Looming change in worker classification rules will cost small businesses big bucks

A lot of attention has been paid to the tax increases that are part of the Democratic-backed Inflation Reduction Act that’s making its way through Congress. And while these increases are concerning to both businesses and taxpayers, there’s another rule coming from the Biden administration that will have an even bigger impact on costs for millions of small businesses: a looming change in worker classification rules.

The new rules will result in changing the status of countless “independent contractors” to employees. So why is that such a big deal?

Small businesses rely on independent contractors to perform ad-hoc and infrequent tasks that usually do not require the attention of full-time employees. Often called “1099 workers” (thanks to the tax form that needs to be filed with the IRS to report payments over $600), these freelancers (or “gig workers”) are stand-alone entrepreneurs who oftentimes serve multiple customers.

They’re truck drivers, software developers, project managers, construction workers, content producers, health care professionals, counsellors and trainers. They belong to professional organizations that support freelancers. Along with millions of others, they get projects and side gigs through platforms such as Fiverr, Craigslist, UpWork and Freelancer.com. Most of these entrepreneurs operate independently as small business owners themselves and earn their entire livelihoods this way. Others enjoy the extra income these freelancing opportunities provide.

But the Biden administration feels that these independent contractors need more protections. And so the Department of Labor (DOL) is taking action.

“The department now plans to engage in rule-making on determining employee or independent contractor status under the Fair Labor Standards Act,” Jessica Looman, the acting administrator for the Department of Labor’s Wage and Hour Division, wrote recently on the DOL’s blog. “We remain committed to ensuring that employees are recognized correctly when they are, in fact, employees so that they receive the protections the FLSA provides.”

The DOL’s new rules will throw away the multiple requirements that have long been used to determine whether a freelancer is truly independent or should be classified as an employee and replace these requirements with a more simplified “ABC Test.” These new rules focus on just three factors:

A: The worker is free from the control and direction of the hirer in connection with the performance of the work;

B: The worker performs work that is outside of the usual course of the hiring entity’s business and

C: The worker is customarily engaged in an independently established trade, occupation or business.

For small businesses, the biggest challenge will be meeting the “B” rule. That’s because, in essence, that specific test basically says a small business owner cannot use a 1099 worker to perform tasks that generate revenue for his business. The work must be “outside of the usual course” of what his company does. So, if he’s going to charge his clients for the services performed by the outside developers and tax experts he uses, then he can’t treat these outsiders as independent contractors.

Instead, he must classify these workers as employees. And that’s a big problem for small businesses. Why? Because it’s a big tax increase. Not only will small business owners have to withhold payroll taxes for these workers, but they’ll also need to pay the employer’s portion of both Social Security and Medicare taxes as well as any related state and local taxes. As employees, they also may be qualified to participate in the company’s benefit plans, which could incur further health insurance and retirement costs.

Sure, these workers will also have protections under the Fair Labor Standards Act. They’ll also have the freedom to unionize (which many opponents are saying is the main driver behind the Biden administration’s actions). But do independent contractors and freelancers really want to be employees? Many contractors prefer to be their own boss and have no desire to be on a payroll. They like their independence. They serve multiple customers. They make their own choices, from billing to the clients they work for and the hours they work.

“We told the Labor Dept. that we want these attacks on our small businesses to stop,” says Karon Warren, co-leader of Fight For Freelancers USA. “There are 59 million independent contractors in this country. We’re a third of the U.S. workforce, and the majority of us are happy. Lawmakers and regulators need to stop their outrageous attempts to misclassify us as employees.”

“The bill could end my ability to be my own boss, set my own hours and otherwise live the American worker’s dream,” wrote Judi Ketteler on NBCNews.com. “According to the ABC test, businesses need to treat someone like me as an employee — with all the rights and benefits that entails — even if I’m writing only a single story for them. Ditto for all types of creatives who support themselves through gigs, like actors, artists and musicians. How many companies will continue to use our services under these circumstances? It’s simply not feasible.”

Ketteler was referring to the PRO Act, a workers’ rights bill (fashioned on California’s controversial AB5 legislation) that failed to pass the Senate back in 2021. Despite this failure, the DOL is continuing to move forward outside of the legislative process using pieces of that legislation, particularly the ABC Test. The department held two public forums on the issue in June, and most experts are expecting finalized worker classification rules by the end of the year.

It’s inevitable that freelancer organizations and other business groups will challenge the ruling in court. There are already many legal challenges. And it’s important to note that the ruling is coming from the DOL and does not impact how the IRS – a separate agency – defines independent contractors for tax filing purposes. So, confusion and chaos are also inevitable.

In the meantime, countless small business owners will be stuck in the middle. Amid inflation, supply chain problems, labor shortages and a continued economic slowdown, these changes could not be coming at a worse time.

Gene Marks is founder of The Marks Group, a small-business consulting firm. He frequently appears on CNBC, Fox Business and MSNBC.