Final Rule on Classifying Workers as Employees OR Independent Contractors under FLSA
On January 10, 2024, the U.S. Department of Labor (DOL) published the Final Rule regarding Employee or Independent Contractor Classification Under the Fair Labor Standards Act. It revises the DOL guidance on how to analyze who is an employee or independent contractor under the Fair Labor Standards Act (FLSA). The Final Rule is slated to take effect on March 11, 2024, however, it is currently subject to legal challenges in multiple courts.
The Department believes that this final rule will reduce the risk of situations where employees are misclassified as independent contractors, while at the same time providing greater consistency for businesses that engage (or wish to engage) with individuals who are in business for themselves. The Final Rule returns to the pre-2021 approach of considering multiple factors when assessing worker classification.
The FLSA generally requires covered employers to pay non-exempt employees at least the federal minimum wage for all hours worked and at least 1.5 times the employee’s regular rate of pay for every hour worked over 40 in a workweek. Individuals who perform services for a company as an independent contractor are not covered under the FLSA’s provisions on minimum wage and overtime protections because they are not “employees.” The FLSA however, is silent on how to distinguish an employee from an independent contractor.
The definition of “independent contractor” holds paramount importance as it determines the coverage under federal wage-and-hour laws. The FLSA’s regulations on minimum wages, overtime, and record-keeping apply exclusively to employees and not independent contractors. Thus, understanding and correctly applying this distinction is crucial for compliance with federal labor laws.
Case Laws by Supreme Court
In a series of cases from 1944 to 1947, the U.S. Supreme Court considered employee or independent contractor status under three different Federal statutes that were enacted during the 1930s New Deal Era – the FLSA, the National Labor Relations Act (NLRA), and the Social Security Act (SSA) and applied an “economic reality test” under all three laws to analyze employee or independent contractor status.
An “economic realities” test is a test to determine whether a worker is an employee or an independent contractor. Certain key factors should be considered in light of the ultimate determination of whether the worker is really in business for him or herself (and thus is an independent contractor) or is economically dependent on the employer (and thus is its employee).
In NLRB v. Hearst Publications, Inc., 322 U.S. 111 (1944), the Supreme Court (federal) considered the meaning of “employee” under the NLRA, which defined the term to “include any employee”. The Supreme Court rejected the application of the common law standard, noting that “the broad language of the [NLRA’s] definition leaves no doubt that its applicability is to be determined broadly, in doubtful situations, by underlying economic facts rather than technically and exclusively by previously established legal classifications.” Following the decision, Congress amended the NLRA’s definition of “employee” to clarify that the term “shall not include any individual having the status of an independent contractor.
On June 16, 1947, in the matter of United States v. Silk, 331 U.S. 704 (1947), the Supreme Court addressed the distinction between employees and independent contractors under the Social Security Act [SSA]. Although the Court found it to be “quite impossible to extract from the SSA a rule of thumb to define the limits of the employer-employee relationship,” the Court identified five factors as “important for decision” i.e. “degrees of control, opportunities for profit or loss, investment in facilities, permanency of relation, and skill required in the claimed independent operation.”
Following these Supreme Court decisions, Congress responded with separate legislation to amend the NLRA and SSA’s definitions of employees. First, in 1947, Congress amended the NLRA’s definition of “employee” to clarify that the term “shall not include any individual having the status of an independent contractor.” The following year, Congress similarly amended the SSA to exclude from employment “any individual who under the usual common law rules applicable in determining the employer-employee relationship, has the status of an independent contractor.”
Various Court precedents developed similar standards for determining whether an individual is an employee or an independent contractor. These factors are:
- The degree of the alleged employer’s right to control the manner in which the work is to be performed;
- The worker’s opportunity for profit or loss depends upon their managerial skill;
- The worker’s investment in equipment or materials required for their task, or their employment of helpers;
- Whether the service rendered requires a special skill;
- The degree of permanence of the working relationship; and
- The extent to which the service rendered is an integral part of the alleged employer’s business.
The courts and the DOL have applied these factors, or some similar variation of them, for more than 70 years.
2021 Independent Contractor Rule
During the Trump Administration, the DOL sought to resolve the tension created by decades of inconsistent and subjective application of the factors. In January 2021, the DOL for the first time adopted a formal independent contractor rule (2021 IC Rule), providing guidance on the classification of independent contractors under the FLSA applicable to workers and businesses in any industry. The 2021 IC Rule elevated the comparative value of two core factors- “the nature and degree of the individual’s control over the work” and “the individual’s opportunity for profit or loss.”.
- The first core factor includes key insights into independent contractor status like whether a worker sets their schedule, selects projects, or provides their own health and safety standards to name a few.
- The second core factor indicates independent contractor status if the worker has an opportunity to earn profits or incur losses based on either 1) their exercise of initiative or business acumen, or 2) their management of investment in equipment to continue work.
Other minor factors considered under the 2021 IC Rule are – the amount of skill required for the work, the degree of permanence of the working relationship between the worker and the employer, and whether the work is part of an integrated unit of production. While these three minor factors can be utilized in identifying a worker’s labor status, the rule has made clear that they cannot outweigh the combined probative value of the two core factors mentioned above which remains the current rule today.
Rescinded 2021 Independent Contractor Rule
After the Biden Administration took office, DOL first delayed implementing the 2021 IC Rule and then withdrew the rule altogether in May 2021.
While the 2021 IC Rule was initially enacted to promote certainty for stakeholders, reduce litigation, and encourage innovation, the Department of Labor has stated in its new proposal that the 2021 IC Rule is not in alignment with the purpose of the FLSA and the interpretation of the FLSA’s text by federal courts. The 2021 IC Rule mostly elevated the core factors, which the Labor Department believes will result in the misapplication of the initial economic reality test would cause more workers to mistakenly be classified as independent contractors rather than employees.
The Department of Labor asserts that workers are being misclassified due to the 2021 rule’s focus on only a few factors, as opposed to taking a totality-of-the-circumstances approach.
In the FLSA context, employees misclassified as independent contractors are denied basic workplace protections, including the rights to minimum wage and overtime pay. Meanwhile, employers that comply with the law are placed at a competitive disadvantage compared to other businesses that misclassify employees, contravening the FLSA’s goal of eliminating unfair methods of competition in commerce.
Final Rule on Classification of Workers
The Final Rule provides detailed guidance on employee or independent contractor status that is not only consistent with the FLSA and the decades of case law interpreting it but more robust than the Department’s earlier sub-regulatory guidance. For these reasons, the final rule will provide helpful guidance for workers and businesses alike. The Final Rule continues to affirm that a worker is not an independent contractor if they are, as a matter of economic reality, economically dependent on an employer for work. The Final Rule introduces a non-exhaustive six-factor “economic realities” test, replacing the 2021 rule and aiming to bring clarity to the classification of workers as independent contractors or employees.
- Opportunity for profit or loss depending on managerial skill – This factor considers whether the worker has opportunities for profit or loss based on managerial skill (including initiative or business acumen or judgment) that affect the worker’s economic success or failure in performing the work.
- Investments by the worker and the potential employer – This factor considers whether any investments by a worker are capital or entrepreneurial in nature. Costs to a worker of tools and equipment to perform a specific job, costs of workers’ labor, and costs that the potential employer imposes unilaterally on the worker, for example, are not evidence of capital or entrepreneurial investment and indicate employee status.
- Degree of permanence of the working relationship – This factor weighs in favor of the worker being an employee when the working relationship is indefinite in duration, continuous, or exclusive of work for other employers.
- Nature and degree of control – This factor considers the potential employer’s control, including reserved control, over the performance of the work and the economic aspects of the working relationship. Facts relevant to the potential employer’s control over the worker include whether the potential employer sets the worker’s schedule, supervises the performance of the work, or explicitly limits the worker’s ability to work for others.
- The extent to which the work performed is an integral part of the potential employer’s business – This factor considers whether the work performed is an integral part of the potential employer’s business. This factor does not depend on whether any individual worker, in particular, is an integral part of the business, but rather whether the function they perform is an integral part of the business.
- Skill and initiative – This factor considers whether the worker uses specialized skills to perform the work and whether those skills contribute to the business-like initiative. This factor indicates employee status where the worker does not use specialized skills in performing the work.
Under the final rule, additional factors may be relevant in determining whether the worker is an employee or independent contractor for purposes of the FLSA if the factors in some way indicate whether the worker is in business for themself, as opposed to being economically dependent on the potential employer for work.
Voluntarily Waiving Employee Status
The Final Rule states that while businesses are certainly able to organize their businesses as they prefer consistent with applicable laws and workers are free to choose which work opportunities are most suitable for them, if a worker is an employee under the FLSA, they cannot waive FLSA-protected rights (such as minimum wage or overtime pay). The Supreme Court explained that permitting employees to waive their FLSA rights would harm other employees and undermine the FLSA’s goal of eliminating unfair methods of competition in commerce.
Reporting and Recordkeeping
The Federal Act’s minimum wage, overtime pay, and recordkeeping obligations apply only to workers who are covered employees. Workers who are independent contractors are not covered by these protections. The Final Rule does not create any reporting or recordkeeping requirements for businesses.
The DOL has stated that the Final rule is designed to provide more protection to workers. Industries such as construction, trucking, and health care have been specifically identified as those that may be significantly impacted by the new rule.
Finally, the DOL’s independent contractor Final Rule only defines independent contractor status under the FLSA. The standard does not apply to other federal laws, including the National Labor Relations Act, or state wage and hour laws (or lawsuits alleging independent contractor misclassification under those statutes).
The FLSA sets guidelines for what constitutes an employee, it does not define independent contractors. The Internal Revenue Service (IRS) defines an individual as an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done or how it will be done. While an employer must ensure they comply with FLSA standards regarding their employees, the protections of the FLSA on things like minimum wage do not apply to independent contractors. Independent contractors are essentially their entity and are described by the Department of Labor to be in “business for themselves” and not dependent on their employer for work.
Conclusion – The guidance provided by the Final Rule is expected to align with longstanding judicial precedent on which employers have previously relied to determine a worker’s status as either an employee or independent contractor. Employers should consider taking protective steps to prevent independent contractor misclassification, including the following:
- evaluating the business’s need and use of independent contractors;
- conducting a privileged self-audit to ensure proper classifications of current independent contractors;
- reviewing and updating independent contractor agreements;
- creating an evaluation and approval process for the retention of new independent contractors;
- monitoring for legal developments in those jurisdictions where independent contractors are providing services.