The DOL Publishes its Long-Awaited Final Independent Contractor Rule
On January 10, 2024, the U.S. Department of Labor (the “DOL”) published its long-awaited final rule (the “Final Rule”) for determining who is an employee versus independent contractor under the Fair Labor Standards Act (the “FLSA”). Replacing the DOL’s 2021 rule, the Final Rule adopts a six-factor, totality-of-the-circumstances test which looks at the “economic reality” of the worker relationship and “focuses more broadly on a worker’s economic dependence on an employer.” The Final Rule is scheduled to go into effect on March 11, 2024, and will be codified in 29 C.F.R. Part 795.
The six factors are: (1) the worker’s opportunity for profit or loss depending on managerial skill; (2) investments by the worker and potential employer; (3) degree of permanence of the work relationship; (4) nature and degree of control; (5) extent to which work performed is integral to the employer’s business; and (6) worker’s skill and initiative.
Background: The Economic Realities Revival
Since the 1940s, the DOL has applied an economic reality test to determine whether a worker is an employee or an independent contractor under the FLSA.
- On January 7, 2021, the DOL under the Trump Administration published “Independent Contractor Status Under the Fair Labor Standards Act” (the “2021 Rule”), which marked a departure from the economic reality test, identifying five economic reality factors to guide the inquiry into a worker's status as an employee or independent contractor and emphasizing two “core” factors: “the nature and degree of the individual’s control over the work” and “the individual’s opportunity for profit or loss.”
- Days before the 2021 Rule’s effective date, the DOL announced that the rule would be delayed and, on May 6, 2021, it withdrew the rule (the “2021 Delay and Withdrawal Rules”).
- Only a week later, a Federal District Court in the Eastern District of Texas issued a decision vacating the 2021 Delay and Withdrawal Rules and concluded that the 2021 Rule became effective on the original effective date of March 8, 2021.
- On October 13, 2022, the DOL published a Notice of Proposed Rulemaking (the “NPRM”) regarding employee and independent contractor classification under the FLSA, proposing to rescind and replace the 2021 Rule.
- This brings us to the Final Rule, published by the DOL on January 10, 2024. The Final Rule largely follows the NPRM and is intended to be more consistent with the FLSA as interpreted by longstanding judicial precedent.
The Six-Pronged Economic Realities Test
Effective March 11, 2024, the six non-exhaustive factors for determining employee versus independent contractor status for purposes of the FLSA are the following. None of the six factors discussed below are given any predetermined weight under the Final Rule; instead, the Final Rule looks to the “totality of the circumstances.”
- Worker’s Opportunity for Profit or Loss Depending on Managerial Skill
The first factor looks at whether the worker exercises managerial skill, initiative, business acumen or judgment that affects the worker’s opportunity for economic success or failure. The following facts may be relevant: Can the worker negotiate or set their rate of pay? Can the worker expand their business or secure additional work? Does the worker engage in marketing or advertising for the enterprise? Is the worker empowered to hire others, purchase space or materials? Importantly, this factor looks to the worker’s opportunity for potential profits or losses, and not whether the worker takes advantage of available opportunities. If a worker has the opportunity to earn more (not at a fixed rate) by taking on more work or opportunities, this may be indicative of independent contractor status. - Investments by the Worker and Potential Employer
The second factor considers whether any investments by a worker are “capital or entrepreneurial” in nature. Relative to the employer’s investments in its overall business, if the employer has “invested” more than the worker, it is more likely that the worker is an employee as opposed to an independent contractor. The investment comparison should be primarily qualitative, rather than quantitative, focusing on whether the worker is making similar types of investments, not on the amount or size of the investments. Further, costs unilaterally imposed by an employer on a worker are not capital or entrepreneurial in nature. - Degree of Permanence of the Work Relationship
The third factor considers that a worker: (a) subject to “indefinite or continuous” work, is more likely to be an employee, and (b) with “definite, non-exclusive, project-based, or sporadic” work who is self-employed, or marketing their services to multiple employers, is more likely to be an independent contractor. It is important, however, to look at the context of the overall worker relationship (e.g., the nature of the work may be inherently sporadic due to the industry itself or some independent contractors may rely on “repeat business and long-term clients or customers in order for their business to remain economically viable or successful”). - Nature and Degree of Control
The fourth factor looks at the nature and degree of control that an employer has over a worker. The more control a worker has over their schedule, the pricing of their services and the ability to work elsewhere, the more likely they are to be considered an independent contractor. The Final Rule clarifies that actions which are ostensibly acts of control, such as adopting policies to maintain compliance with Federal or State health and safety regulations, are not presumptive of employee status: “actions taken by the potential employer that go beyond compliance with a specific, applicable Federal, State, Tribal, or local law or regulation and instead serve the potential employer’s own compliance methods, safety, quality control, or contractual or customer service standards may be indicative of control.” - Extent to Which Work Performed is Integral to the Employer’s Business
The fifth factor centers on whether the work to be performed is an integral, material part of the employer’s business function. The more “critical, necessary, or central” the worker’s role, the more likely the worker is to be classified as an employee. - Use of the Worker’s Skill and Initiative
The final factor considers whether the worker uses any specialized skills in connection with a “business like initiative,” departing from the “integrated unit of production” standard used in the 2021 Rule. Potentially the most contested factor, employee status is more likely if the worker does not use specialized skills in performing the work or is dependent on training from the employer to perform it, with the important caveat that such specialized skills must be necessary for the work to be performed.
Why is Worker Classification Important?
Federal wage and hour laws under the FLSA differ depending on whether a worker is classified as an independent contractor or an employee. The FLSA’s minimum wage and overtime Federal rules do not apply to independent contractors. As Julie Su, Acting U.S. Secretary of Labor, stated, “[m]isclassifying employees as independent contractors is a serious issue that deprives workers of basic rights and protections … This rule will help protect workers, especially those facing the greatest risk of exploitation, by making sure they are classified properly and that they receive the wages they’ve earned.”
While the Final Rule provides the independent contractor test for purposes of the FLSA, it does not apply to other statutes, such as the Internal Revenue Code or State labor laws. Various States (including California, Massachusetts, and New Jersey) still apply an “ABC” test, with different or, at times, more stringent classification factors.
How does Worker Classification Affect Employee Benefit Plans?
The classification of workers under U.S. tax-qualified employee benefit plans is governed by the U.S. Internal Revenue Code and the regulations promulgated thereunder (the “IRS Rules”). The IRS Rules are derived from common law and use three factors as evidence of the degree of control the employer has over the worker: the more control the employer has over the worker, the more likely the worker is to be classified as an employee. The three factors are: (1) behavioral control (whether there is a right to direct or control how the worker does the work); (2) financial control (whether there is a right to direct or control the business part of the work); and (3) the relationship of the parties (how the business and the worker perceive their relationship).
Employers should be mindful of the differences between the Final Rule and the IRS Rules when determining coverage and administering employee benefit plans, to avoid the following pitfalls:
- Retroactive Coverage
If a worker has been misclassified as an independent contractor instead of an employee, they may be entitled to retroactive coverage for retirement and health and welfare plan benefits, which can be costly for the employer and result in retroactive penalties under the Affordable Care Act (“ACA”), including for failing to file or filing inaccurate healthcare coverage forms with the IRS (e.g., Forms 1094-C and 1095-C). - Plan Testing
The misclassified employee will also need to be included in a qualified retirement plan’s annual non-discrimination compliance testing, which could affect whether the plan meets the actual deferral percentage, annual contribution, and top-heavy tests. - Coverage for Independent Contractors
Most employer-sponsored retirement, health and welfare plans prohibit independent contractors from participating, as it can mean that the plan becomes a multiple employer plan or creates a multiple employer welfare arrangement.
What’s Next?
The practical effect of the Final Rule is that more workers – including those who would favor independent contractor status – are more likely to be classified as employees under the FLSA.
The Final Rule is expected to increase labor costs for businesses reliant on freelancers and contract labor, including “gig” services, trucking, and manufacturing. The House Committee on Small Business has warned the DOL that “independent contractors and small businesses often work in concert with one another and the DOL’s rule would effectively ruin their agile partnership.” As with the 2021 Rule (the delay and withdrawal of which is still the subject of a lawsuit which remains pending and may become active again), legal challenges to the Final Rule have already been filed, and many more are to be expected.
As 2024 gets underway, it’s important for employers to evaluate their own classification practices and policies, especially since the Final Rule differs significantly from prior guidance, including the 2021 Rule and Fact Sheet 13. Time will tell whether the Final Rule survives an election year.
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We are continuing to monitor updates on worker classification both in the U.S. and across the globe. If you would like to speak to one of the team about worker classification in your jurisdiction, please get in touch.
