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What SMB Employers Need to Know About the Independent Contractor Rule


Quick look: With the recent updates to the independent contractor classification rule, SMB employers must be mindful of how they are categorizing those they employ. Misclassification can come with costly implications and hold companies back from their potential growth. Fortunately, business leaders are not alone in navigating this new legislation and can turn to a PEO partner for expertise, experience, and guidance.

The surge of contractor roles has risen significantly since 2020, as many companies are hiring freelancers to fulfill their business needs. While this can be part of an impactful strategy for small- and medium-sized businesses (SMBs) in order to scale, it’s critical to know how each person should be legally classified. This applies to new hires as well as current contractor relationships.

In 2021, the U.S. Department of Labor rescinded its previous independent contractor classification rule and updated it under the Fair Labor Standards Act (FLSA). Effective as of October 13, 2022, the ruling restores the multi-factor analysis needed to determine a worker’s status and reverts back to evaluating whether the work being performed is integral to the employer’s business.

The goal of the independent contractor rule is to prevent misclassification of workers and eliminate the denial of basic protections such as minimum wage and overtime pay. Non-compliance may result in hefty implications regarding tax and wage liabilities, including uncollected social security and Medicare taxes, as well as unexpected expenses to cover liability for unpaid employee benefits and owed wages.

With the heightened scrutiny regarding employee classification, business leaders are looking for expert guidance and solutions as they develop growth strategies and company policies involving independent contractors. To minimize risk and uphold hiring best practices, it’s beneficial for SMBs to work with a professional employer organization (PEO) partner well-versed in all things HR.

Determining worker status

The origins of the independent contractor rule stem from the gig economy, primarily focusing on rideshare and trucking companies. However, with the rise in self-employed/freelance workers across most industries, knowing the difference between an employee and independent contractor is crucial beyond gig workers.

Per the Internal Revenue Service (IRS), the general rule when classifying an individual as an independent contractor is if the person has “the right to control or direct only the result of the work and not what will be done and how it will be done.” However, there are additional factors to provide classification guidance including:

  • How integral the services performed are for the business
  • The permanency of the working relationship
  • The worker’s investment in equipment, facilities, or materials
  • The degree and nature of control by the business

In addition to federal compliance, certain states also implement their own separate parameters for employee classification. For example, California and Illinois both use the ABC test to determine employee status. The ABC test presumes an individual as an employee unless the business can prove:

  • The worker is free from the control and direction of the hiring entity
  • The worker performs work outside the usual course of the hiring entity’s business
  • The worker is customarily engaged in an independently established trade, occupation, or business

Though the intent of the independent contractor rule is to provide fair wages for employees, it can also have a negative impact on SMB employers. Since there is subjectivity when it comes to applying factors under the new ruling, it could pose restrictions on SMB leaders who do not have the budget or resources to onboard all independent contractors as full-time employees.

The effect on growth strategies for SMBs

Working with independent contractors is a trending business model for many SMBs. As companies build their client portfolio, their need for workers can ebb and flow, making the partnership with independent contractors valuable for both parties. SMB leaders can still offer competitive rates but without the expense of providing company benefits, equipment, office space, and other costs associated with full-time employees.

This type of agreement aligns with the majority of workers today who say they prefer to be self-employed rather than take a traditional full-time job. They seek the schedule flexibility, remote work opportunities, and increased autonomy freelance work provides. Though every company and situation is different and often fosters a healthy mix of full-time workers with independent contractors, the future favors individuals being in control of their own work destiny. However, since the factors outlining the federal rule can be misconstrued, having the expertise of a PEO partner to maintain compliance is crucial.

Companies must work within the regulatory framework outlined by the government, while adhering to the current workplace trends in order to stay relevant. Though the answer may be to onboard independent contractors during the earlier stages of company growth, SMBs must abide by the rules in place.

Grow your business with the support of a PEO

Freelancers are becoming a main thread of the modern workforce. Without them, it can make it more difficult for SMBs to grow. Therefore, working with a PEO partner who understands the ins and outs of what’s required to operate as well as meet independent contractor expectations can help to ensure a successful outcome.

It can be challenging to keep pace with changing regulations and understanding the implications when it comes to employee and wage law. This can easily sidetrack operational efforts and prohibit growth, leaving certain companies struggling to stay competitive. A PEO provides comprehensive HR capabilities and support to SMB employers. This includes administration and implementation of HR, payroll, and benefits solutions, while also tracking new regulation updates and workplace trends to keep SMB companies competitive and in compliance.

HR is a complex undertaking and requires the skills, technology, and experience of HR experts to guide the way. At ExtensisHR, we are focused on the individual needs of the SMBs we work with to tailor strategies and champion business growth. Learn about the benefits of working with a PEO partner and how our services can support you.

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