Employee or Independent Contractor? New Rule From the Department of Labor Clarifies Distinction

In the dynamic landscape of federal regulations, significant changes have emerged in 2024 that businesses need to be aware of. One of these changes includes the redefining of the classification of “independent contractors” under the Fair Labor Standards Act (FLSA). The U.S. Department of Labor issued this new final rule with the aim of reducing “the risk that employees are misclassified as independent contractors.” Ultimately, this final new rule would make it more difficult to classify workers as independent contractors. This rule will go into effect starting March 11, 2024. Different rules may apply based on the state you are located in.

Redefining “Independent Contractor” under FLSA

In a decision published on January 10, 2024, the U.S. Department of Labor introduced a final rule redefining the “independent contractor” under the FLSA that applies to workers in any industry. This rule replaces a 2021 rule, adopting a six-factor test focusing on the economic reality of the relationship between a potential employer and a worker, a return to a totality-of-the-circumstances analysis of the economic reality test.

This final rule reiterates that economic dependence is the ultimate inquiry into whether a worker is an employee or an independent contractor, meaning that a worker is an independent contractor if the worker is, as a matter of economic reality, in business for themselves. Further, these six factors in the text work as a guide to the assessment of the economic realities of the working relationship, but not one factor is necessarily determinative. These six economic reality factors to be considered include:

1. The opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the potential employer
3. The degree of permanence of the work relationship
4. The nature and degree of control
5. The extent to which the work performed is an integral part of the potential employer’s business
6. Skill and initiative

Additionally, the decision cites that, just as under the 2021 IC Rule, and in accordance with longstanding precedent and guidance, additional factors may also be considered if they are relevant to the overall question of economic dependence.

Why the Definition Matters:

The distinction between employees and independent contractors determines coverage under federal wage-and-hour law, including minimum wages, overtime, and record-keeping requirements. This means that the language of your service-related agreement (whether it is an “employment agreement” or “independent contractor agreement”) is not determinative of whether the IRS or other regulatory agencies find that you have correctly classified your employees or contractors. Rather, the IRS and other regulatory agencies may choose to audit your contracts to determine if you mischaracterized your employees as contractors and penalize you. If the IRS finds that your misclassification of employees and failure to pay wages was unintentional, then you as the employer face at least the following penalties:

• $50 for each Form W-2 that should have been filed;
• A penalty of 1.5% of the wages, plus 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid;
• Interest also accrues on these penalties daily from the date they should have been deposited;
• A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability; and
• If the IRS finds fraud or intentional misconduct, it can impose additional fines and penalties that include 20% of all of the wages paid, plus 100% of the FICA taxes, both the employee’s and the employer’s share, plus criminal penalties of up to $1,000 per misclassified worker and one year in jail against the person responsible for withholding taxes who could also be held personally liable for any uncollected tax.

Beyond the IRS and regulatory agencies, you could be sued by an independent contractor for unpaid minimum wage and/or overtime that could result in substantial back pay owing to employees, and liability to misclassified workers for the value of benefit plan contributions that should have been made had the workers been properly classified as employees and for the costs that they incurred when they were sick or injured and were not able to utilize the employer’s group health insurance plan that would have covered them but for the misclassification.

Key Changes in the Final Rule:

• Legal Compliance:
  • Control necessary to comply with specific legal requirements does not necessarily indicate employee status.
  • Additional control for convenience may affect the analysis.
• Relative Investments:
  • Comparison of relative investments rather than absolute dollar-for-dollar comparison.
• Tools and Equipment:
  • Limitation on costs unilaterally imposed by the potential employer.
• Earning More by Working More:
  • A worker’s ability to earn more is not considered entrepreneurial when paid a fixed rate per hour or job.
• Specialized Skills:
  • Specialized skill alone does not determine independent contractor status; relevance lies in using specialized skills with business-like initiative.

Link to the Federal Register for more Information

What does this mean for employers?

This final rule may result in more workers being classified as employees rather than independent contractors under FLSA. As such, this could increase the employer costs associated with benefits, such as health care and paid leave. Additionally, while it is too early to see the extent of the impact it would have, this final rule could potentially cause further complications for other federal and state laws that rely on a worker classification system, be it coverage under the Affordable Care Act, state wage/hour requirements, and income and employment tax withholding. Ultimately, employers that may potentially struggle to make the classification decisions will have to wait to take the conservative approach in leaning towards an employee classification or wait and see how this new rule plays out in litigation.

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