Classifying a Worker as an Independent Contractor vs. Employee Under the Fair Labor Standards Act
The Department of Labor (DOL) is tasked with enforcement of wage and hour requirements for employees under the Fair Labor Standards Act (FLSA). The FLSA requires that employees are fairly compensated for all hours worked and provides certain protections from unfair compensation practices. However, as this law only applies to employees, not independent contractors, one crucial task within the DOL’s purview is to review and analyze worker classifications to ensure that workers are afforded the rights and protections they are entitled to under the Act.
Misclassifying an employee as an independent contractor can be a costly mistake for employers, resulting in back pay and damages to the employee as well as fines and other penalties assessed by the DOL. Properly classifying workers can be further complicated by the fact that the IRS has its own set of standards and tests to determine if a worker is properly classified under tax law. Worker classifications that comply with the tax code do not necessarily comply with the FLSA. Business owners must ensure that workers are properly classified in accordance with FLSA requirements as well.
The DOL analyzes worker classifications by using a six-factor test that looks at the worker’s economic dependence on the employer to determine if the worker is properly classified as an independent contractor or whether they should have been classified as an employee (Notably, a worker who could otherwise have been classified as an independent contractor can be classified as an employee, but a worker who should have been classified as an employee cannot be classified as an independent contractor without violating the FLSA). The analysis under the “economic realities” test is dependent on the facts of the individual worker’s relationship to the business based on the totality of circumstances, and it is determined on a case-by-case basis.
What Are the “Economic Realities” Test Factors?
The key issue of the “economic realities” test is whether workers are economically dependent on a potential employer for work, and, therefore, considered an employee, or whether the workers are in business for themselves, which would be an independent contractor. All factors are considered, but no one factor is dispositive. The six-factor test to determine whether a worker should be classified as an employee is as follows:
1. There is an opportunity for profit or loss depending on managerial skill
Facts relevant to this analysis include whether the worker determines or can meaningfully negotiate the charge or pay for the work provided; whether the worker accepts or declines jobs or chooses the order and/or time in which jobs are performed; whether the worker engages in marketing, advertising, or other efforts to expand their business or secure more work; and whether the worker makes decisions to hire others, purchase materials and equipment, and/or rent space.
2. Investments by the worker and the potential employer
Here, the focus is whether the worker is making investments similar to the potential employer, which would indicate that the worker is operating independently. This would include investments that are “capital or entrepreneurial in nature,” which can serve a business-like function, such as those that increase the worker’s ability to diversify their work or reduce their costs.
3. The degree of permanence associated with the relationship
The consideration here is whether the work relationship is continuous, indefinite, or exclusive to work for other employers versus work for a definite duration or work that is non-exclusive, sporadic, or project-based.
4. The nature and degree of the worker’s control over the work
This factor analyzes what control is exercised by the potential employer over key aspects of the worker’s performance, such as where, when, or how that work must be performed, the worker’s schedule, supervising the work, and limiting the worker’s ability to work above and beyond for other prospective employers that prescribe standards to meet specific legal or regulatory requirements.
5. The extent to which the work performed is an integral part of the potential employer’s business
The key consideration of this factor is whether the work performed is integral, critical, necessary, or central to the potential employer’s principal business and/or if the work is performed by large numbers of workers. If the potential employer could not function without the position or role, or the services provided by the worker, their services are integral, and the worker is likely an employee.
6. Whether the work performed requires special skills and initiative
Where the worker does not use specialized skills or is dependent on the potential employer for training to perform the work, the worker is likely an employee. Where the worker does utilize specialized skills or performs highly skilled work and combines those skills with a business-like initiative, it may be indicative of an independent contractor relationship.
Factors and Totality of the Circumstances
Each factor of the test is highly fact-dependent, as is the analysis of all six factors of the test as a whole based on the totality of circumstances. No one factor is dispositive. All factors must be analyzed and weighed.
Furthermore, in some circumstances, additional factors may be considered that do not fit squarely within one of the enumerated factors above. Ultimately, all facts relevant to the question of the worker’s economic dependence or independence are relevant to the worker’s classification as an employee or independent contractor.
State Law
Employers must also comply with any applicable state laws regarding worker classifications, which may differ from, or be more stringent than, the factors set forth above under the FLSA. Employers are encouraged to consult with a trusted employment law attorney in their state to ensure compliance with federal and state requirements for worker classifications.
Action Items: Review Worker Classifications
The DOL implemented a Rule in 2021 that temporarily changed the factors used for analyzing worker classifications until early 2024 when that rule was rescinded. Outside of this brief regulatory interlude, the “economic realities” factors have been used by the DOL and reviewing courts for roughly 84 years. This test is not “new,” but rather, “renewed.” However, , businesses should be sure to review the classifications of workers hired as independent contractors in reliance on the factors contained in the now-rescinded rule and apply the “economic realities” test factors to ensure those classifications still pass muster. Employers should take all steps necessary to reclassify any misclassified employees as well as apply these factors to new worker relationships moving forward (Employers in states with more stringent requirements should analyze worker classifications under the more restrictive factors).
It is not a violation of the FLSA to classify a worker as an employee, even if they could have been classified as an independent contractor. On the other hand, classifying a worker as an independent contractor where they should have been classified as an employee in accordance with these factors is a violation of the FLSA, and misclassification can carry significant financial consequences for the employer.
An employer can be liable to the misclassified worker for: Back wages, back overtime compensation, two to three times the amount of back pay owed in damages, penalties for failing to pay wages promptly in accordance with state law, the value of benefits denied for which they would have been entitled as an employee (including unemployment compensation and/or workers’ compensation benefits), back payment of employee payroll tax obligations and/or employer contributions to employee payroll taxes, FICA, and Social Security and Medicare, and an award of attorney's fees and costs.
Misclassification can jeopardize an employee’s benefit plan’s tax-qualified status under ERISA and can also result in fines and penalties assessed by the DOL, by state unemployment and/or worker’s compensation authorities, by federal immigration authorities for failure to complete relevant employment verification processes, under the Patient Protection and Affordable Care Act, and by federal, state, and local tax authorities, any of which may result in government agency audits into your related tax, payroll, and employment practices, tax returns, and other employment practices with additional fines, penalties, and damages for additional violations uncovered.
Given the substantial costs and potential liability for misclassifying employees as independent contractors, employers are encouraged to take a careful, considered, and conservative approach when classifying a worker as an independent contractor. When in doubt, it would be prudent to err on the side of an employee classification. Employers should be particularly mindful where an independent contractor is performing the same or similar duties as those performed by employees, and those duties are fundamental to the nature of the company. While the risks of unintentional misclassifications are high, intentionally misclassifying workers as independent contractors can also carry the risk of criminal and civil penalties in addition. Employers are encouraged to consult with an attorney to ensure compliance with federal and state laws regarding their worker classifications.
Businesses Should Take Care When It Comes to Contract Hire Status.
When the new 2024 rule goes into effect, businesses will need to be sure to follow the new guidelines correctly for each employee who is currently working with them, as well as for new individuals who are contracted to work on specific essential tasks. Being sure to follow the new guidelines will be key in avoiding costly legal wrangling over the status of contract staff.
Businesses that need more information about the ruling and its proposed effect on hiring and contracting new staff will need to check out the information offered on the DOL website about the new contractor rules.