Defining an Employee vs. Independent Contractor—New DOL Guidelines

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor in New Mexico is representative of a common inquiry related to the definition of employee. The advisor asked: Do the final Department of Labor regulations defining employee vs. independent contractor affect who can participate in retirement plans?

Highlights of Discussion

The answer is … they may. Whether a worker is an employee or independent contractor is an important determination that has several implications for employers, including for labor standards, tax purposes and retirement plan coverage. When it comes to plan coverage purposes, ERISA imposes a two-part test that an individual must meet to qualify as a plan participant[1]:

1. First, the individual must be an employee.
2. Second, the individual must be eligible to receive benefits under the plan according to the terms of the plan document.

For the first prong, we need a definition of employee. The second prong underscores the importance of reviewing plan document language to see how the terms “employee” and “participant” are defined.

The Department of Labor (DOL) has issued new regulations, effective March 11, 2024, addressing how to analyze whether a worker is an employee or an independent contractor under the Fair Labor Standards Act (FLSA). It also updated its Fact Sheet 13: Employment Relationship Under the Fair Labor Standards Act (FLSA).

While the final rule does not directly apply to ERISA, historically, the industry has looked to the FLSA, court rulings and informal guidance from the DOL and IRS to help define who is an independent contractor (and not an employee). The U.S. Supreme Court on several occasions has ruled that there is no single rule or test for determining whether an individual is an independent contractor or an employee for purposes of the FLSA. The Court has held that it is the total activity or situation that controls. Among the factors which the Court has considered significant are:

• The extent to which the services rendered are an integral part of the principal's business.
• The permanency of the relationship.
• The amount of the alleged contractor's investment in facilities and equipment.
• The nature and degree of control by the principal.
• The alleged contractor's opportunities for profit and loss.
• The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
• The degree of independent business organization and operation.

Under the new FLSA standard, which is specific to FLSA purposes, including equitable wages, the fair treatment of employees, child labor laws, etc., whether a worker is an employee or an independent contractor is determined by applying a six-part “economic realities” test.

The six factors are:

1. The opportunity a worker might have to affect profit or loss;
2. The financial stake and nature of any resources a worker has invested in the work;
3. The degree of permanence of the work relationship;
4. The degree of control an employer has over the person’s work;
5. Whether the work the person does is essential to the employer’s business;
6. A factor regarding the worker’s skill and initiative.

Employers must look at the entire working relationship to decide whether a worker is an employee or an independent contractor. The final rule provides detailed guidance regarding the application of each of these six factors. No factor or set of factors among this list of six has a predetermined weight, and additional factors may be relevant as well.

The IRS, for tax purposes, has a separate “employee” standard. In the past, the IRS applied a 20-part test, but it has since reduced it to a three-part test to determine employee or independent contractor status:

The three factors are:

1. Financial control
2. Behavioral control
3. The nature of the working relationship

The IRS has some helpful online information as well on determining worker status at Independent Contractor (Self-Employed) or Employee? For more certainty, a person or entity can ask the IRS to make a formal determination on a worker’s status by filing IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The filing takes at least six months to process.

If it can be summarized, the determination of whether a person who provides services to a business is considered an employee or independent contractor is based on the degree of “control or direction” provided by the business to the worker and is dependent upon the facts and circumstances of each case.

Generally, an individual is an independent contractor if the business for which he/she performs services does not control the means or methods used by the worker to accomplish the promised result. It is important for the business owner to look at the entire relationship with the worker, consider the degree of his or her right to direct and control the worker’s actions and, finally, to document each of the factors the business owner uses to arrive at the determination.

Conclusion

Determining whether a worker is an employee or independent contractor particularly for retirement plan coverage purposes can be tricky. The DOL has a new FLSA employee standard. There’s also the IRS definition of employee for tax purposes and Supreme Court rulings. All three of these standards may impact whether a worker is an employee that should be covered under an employer-sponsored retirement plan. Sponsors and their legal advisors should look to the plan document for guidance and document the determination process. This case is covered on our YouTube channel Defining an Employee vs. Independent Contractor—New DOL Guidelines.

Any information provided is for informational purposes only. It cannot be used for the purpose of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

©2024, Retirement Learning Center, LLC. Used with permission.