INTRODUCTION

On 10 January 2024, the US Department of Labor (DOL) published a final rule (Final Rule) that significantly changes the test for determining whether a worker is an independent contractor or employee under the Fair Labor Standards Act (FLSA). In doing so, the DOL rescinds a Trump-era rule from 2021, which went by the same name (economic reality test) but had functionally eased the standard for employers to classify workers as independent contractors.

The Final Rule sets forth a six-factor test focused on the economic realities of the relationship between a worker and a potential employer to determine independent contractor status and is scheduled to go into effect on 11 March 2024. As the Final Rule restricts the standard for determining independent contractor status, employers, especially those in certain industries, including hospitality and transportation, should pay particular attention to the Final Rule and consider revisiting the way they classify their workers.

THE RULE CHANGES AND WHY THEY MATTER

The Final Rule substantially modifies the test for classifying workers as either employees or independent contractors under the FLSA, a federal law that establishes the minimum wage and the standards for overtime pay for most employers. If an employer is covered by the FLSA, it generally must provide minimum wage and overtime pay protections to its employees and comply with the law’s recordkeeping obligations. However, FLSA requirements do not apply to independent contractors.

In January 2021, the DOL finalized a rule that included a five-factor test for determining whether a worker could properly be classified as an independent contractor. This test was weighted towards two factors: the principal’s right to control the work and the worker’s opportunity for profit or loss. If both factors suggested either an employee or independent contractor relationship, there was no need for further analysis. If those two factors did not clearly indicate the proper classification, the analysis then required consideration of three additional factors: the amount of skill required, the degree of permanence of the working relationship, and whether the work was part of an integrated unit of production.

Shortly after the 2021 rule went into effect, there was a change in administration and the DOL subsequently attempted to both delay, and later withdraw, the rule. These actions were challenged in court, and a federal district court held that the DOL, through these subsequent actions, had violated the Administrative Procedure Act. In response, the DOL initiated the rule-making process in October 2022 with a proposed rule and ultimately published this Final Rule.

OVERVIEW OF THE SIX-FACTOR ECONOMIC REALITIES TEST

Effective 11 March 2024, the 2021 rule will be rescinded and replaced with the Final Rule, which includes a new six-factor “economic realities” test that raises the threshold for when a worker can be classified as an independent contractor. The Final Rule closely tracks the DOL’s proposed rule published in October 2022 with some modifications to the application of the economic realities test discussed further below. In applying the test, equal weight will be given to each of the following factors, and no one factor is determinative:

Opportunity for Profit or Loss Depending on Managerial Skill

This factor weighs the worker’s opportunities for profit or loss based on their entrepreneurial capabilities that impact the worker’s “economic success or failure in performing the work.” Employers should consider the following when weighing this factor: if the worker has the ability to negotiate the compensation for the work performed, if the worker is able to accept or decline work and determine the schedule of performance, if the worker markets or advertises to secure additional work, and if the worker has the authority to purchase equipment or materials and secure space to perform the work. Where a worker has no profit or loss opportunity, this will weigh in favor of an employment relationship. Employers should note that a worker’s ability to earn more pay by working more hours or taking more jobs when paid at a fixed amount is not necessarily evidence of managerial skill or determinative of independent contractor status. 

Investments by the Worker and the Potential Employer

For this factor, the focus is on “whether any investments by a worker are capital or entrepreneurial in nature.” Costs that are “unilaterally imposed” on a worker by a potential employer are not evidence of “capital or entrepreneurial investment” and generally indicate employee status. However, investments by a worker to expand the types of work they can perform or increase their market presence are more akin to an independent contractor as they are “capital or entrepreneurial” and serve a business-like function. In evaluating the scope of investments, potential employers should view them on a relative basis to determine if the investments are similar to those of the employer, even if smaller in scale, which would indicate operational independence and favor a contractor relationship. 

Degree of Permanence of the Work Relationship

In evaluating this factor, the Final Rule highlights that a work relationship that is “indefinite in duration, continuous, or exclusive of work for other employers” may be more indicative of an employment relationship. For an independent contractor relationship to be present, the Final Rule notes that the work relationship would likely be “definite in duration, nonexclusive, project-based, or sporadic” due to the worker being engaged in their own business and performing work for other parties. Employers should note that if a lack of permanence of the work relationship is due to industry-specific or operational reasons, this is not necessarily determinative of independent contractor status, unless it is in conjunction with the worker exercising their own independent business initiative.

Nature and Degree of Control

To determine the nature and degree of control, the focus is on whether a potential employer determines the worker’s schedule, manages the work being performed, or explicitly restricts the worker’s ability to perform work for other parties. Additional considerations under this factor include whether the potential employer uses technology to supervise a worker’s performance, disciplines workers, controls the prices or rates for the worker’s services, or otherwise functionally restricts their ability to perform work at their own schedule. Further, the Final Rule addresses issues related to a potential employer’s compliance with legal requirements, providing that “[a]ctions taken by the potential employer for the sole purpose of complying with a specific, applicable Federal, State, Tribal, or local law or regulation are not indicative of control.” However, the Final Rule clarifies that any actions that extend beyond general compliance with applicable regulations, including for compliance with internal policies, to maintain safety or quality control, or to satisfy service levels or standards may indicate more control over the worker. The more control that is exerted by the potential employer over the worker, the more likely the worker should be classified as an employee. 

Extent to Which the Work Performed is an Integral Part of the Potential Employer’s Business

In evaluating this factor, employers should focus their analysis on whether the function being performed by the workers, rather than the workers themselves, is an integral part of the business. Workers who perform functions that are “critical, necessary, or central to the potential employer’s principal business” are more likely to be classified as employees. The Final Rule highlights that if the potential employer is unable to function without the service performed by the workers, then the service they provide is likely integral. The DOL also addressed comments to the proposed rule that claimed this factor may lead to the classification of all workers as employees by reiterating that this one factor is not dispositive and underscoring that “only work that is critical, necessary, or central to the potential employer’s principal business is integral.” 

Skill and Initiative

To determine whether a worker’s specialized skills in performing the work are indicative of employee or independent contractor status, potential employers should consider whether the specialized skills contribute to business-like initiative. Where a worker depends on training from the potential employer to perform their work and does not bring any specialized skills, an employment relationship is more likely to be determined. However, even if a worker already has specialized skills, that alone does not determine independent contractor status as both employees and contractors can be skilled workers. Rather, an independent contractor relationship may be determined where a worker “uses those specialized skills in connection with business-like initiative.”

These six factors are not exhaustive, and additional factors may be considered if appropriate in a particular case, especially if they indicate that a worker is operationally independent from a potential employer. Workers are more likely to be classified as employees under the new test. 

INDUSTRIES RELIANT ON FRANCHISING, SUBCONTRACTING, TECH PLATFORMS MAY BE ESPECIALLY VULNERABLE

Given the Final Rule sets forth a “pro-employee” standard, businesses that rely on a large independent contractor workforce may face disproportionate legal jeopardy under the FLSA. Examples of such industries include health care institutions, ride-sharing platforms, car rental firms, logistics companies, and retailers that depend on independent contractors frequently hired by franchising or through staffing firms. Indeed, employers in those industries and using such business models have already challenged the National Labor Relations Board’s separate worker-classification rule under federal labor law.

Some of the most strident opposition to the DOL’s Final Rule can be gleaned from the more than 54,000 comments the agency received on its proposed rule, many from employers, business associations, and their allies, as well as independent contractors themselves. In response, the DOL extensively defends the application of the economic realities test to cutting-edge business models and employers in the Final Rule.

Nevertheless, because of the current historically tight labor market and rising levels of worker activism, as evidenced by headline-generating union drives and related litigation, all employers that use independent contractors should consider revisiting how they classify workers in light of the DOL’s Final Rule. Employers should prepare for vigorous DOL enforcement of the Final Rule and an increase in lawsuits from current and former employees alleging FLSA misclassification.

Legal opponents of the DOL’s Final Rule will likely include trade associations and their affected employer-members that now risk greater FLSA exposure, while employee advocacy groups and labor unions will likely support the rule.

EMPLOYER TAKEAWAYS

Employers and their counsel should consider preemptively reviewing how they classify workers prior to the effective date of the Final Rule on 11 March 2024. Businesses that often rely on franchising, subcontracting, and staffing firms should pay particular attention to the types of workers that they classify as independent contractors, as they may face greater regulatory scrutiny and legal exposure under the DOL’s Final Rule. Indeed, employers heavily dependent on independent contractors risk facing FLSA liability, which may include minimum wage and overtime back pay, liquidated damages, and attorneys’ fees, as well as potential injunctive relief and even civil or criminal penalties if they are found to have misclassified their workforce.

When preemptively reviewing worker classifications, employers should holistically view their workforce with the Final Rule in mind. Specifically, employers should analyze different positions using the six-factor economic realities test that the DOL’s Final Rule adopted based on decades of case law. Once the Final Rule goes into effect, employers should no longer focus their analysis primarily on the 2021 rule’s “core factors” (i.e., control and opportunity for profit and loss). Rather, employers should apply a totality-of-the-circumstances analysis, with none of the Final Rule’s factors receiving greater weight than any other, and consider any additional relevant factors. The “ultimate inquiry” under the Final Rule is whether a worker is economically dependent on an employer, thus employers should classify workers accordingly.

Although the DOL announced that its Final Rule will provide greater consistency for businesses using independent contractors, employers should vigilantly track how the DOL ultimately enforces the Final Rule and be mindful that this may differ from existing FLSA case law. Moreover, because the six factors are nonexhaustive, employers should also consider any other facts that may be relevant to determining whether workers are in business for themselves rather than economically dependent on them.

Somewhat comfortingly, the DOL’s Final Rule does not adopt the even more pro-employee “ABC” test that some states, such as California and New Jersey, apply under state analogues to the FLSA. Unlike the ABC test, where employers must satisfy each of three factors to properly classify workers as independent contractors, the DOL’s economic realities test applies a nonexhaustive six-factor analysis, with no single factor being dispositive.

Employers must remain mindful the DOL’s Final Rule only affects worker classification under the FLSA. Other federal, state, and local laws with different standards are unaffected by this Final Rule, including those related to classification of workers for unemployment insurance, workers’ compensation, hours of work, and wage payment. 

While the ultimate fate of the DOL’s Final Rule remains unclear because of fierce industry, congressional, and judicial headwinds, employers should ensure that their worker classifications are consistent with the Final Rule in advance of its 11 March 2024 effective date.