Employees or Independent Contractors—How Do You Tell?

On October 11, 2022, the U.S. Department of Labor (DOL) proposed a new rule for determining whether a worker is an employee or an independent contractor. This article discusses the new rule and why it is vitally important for all businesses.

FLSA and the Employee vs. Contractor Distinction

The DOL interprets and enforces the Fair Labor Standards Act (FLSA), a federal law that requires employers to pay employees a minimum wage and to give overtime pay for non-exempt employees. FLSA applies to most employers and regulates the wages and hours for employees, but not for independent contractors. The latter are generally not entitled to minimum wage or overtime pay. But distinguishing these two classes of workers has been a point of confusion since FLSA was passed in 1938.

The employee vs. contractor distinction is vital for businesses to consider. It is not only crucial for complying with FLSA and state wage-and-hour regulations, but also for compliance with laws on workers’ compensation, unemployment insurance, payroll taxes, anti-discrimination, OSHA, and other regulations. In most jurisdictions, these laws apply with respect to employees but not to contractors.

Businesses often struggle with classifying workers correctly, and misclassification can lead to substantial legal liability for businesses. Misclassification can result in significant fines, back taxes, audits, expensive litigation, large civil judgments, and sometimes even criminal penalties.

Courts and governmental agencies have come up with various tests for determining whether a worker is an employee or a contractor. These tests vary from jurisdiction to jurisdiction and even from agency to agency. For example, the IRS has a test for employment for tax purposes that is different from the criteria used by the EEOC for purposes of enforcing discrimination laws. And both of these tests are different than the test for employment under FLSA. These tests can also change over time, requiring businesses to stay abreast of changes to maintain compliance.

The Current “Economic Realities” Test

The rule that is currently in place determined a worker’s status by whether, as a matter of “economic reality,” the worker was economically dependent on the business for work (and thus an employee) or was rather in business for themself (and thus a contractor).

The 2021 IC Rule identified five “economic realities” factors to guide the inquiry into a worker's status:

1. The nature and degree of control over the work;
2. The worker’s opportunity for profit or loss;
3. The amount of skill required for the work;
4. The degree of permanence of the working relationship between the worker and the employer;
5. Whether the work is part of an integrated unit of production.

According to the 2021 IC Rule, not all of these factors were equal. The DOL said that the first two factors were the “core factors” to be evaluated. Classifying workers as contractors (at least for FLSA purposes) was as easy as making sure that those two boxes were checked. It was a fairly business-friendly standard.

Reality Check: The New “Totality of the Circumstances” Test

However, with a new administration came a DOL with an overall approach to interpreting and enforcing FLSA that was more focused on employee rights than on being business-friendly. The DOL set about formulating new criteria for worker classification. The DOL published its new rule in October 2022.

The new rule proposed by the Biden DOL replaces the “economic realities” test and its two “core factors” with a more complex and fact-intensive “totality of the circumstances” standard. The new rule has six broad factors:

1. Opportunity for profit or loss depending on managerial skill - This factor considers whether the worker exercises managerial skill that affects the worker's economic success or failure in performing the work.
2. Investments by the worker and the employer - This factor considers whether any investments by a worker are capital or entrepreneurial in nature.
3. Degree of permanence of the work relationship - This factor weighs in favor of the worker being an employee when the work relationship is indefinite in duration or continuous, which is often the case in exclusive working relationships.
4. Nature and degree of control - This factor considers the employer's control, including reserved control, over the performance of the work and the economic aspects of the working relationship.
5. Extent to which the work performed is an integral part of the employer's business - This factor weighs in favor of the worker being an employee when the work performed is critical, necessary, or central to the employer's principal business.
6. Skill and initiative - This factor considers whether the worker uses specialized skills to perform the work and whether those skills contribute to business-like initiative.

The new rule does not weight some factors as more important than others. Rather, all the factors are equal and there’s no bright-line standard of boxes to check to ensure that a worker is properly classified as an independent contractor.

Moreover, in addition to these six factors, the new IC Rule states that “additional factors may be relevant in determining whether the worker is an employee or independent contractor for purposes of the FLSA.” Therefore, the six-factor test is non-exhaustive and there’s no definite limit to what information the DOL or a court might consider when determining a worker’s status. This means the outcome of an agency or judicial determination is less predictable and that classifying workers as contractors can be riskier.

The new IC Rule is open for public comment until December 13, 2022. After the window for public comment closes, the DOL will review all comments, make any necessary changes to the rule, and likely implement the rule sometime in the first quarter of 2023.

Why it Matters: How the New Rule Affects Businesses

The new proposed IC Rule reflects the current DOL’s philosophy of a broader definition of “employee” under FLSA and a more aggressive enforcement of the Act to ensure fair compensation and hold employers accountable. Assuming it is finalized, businesses that use workers who are classified and treated as independent contractors should be cautious when categorizing workers as contractors. They should also reassess their previous classifications of workers to ensure that they comply with the new standards for determining contractor status. Businesses should ensure that their human resources professionals are up to speed on the DOL rules and should also consult with experienced legal counsel to ensure correct classification of workers.

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Featured Image by Rebecca Sidebotham.