DOL Issues Final Rule on Classification of Independent Contractors

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On January 10, 2024, the Department of Labor’s (“DOL”) released a final rule (the “Final Rule”) addressing how workers are classified under the Fair Labor Standards Act (“FLSA”). Among other things, the FLSA governs minimum wage and overtime requirements applicable to employees but not independent contractors. The FLSA itself does not indicate how to distinguish an employee from an independent contractor. In the absence of a more concrete statutory definition, prior to any formal guidance from the DOL, courts established varying standards, with most focusing on the “economic reality” of the relationship between the employer and the individual. The application of the common law test led to different outcomes based on similar facts. However, in January 2021, the DOL sought to resolve this tension and created the framework for addressing the classification of workers as independent contractors (the “Prior Rule”), which was challenged both administratively and in the courts. The DOL rescinded the Prior Rule and replaced it with the Final Rule, slated to take effect as of March 11, 2024.

The Prior Rule

As explained above, during the Trump Administration, the DOL adopted the Prior Rule, the first formal independent contractor rule, in an effort to create a more consistent and objective standard. The Prior Rule used five “economic reality factors” to determine whether an employee is an independent contractor. The DOL singled out 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 Prior Rule was subjected to multiple challenges in courts and administrative hearings. In fact, after the Biden Administration took office, the DOL delayed and eventually (unsuccessfully) withdrew the Prior Rule later that same year rather than proposing a new (or slightly modified) rule. Notably, in March 2022, a Texas federal court reinstated the Prior Rule. While the DOL appealed the reinstatement, there has been no progress with the appeal given the anticipated issuance of the Final Rule.

The Final Rule

The Final Rule formally rescinds the Prior Rule and provides a new interpretation of the independent contractor analysis altogether. In comparison to the five-factor inquiry with two core factors emphasized by the Prior Rule, the Final Rule applies a six-factor test and does not concentrate on any particular factor(s). Instead, the Final Rule focuses on an individual’s activity as a whole to determine whether such an individual is an independent contractor. This “totality-of-the-circumstances” approach involves the following factors: (1) the worker’s opportunity for profit or loss; (2) investments by the parties; (3) the work relationship’s permanency; (4) the nature and degree of control over the work; (5) whether the work is an integral part of the employer’s business; and (6) the worker’s skill and initiative.

It is the DOL’s stated intent not to give one factor a predetermined weight over other factors. Thus, no above-listed factor is dispositive. At the same time, the DOL recognizes that one or more factors may be more relevant than others, and the list of factors is not exhaustive and may include additional inquiries. However, ultimately, the outcome depends on the economic dependence on the employer: “[E]conomic dependence is the ultimate inquiry for determining whether a worker is an independent contractor or an employee.” Independent contractors who perform substantially all of their work for one business are likely to be economically dependent on that business, and thus likely to be misclassified employees. The DOL clarified that the rescission of the Prior Rule and the issuance of the Final Rule are independent and distinct actions. Thus, even if the Final Rule were to be invalidated, the Prior Rule will remain rescinded and will not take effect in lieu of the Final Rule.

Employer Impact

According to the DOL, the Final Rule is intended to “reduce the risk that employees are misclassified as independent contractors while providing a consistent approach for businesses that engage with individuals who are in business for themselves.” One practical consideration for business, is whether the independent contractor has established a business entity, such as an LLC or corporation, and obtained business licenses to conduct the independent contractor’s trade. Certainly this is one factor, albeit not dispositive, that at least the independent contractor thinks of the arrangement as being “in business” independently. 

The DOL also noted that the Final Rule is only applicable to the FLSA; thus, it does not impact other federal and state laws. In particular, the Final Rule highlights the differences between classification of workers by the DOL and the Internal Revenue Service (“IRS”). For example, the IRS looks at common law rules and takes into account only three factors: (1) behavioral control; (2) financial control; and (3) type of relationship.  Overall, the Final Rule will naturally impact the determination of a worker’s status under the FLSA. However, employers may continue to rely on classification of workers as independent contractors under ERISA and the Internal Revenue Code for other purposes—for instance, the Code’s rules for determination of eligibility for cafeteria and retirement plans.

Health and welfare plans are not generally prohibited from covering independent contractors with some exceptions, such as cafeteria plans and health reimbursement arrangements.  However, employers are also not mandated to cover such workers, and covering independent contractors under the employer’s health and welfare plans may impact their status as independent contractors for other purposes, such as wage benefits. Employers should review the Final Rule and determine how to coordinate the agency guidelines or reach out to their benefits consultants or counsel for further information.

Conclusion

Although the DOL indicated that the Final Rule “is not intended to disrupt the business of independent contractors who are, as a matter of economic reality, in business for themselves,” some commentators nevertheless pointed out the confusion created by the Final Rule. Like the Prior Rule, legal challenges are expected with regard to the Final Rule as well. Some business groups have already signaled opposition and intent to seek rescission (or revision) of the Final Rule. Employers, especially those heavily reliant on independent contractors, should consider the impact of the Final Rule and possibly plan to conduct a worker classification audit using the new framework.