – economically dependent on the company? Obviously, if they're in business for themselves, that's a factor that's going to kind of tip in favor of someone being considered an independent contractor, whereas if they're economically dependent – that's the phrase that DoL looks at – they are probably going to be an employee.

The Department of Labor has a multi-factor test that they encourage businesses to look at when they're making these decisions. And this is exactly what the Department of Labor wants companies to do, is to look at these factors, evaluate when you're bringing somebody on board, okay. “Should we classify them as an independent contractor or an employee.”

And so I'll just quickly list, it's seven factors. And it's important to note that not one of these factors is dispositive, but rather they're to be considered when making these decisions.

And so first one, the extent to which the services rendered are integral to the part of the company's business.

Two: The permanency of the relationship. If it's temporary, that could be a factor that kind of tips in favor of independent contractor. Whereas if it's more long term, that could be more of an employee relationship. Three: The amount of the alleged contractor’s investment in facilities and equipment. If you have an individual come into the workplace and you're providing them with the laptop, access badges, cell phones – you know, the tools needed to do their job – that's a factor that's going to cut against having that person deemed an independent contractor.

Fourth: The nature and degree of control by the employer. I like to think this is actually the most important one, which I'll talk about in a little bit, but control is a very important one.

Five: The alleged contractor’s opportunity for profit and loss.

Six: The amount of initiative, judgment, or foresight in open market competition.

Seven: The degree of independent organization in operation. So, that's a mouthful.

There are seven factors there to consider. I begin every conversation with my clients when we're making these classification calls about, “okay, let's focus on control and independence.” And control, in particular. If the company is controlling “Okay, here's what you're going to do. Here's where you're going to work. Here's when you're going to show up, here's when you're going to stop working.” If they control those aspects of the job, those are going to cut against having that person or individual deemed an independent contractor. Whereas if the individual comes in, they set their schedule, they work when they want, they bring their own equipment, they bring their own knowledge, expertise, experience to do a very discrete task – maybe it's a temporary assignment – that's a factor that could weigh in favor of having that individual be deemed an independent contractor. So, look at the factors. That's what you should look at. But I think it begins by looking at control and independence. And I think the big takeaway, too, is to go back to your initial question. It's going to, now, be a little bit more business-friendly under this current administration to classify workers as independent contractors.

Joe Young

Yeah, I think we see commonly that we've had this in the podcast before, that rules haven't changed, but enforcement changes. So, a lot comes down to what's going to be enforced.

Seth, what are the key differences, then, between having an employee versus an independent contractor on staff?

Seth Berenzweig

Sure. So, this dovetails nicely with what Nick just said, because the underlying litmus test – and I agree with what was noted – really is based upon control and independence. The so-called control test has been with us for a long time. It actually came out as a convoluted 19-point IRS test that the courts used to follow, and it's still kind of floating around out there.

And it kind of, in a more tortured way, gets to control. This DoL approach is a little bit more simplified, but typically based upon that litmus test, that is going to be a differentiation as to whether this individual is going to be classified as a W-2 employee or 1099 independent contractor. Now, something that we do see that comes up, quite frequently is that people sometimes are taking the position that even though the circumstances on the kind of work that's going to be performed and the degree of control that overlaps with that has been set, the parties sometimes approach it to really just make a determination of which one do they feel like doing?

Yeah. And sometimes I've heard folks say, “Well, you know, we were going to have him come in as an employee. But, he'd rather be an independent contractor because he doesn't want to get taxes withheld.” Well, that would be nice. But it really doesn't work that way.

Because, although the administration is going to take a more practical, a more flexible approach, that doesn't mean that the pendulum has swung so wildly out of control that people can just go ahead and just check off whatever the box they want. So, with that litmus test in mind, I think that there still needs to be a degree of control about which you select, because as we'll talk about in a few minutes, Virginia, within the last couple of years, has actually made a pretty dramatic change to the Virginia code in terms of how misclassification can end up becoming a really big deal.

Nick Johnson

And just to kind of piggyback on what Seth was saying: One of the big differences, you touched on taxes, that's a huge component. Obviously, if you're going to be an independent contractor, you're responsible for your own taxes. I think within that, unemployment and workers' comp, that is not the responsibility of the company.

And I think in practice, that's where I see a lot of these misclassification issues come up, is you have somebody working for an organization as an independent contractor. Then, their contract expires, and they go to file for unemployment, and it gets denied because they're an independent contractor. And they say, “Wait a minute, I didn't think I was an independent contractor. I thought I was an employee all along.”

And so, I think we'll touch on how you can kind of guard against some of these issues and put it in writing. But I think unemployment's a big one, obviously, too. I think if someone is truly an employee, not an independent contractor, minimum wage comes into play, FLSA protections, overtime comes into play.

If someone's truly an independent contractor, they're not legally entitled to overtime under the FLSA. So, I think those are some of the things that come into play in terms of differences between an employee and an independent contractor.

Seth Berenzweig

And the one thing that I'll just add very briefly as a footnote is that this also gets a little bit more granular and happens in certain industries, such as brokerages and insurance companies, because you sometimes have the main office of the carrier and then you have registered investment agent offices that are affiliated in different parts of the country.

And if an employee works for an office of the RIA, there is sometimes a lack of clarity about whether that individual, if they get separated by the CEO of that separate entity, whether that person can turn around and go up the food chain to the much larger company in terms of the question of whether they were also an employee there.

So, again, that foots back to areas with regard to control and why turning square corners on how this is treated – as we'll get into a little bit more – really does fundamentally make a difference in terms of how you operate your business.

Joe Young

So, we firmly established the employee cannot self-select what they prefer. We touched a little bit on some of the pluses and minuses to the employee with that classification. Now, let's talk a little bit about, from the employer's perspective, what are some of the benefits or why they would want them to be an employee versus contractor.

Nick Johnson

Yeah. Things to think about or you maybe questions to ask yourself if you're a business owner and you've got someone… I think thinking about the duration of the work, thinking about the information that you want to share with this individual, whether you envision this person as a long term player. I think if you have discrete tasks that are going to go on for maybe a month or two – in the government space, I think the example is if you've got an upcoming opportunity that you want to bring in a subject matter expert to kind of help with your bid and proposal work, to kind of identify pipelines or help you put together a proposal, or identify additional areas of work, that's relatively temporary. That's relatively narrow in scope.

Joe Young

That may be something project-oriented.

Nick Johnson

Exactly. That may be something that's better suited for an independent contractor. Whereas if you have someone that you want to be the face of your organization, you want them to be customer-facing, you want them to kind of grow with your organization. You expect them to manage people within your company. That's probably more of an employee. Particularly if you're thinking about training this person, making a long-term investment in this person, that's going to be more of an employee. I also like to think about, too, what type of information are you going to be giving this individual? Because, if someone's truly an independent contractor, they should, in theory, be coming in with the knowledge, the expertise to kind of run the project on their own with little to no oversight from the company.

Whereas on the other hand, if you're going to be giving someone access to a lot of your sensitive information, you're going to want to have some restrictive covenants in place and.

Joe Young

They could be an independent contractor for a competitor.

Nick Johnson

Right. And so I think the case law on this is that it's much easier and courts are much more willing to enforce restrictive covenants against employees compared to independent contractors, because there's legitimate business reasons for why you would have those restrictions. So, I think those are some things to be thinking about and information that you're going to be giving them to factor in why you want to classify someone as an employee.

Joe Young

Now, as companies are looking to bring in independent contractors, Seth, does it make sense to just hire them in the organization? Are there strategies or reasons for maybe why you would want to set up a separate entity to house those employees or have them under a different organization?

Seth Berenzweig

Yeah, I think you definitely want to have the independent contractor operate as a separate business entity. I've spoken to a handful of folks when I say, “How many people do you have in your organization?” And they would say, “Seven employees, seven W-2s and four 1090 nines. But there's no formal distinction in terms of the paperwork.”

The paperwork doesn't have to be long and complicated or expensive, but it does matter. In addition to having a distinctive difference between an employment agreement and a consulting agreement, there's a higher indicia of separateness. If the consulting company is a separate business entity, one of the elements that Nick referred to early on of the seven or so factors relates to the degree of investment that the independent contractor has placed in their resources, in their organization.

If the individual doesn't even bother to set up their own LLC and set up their own bank account and financials, then obviously, that shows that they're not only bothering to lift a finger to turn square corners, but that's probably going to be disregarded because, listen, it doesn't take much to do this.

People often, if they want to, people set up their own LLC. If you have a very small company, it's just you and an assistant or two. You can have the payroll company take care of withholding of state and social taxes. You can have an accounting firm that does bookkeeping that sets up your financial statements, and gives you quarterly financials.

It's not that hard to do it. You want to make sure that if you're working with an independent contractor, that they're actually taking those processes into consideration because it really is, quite frankly, for everybody's protection in that arrangement.

Joe Young

And back, we touched on a little bit with Nick about agreements and covenants. What are you advising your clients there?

Nick Johnson

Yeah, yeah. Here's a shocker. The lawyers are recommending you document this.

Joe Young

Revenue!

Nick Johnson

Here are a couple of qualifiers, though. I've had many clients come to me and say, “I've got this individual subject to an independent contractor agreement. Of course, he’s a 1099.” That is not dispositive of the issue. Just because you call somebody an independent contractor, and even if you have an agreement that says they're an independent contractor, that's not what DoL and these state departments of labor are going to be looking to in terms of proper classification.

They're going to actually look to the realities of the working relationship. But to answer your question, yes, it is a good idea. It is recommended to have an independent contractor agreement in place, to have a consulting agreement of some sort spelling out the realities of the arrangement. Things that I always like to put in there: certainly a representation that both parties acknowledge that you're an independent contractor, that you don't get the benefits of other employees.

And let's unpack that a little bit. What that means is, independent contractors, they generally are not going to be on the company's health insurance. They're not going to be on a 401(k) plan, none of that. They're not going to be part of the company's workers comp. We already talked about unemployment.

Seth Berenzweig

They’re responsible for their own taxes.

Nick Johnson

Exactly. Spell that out. Spell that out that this person's coming to the table with their own unique set of skills, their own unique qualifications. I think laying that out in a contract kind of manages expectations. We gave the example of a lot of these classification issues coming up after the fact, when someone applies for unemployment. Spell out in the employment agreement that, “Hey, you're not eligible for unemployment.” Just so that they know at the front end, “Hey, you are an independent contractor.”

So, yeah, I think putting it in writing will certainly help.

Joe Young

Yeah. So, we've we've been through the classifications, the pluses and minuses. But say you do have somebody misclassified. What are the penalties? What are the risks there of having somebody misclassified and there being an enforcement action?

Seth Berenzweig

So, it's interesting because for a very long time in Virginia, there was essentially not much blowback or really no significant legal exposure with regard to misclassification between an employee and an independent contractor. Virginia took a very ho-hum approach where they, frankly, didn't really care very much. A couple of years ago that recently changed.

And now there is a brand new statute, a relatively new statute, in the Virginia Code for misclassification of an employee as an independent contractor. So, if you do that and you miss the putt, what happens? Well, misclassified employees now have a new statutory private right of action to come after the company for all sorts of things, including back wages, overtime pay, and benefits.

And it really is going to essentially require employer to unring the bell and to go back, and cover that. And if my memory is correct, I think that you can also get attorney's fees.

Nick Johnson

I think that right. Yeah. So, this Virginia statute was one that was rolled out in 2020 with a number of changes that were made in the summer legislative session that basically provide additional protections under the Virginia Values Act. You have two classes. You had a new wage theft act, and one of them was, as Seth correctly pointed out, the misclassification statute that allowed for private right of action.

Seth hit it on the head in terms of damages. Another category of damages, which I think is actually very interesting, is that you can get attorney's fees, you can get back pay, and get interest. You can also seek damages for the benefits that should have been provided to you. So, let's say you have somebody who…

Joe Young

401(k) match.

Nick Johnson

401(k) match, health insurance. They've been with the organization for two years. They sue under this misclassification statute. They can get a monetary damage award equivalent to what they would have received for health insurance, because you can even pull the threat a little bit more. If they went out of pocket on medical costs, you can make a damages claim there.

And so, there are some pretty hefty penalties for noncompliance, at least in Virginia.

Seth Berenzweig

And there's one other wrinkle to that, which is that if it was an intentional misclassification, you could be subject to additional penalties and fines, including an additional 20% wage penalty on top of everything else. Keep in mind that a lot of these disputes come up not during the time when everybody's in love with each other and they're all just kind of hanging out, hugging over a drink of your favorite choice.

Sometimes you have an unhappy, separated former worker for a company. They have an ax to grind, and they're going to go in and they're going to be adverse. So, they're going to maybe inflect the facts just a little bit, against the company. And that's an avoidable headache. If you are litigating against someone who separated unpleasantly from the company, you're guaranteed that you're going to have a difference of viewpoint on the facts.

And if a government investigator asks a disgruntled former worker, do you think that might have been an intentional misclassification? Don't be surprised if you end up getting caught in a trap. So, these are things where an ounce of prevention is definitely worth it.

Joe Young

Well, let's take that scenario to the other side of the equation and that it isn't a disgruntled employee. And this isn’t after the fact of a separation. This is a responsible HR department that's going back, reevaluating, doing an audit. And now they realize they do have somebody misclassified. What are the strategies for fixing this without triggering bigger issues?

Or as you said, ringing the bell. What are some strategies?

Seth Berenzweig

Call Nick.

Joe Young

What? You don’t like getting those questions?

Nick Johnson

Oh, that's a sticky one. Because you don't want to go to the individual and just say, “Hey, oh by the way, for X number of years we've misclassified you.” There may be some strategies to employ there. Maybe put them in a new role, kind of change the responsibilities, and with that new role, message that because your responsibilities are changing, you are now going to be an employee.

That may be one thing. Certainly entering into a new agreement, something in writing, that would help. That’s a sticky one, though, because you want to make sure that you're not, you know, by trying to correct the wrong, you're not admitting to prior violations.

Joe Young

Yeah, yeah. Setting yourself up for the litigation.

Nick Johnson

Right, right, right.

Joe Young

Well, Nick, we also continue. You guys have mentioned a little bit about Virginia. But as far as other states and how that comes into play, and maybe as it relates to the federal law and enforcement, how do you have to think about the states?

Nick Johnson

Good question. Because the states are a whole different animal. Just because you comply with the new federal enforcement guidance doesn't necessarily mean that you are complying and good to go on the state level. We talked a little bit about Virginia, the new law that they passed. Virginia goes so far as to say the presumption is that the worker is going to be an employee, and they put the burden on the employer to establish that the individual actually should be an independent contractor.

So that just kind of shows you the intent here in Virginia of, “Hey, we're going to presume all of your workers are employees, unless you can show us that they're independent contractors.” You're seeing a lot of states take similar approaches. California, no shocker. New Jersey is actually another one. They follow something called the ABC test, which makes it actually very difficult for businesses to classify individuals as independent contractors.

And so, when you are making these determinations about your workers, you're going to want to be mindful of who's in office. You're also going to want to be mindful of the state that they're providing services in, where they reside. Because depending on where you're located, you may find yourself in one of these states like California, New Jersey, and I would even put Virginia in that category. It's hard in Virginia to have someone deemed an independent contractor. You’ve got to be mindful of the state where they're doing the work.

Joe Young

All right. So, before we move on, we do have an audience question. And I do want to kind of address a topic. But we've got a follow-up here and I do want to address this for our listeners out there. So, back to the situation we kind of talked about earlier. What the employee says they would prefer to be. So the question has been presented to us that they had an employee that said they would prefer to be an independent contractor. And I'm going to read this here. The new hire requested to be an independent contractor. May the org proceed with this request? Or is the organization obliged to consider all factors in hiring? And the follow-up to that is, what verbiage can be added to offer that if the person was declined to be an employee, is the employer protected there?

Nick Johnson

It's a great question. And I would say the knee-jerk reaction is, of course, if everybody agrees that should be fine, right? I mean, if… but the reality is no. Consent is not a defense to this. And we've had a number of clients come to us and say, “Listen, the person, they have their own business, they want to do this as a 1099. They've been doing this for a bunch of other companies as an independent contractor.”

That is irrelevant really to DoL and the State Department of Labor when they're evaluating these issues. And so simply because the worker wants to be, even if they sign an agreement saying, “Hey, I agree that I'm an independent contractor, waive all of the…” You can't really contract around that.

The Department of Labor says we're going to look at the realities of the working relationship, realities of the work that's being done. And, unfortunately, what you have in the contract is not going to carry the day. It's good to spell it out, but that's not going to be dispositive.

Seth Berenzweig

The one nuance that I would add to that is asking, is it possible to accentuate or modify the terms of the work? So, in other words, if you would be able to make some kind of an adjustment, some kind of a moderate adjustment to the structure in terms of control, reporting, oversight, obviously, as we've talked about, you would want the individual to understand that they need to set up a business.

It's just not like walking over the wall and flicking a switch, and then you're done. Is it practical to adjust the working relationship so that you can point to actual changes to the circumstances on the ground to show that it fits with reality and is not just something that you just want to do to make somebody happy?

Seth Berenzweig

Yeah, yeah.

Joe Young

So, we're at time. There's one other question here that we're going to maybe go over a little bit because I think it's an interesting question. Does using a staffing agency or a third-party shield you from this classification liability?

Nick Johnson

It's a great question. And this question actually touches on what's referred to as joint employment. And the short answer is simply: using a staffing agency does not address these issues. And, in your typical staffing agency arrangement, you have the staffing agency as the employer of record, but then you have the company, the government contractor, kind of controlling the day-to-day.

There's a lot of litigation on these employer issues and simply using a staffing agency does not overcome that, because what could happen is you could have the worker. They would file a misclassification lawsuit against both the staffing agency and the company that they were working for, saying that essentially they were one and the same. That, “Hey, you had one employer of record, but one person kind of controlled my day-to-day.” And if the day-to-day was more akin to what really should have been an employee, you're still going to have the same issues, even if you're using a staffing agency.

Seth Berenzweig

So, it doesn't provide any insulation. You can't just say, “Don't look at me, look at the staffing agency.”

Joe Young

“That’s why we're using the staffing agency.”

Seth Berenzweig

Exactly.

Joe Young

Can't hide behind that. It’s never that easy, right?

Seth Berenzweig

No. Right.

Nick Johnson

Yeah.

Joe Young

Okay, guys. Great topic. I know I learned a lot in this, as I always do. I think it was a great topic for our group today. So, wrapping up again, thank you everybody, for joining us today. I want to thank Nick for being back as our special guest and supporting us. Next month, we will be back again, scheduled for our third Thursday.

That will be August 21st. As of right now, we don't have a topic. So, you know, keep an eye on our social media. We'll be getting it out there. I know there's a lot of good things there to talk about. We just haven’t narrowed down. But keep an eye out for that. Enjoy your summer and we look forward to seeing everybody next month. Take care.