March 14, 2024Compliance

Converting contractors to employees: A step-by-step guide

It’s time for you to take a look at how you classify your workforce. The United States Department of Labor (DOL) introduced a new rule that revisits the Fair Labor Standards Act’s (FLSA) provisions for classifying workers. This rule, effective from March 11, 2024, swings the pendulum back to the Obama administration’s six-factor “economic reality” test, making it more challenging to classify workers as independent contractors. This shift underscores how important it is to understand what how to correctly classify workers as either W-2 employees or 1099 contractors and what contractor conversion entails.

Let’s unpack why this matters, the ramifications of misclassification, and how you can smoothly convert contractors to employees without skipping a beat.

What is the DOL worker classification rule? 

The new rule reintroduces the economic reality test, which examines the nature of a working relationship to determine if a worker should be classified as an employee or an independent contractor according to the Fair Labor Standards Act (FLSA). The test focuses on whether a worker is economically dependent on the employer for their livelihood, indicating an employee status, or if they are running their own business, which would suggest they are an independent contractor. The assessment is holistic, considering multiple aspects of the working relationship without prioritizing one factor over another.

Key elements of the economic reality test include:

  • The worker’s ability to make a profit or incur a loss based on their own decision-making, which can indicate independence or dependence.
  • The extent of the worker’s and the employer’s investments, suggesting who controls the business operations.
  • The permanency of the relationship, with more permanent arrangements hinting at an employee status and temporary, ad-hoc or projects with a fixed end date suggesting independence.
  • How much control the employer has over the worker, and the nature of this control. This can include things like scheduling, pay rates and supervision, and generally looks at things that would prevent a worker from taking other employment. 
  • The importance of the work performed to the employer’s business, suggesting an employee if it’s integral.
  • The level of skill and “business-like initiative” required from the worker, indicating independence if higher. 

While these factors are central, the test allows for the consideration of additional relevant factors to accurately assess the worker’s status. However, certain details, like the job title, payment method, or where the work is performed, don’t influence the determination of a worker’s status under the FLSA. The essence of the economic reality test is to look beyond superficial labels and examine the actual dynamics of the working relationship to ensure workers are classified correctly and receive the appropriate protections and benefits.

It’s important to read about the classification rules yourself and interpret them for your business and workers. Check out this guidance from the DOL and its FAQ page

Why you need to get worker classification right

The DOL’s new rule makes it tougher to classify workers as independent contractors and getting it wrong can be costly. Classifying an employee as a contractor means they don’t have benefits like overtime pay, health insurance, and workers’ compensation. 

Misclassification can trigger a domino effect of legal and financial headaches. Beyond the immediate fines and legal fees, you might find yourself on the hook for unpaid taxes to the IRS, owed overtime compensation, back pay and interest. Misclassifying workers could also make you vulnerable to lawsuits from workers disputing their status. This can amount to a substantial sum, putting a strain on your business’ finances and reputation. 

Contractor conversion: Can’t-miss steps to take

Converting a worker from 1099 to W-2 status isn’t just a bunch of busywork–it’s a significant change in their employment status. Here’s how to do it right:

  • Notify the worker: Start with an open conversation. Explain the why, the how, and the what-next of their transition to W-2 status. It’s a good idea to notify them in writing and keep a copy of the notification in your records.
  • Set them up as an employee in your systems: This logistical step is crucial. Update your records across accounting, HRIS, and payroll systems to reflect their new status.
  • Have them complete a W-4 form: A new W-2 status means new tax obligations. Ensure your workers fills out W-4 forms to get tax withholdings right from the get-go. This tool from the IRS helps them know what to claim so they don’t have too much or too little taxes taken out. 
  • Set a pay schedule and account for overtime if relevant: Establish a regular pay cycle and become familiar with your state overtime laws if you have hourly employees. If speed of pay was a perk your contractors loved, consider payroll solutions like Everee, which offer same-day or instant payment options for W-2 workers as well. 
  • Have a plan for W-2 form distribution: You’ve had to issue 1099 tax forms to your contractors in the past, but employees need to receive W-2s. It’s required that employees receive W-2 tax forms for the previous year before January 31. If you haven’t issued these before, now’s the time to inquire if your payroll software handles them and if there are any additional fees. 

Beyond paychecks: State labor laws and ACA reporting

Diving deeper, ensure your compliance extends to state-specific labor laws covering sick leave, breaks, and more. And don’t forget the Affordable Care Act (ACA) reporting requirements. If converting contractors pushes your employee count over 50, you’ll need to navigate ACA reporting, a critical piece of the compliance puzzle and one your payroll provider should be able to help you manage.

Making the switch attractive to your workers

Some contractors might be skeptical about the switch, worrying that they’re giving up autonomy or flexibility. But you can ease their concerns by shining a light on the benefits and keeping their experience with your company as similar as possible: 

Highlight new benefits: If they’re now eligible for health insurance, retirement benefits, paid time-off or other benefits, make sure you communicate how valuable these perks are. 

Adjust compensation if needed: Consider whether a bump in pay is necessary to offset the bite of taxes and withholdings.

Speed of pay: For many, the prompt payment they enjoyed as contractors was a big plus. Offer them the same convenience with payroll solutions (like Everee) that provide same-day or instant pay even now that they’re a W-2.

Navigating from 1099 to W-2 status is more than a regulatory hoop to jump through; it’s an opportunity to reassess and realign how you value and support your workforce. With the DOL’s new rule as your compass, and a clear, comprehensive strategy for the transition, you can ensure this change is positive for everyone. 

With the right approach, you can navigate this change confidently, keeping your business on solid ground and your workforce engaged and motivated.

If you’re converting contractors to employees, Everee’s payroll software can help. We handle all tax filings and remittances, ACA reporting, year-end tax doc distribution and more, while offering instant and same-day pay for both worker types. To learn more, book time with our team.