1099 vs. W-2: Employers should take a second look at their independent contractors

Employers need to revisit how they identify independent contractors in light of the U.S. Department of Labor’s proposed rule on employee classification, which will rescind its 2021 rule. Although RIN 1235-AA43 is not yet finalized, the period for public comment ended on Dec. 13, 2022.

The proposed rule would require employers to analyze whether the worker is economically dependent on the employer for work or is in business for themselves — which can be a complicated determination.

Related: New proposed independent contractor regulations issued from DOL (again)

The distinction is important and affects both parties primarily by determining whether an agency issues a form W-2 (employee) or 1099 (independent contractor) to the worker at the end of the year. This decision, of course, affects taxation and benefits.

Economic reality factors as addressed in the proposed rule have been described by The Society for Human Resource Management (SHRM) or business law firm Brooks Pierce as:

1. The opportunity for profit or loss depending on managerial skill.
2. The investments by the worker and the employer.
3. Whether the working relationship is long- or short-term.
4. The nature and degree of employer control over the work.
5. The extent to which the work performed is an integral part of the employer’s business.
6. The worker’s use of skill and initiative.

While employers should always discuss their specific situation with a qualified attorney, here’s an example: An independent contractor who presumably satisfies the proposed rule is an IT professional on retainer with an employer to provide IT-related services for several employees. Since the professional’s main business is IT, they should qualify as an independent contractor.

However, employers could be particularly troubled by the fifth economic reality noted above: The extent to which the work performed is an integral part of the employer’s business.

The most common roles for which agencies use independent contractors are customer service representative (CSR) and producer. Let’s consider a CSR working for an agency remotely, in another state, for 20 hours a week reviewing policies before they are sent to the insured. Common sense suggests that work is an integral part of the employer’s business.

If an independent contractor is indeed classified as an employee, they must be covered for FICA (Social Security), workers’ compensation, vacation, health insurance if eligible, and other benefits and workforce protections. And this does not include regulatory issues at play.

An employer might argue: “I’m paying a higher hourly rate to the independent contractor to compensate them for health insurance and retirement contributions.”

The answer: It does not matter.

Another example is a salesperson who is getting a 1099 because they can “come and go and work on straight commission.” Again, that No. 5 prong would apply because selling is an integral part of the business. Whether or not the classification was correct under the previous rules, many employers that have been issuing 1099s to their salespeople will need to switch to W-2s and all that the employee classification entails.