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The Department of Labor’s “new” rule for classifying workers as employees or independent contractors under the Fair Labor Standards Act took effect March 11, 2024. The DOL’s Final Rule returns employers to a familiar pre-Trump administration totality of the circumstances test that focuses on the “economic realities” of the worker’s situation. The practical impact is that it is now harder for businesses to classify workers as independent contractors, and it will likely increase federal wage and hour claims.

There are mounting legal challenges to the Final Rule contesting the DOL’s rulemaking authority. However, to date, none of the suits have been successful at blocking implementation of the Final Rule. So, for now, it stands.

Practice pointer: different legal tests for different laws

Employers new to the US are often baffled to learn that no single test exists to evaluate independent contractor status for all purposes. This means compliance is complicated since different tests may apply depending on the context. And yes, this also means that it’s feasible for a worker to be an independent contractor for some purposes and an employee for others (such as under state and federal law, for example). Continue reading for a summary of the key tests that come up most often for US multinationals.

Why does this matter?

Misclassification is a key issue for US employers since many laws apply only to employees – not independent contractors. Thus, if workers are misclassified as independent contractors and subsequently determined to be employees under the law, a cascade of unforeseen obligations will be thrust upon the company.

Misclassification can lead to significant liability. The FLSA requires employers to provide minimum wage and overtime pay to qualified employees—but not to independent contractors. In addition, most employees, especially full-time employees, are also entitled to various statutory benefits, such as state law paid sick leave entitlements, workers’ compensation benefits, unemployment benefits, and to benefits under an employer’s ERISA-governed benefit plans, such as group health insurance policies and 401(k) plans. Failure to properly classify workers can result in substantial damages and penalties (even if unintentional), including: back pay, including overtime compensation; employee benefits, including stock options, retirement benefits, and health plan coverage; disability payments and workers’ compensation; tax and insurance obligations; liquidated damages; and civil monetary penalties.

The DOL’s Final Rule applies under the FLSA

The 2024 Final Rule replaces a more employer-friendly rule from 2021. It adopts a six-factor test focused on the “economic reality” of the engaging entity and the worker to determine whether federal wage and hour law applies to the worker.

Under the test, each of the six factors will be considered equally:

  • The degree to which the employer controls how the work is done.
  • The worker’s opportunity for profit or loss.
  • The amount of skill and initiative required for the work.
  • The degree of permanence of the working relationship.
  • The worker’s investment in equipment or materials required for the task.
  • The extent to which the service rendered is an integral part of the employer’s business.

An individual’s specific work circumstances determine their employment status for FLSA purposes and no single factor is dispositive. Contractual language, the worker’s title or label, and common law factors evaluated in isolation do not define the relationship.

The DOL’s FAQ allows that additional factors may also be considered if they in some way indicate whether the worker is in business for themself, as opposed to being economically dependent on the potential employer for work.

State rules still apply

As alluded to above, many states have their own tests that are applied to state-level wage and hour claims. In addition to the FLSA, employers must also comply with any applicable state law regarding worker classification in order to avoid legal liability. For example, several have adopted the so-called “ABC test” to determine employee status under wage and hour law (e.g. New Jersey and California). The ABC test makes it much more difficult for many companies to treat workers as independent contractors, and more difficult for businesses to hire smaller, entrepreneurial businesses.

California’s AB 5 codified the state supreme court’s adoption of an ABC test in Dynamex Operations W. v. Superior Court. (Read more here.) However, a few select industries qualify for exemption under AB 5 and are subject to a less stringent standard.

Under California’s ABC test, a worker is presumed to be an employee unless a hiring entity can establish three conditions:

  1. That the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  2. That the worker performs work that is outside the usual course of the hiring entity’s business; and
  3. That the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

The National Labor Relations Board’s employee-friendly standard

In June 2023, the National Labor Relations Board reverted from a standard placing primary importance on a worker’s “entrepreneurial opportunity for profit or loss” to a 2014 Obama administration multi-factor test. The Atlanta Opera test gives equal weight to 11 factors, including the extent of control the employer can exercise over the work, and whether the kind of work being done is typically supervised by the employer or performed independently by a specialist. Atlanta Opera is important to both union and nonunion employees because independent contractors are excluded from the NLRA’s protections—which include the statutory rights to form a union and strike, among others—under Section 2(3) of the NLRA. The NLRB’s move made it more likely for workers to be deemed employees, and thus eligible for union and strike protections.

Steps employers should take now

Because misclassification mistakes can trigger staggering liability (class action lawsuits, settlement demands in the millions, etc.) even with a small contractor population, investing in compliance and risk mitigation to get ahead of any classification challenges from the DOL or in private litigation is essential. We recommend:

Conducting an internal audit with counsel

Internal audits are essential to risk mitigation. Partner with counsel to conduct an internal audit, examining the specific facts of different independent contractor engagements and whether they are defensible under the applicable misclassification tests. Misclassification audits are complex and should be done under the advice of counsel, which may also preserve privilege over advice provided in connection with the audit.

Key steps of an internal audit include:

  • Reviewing independent contractor agreements
  • Determining each contractor’s current compensation structure
  • Determining each contractor’s day-to-day duties and role in the company’s organizational structure (which may require interviewing responsible managers), and
  • Assessing the likelihood of misclassification and the company’s potential exposure considering applicable state law and any legal protections in place such as arbitration agreements.

Once this review is complete, the company will need to determine whether the level of risk justifies reclassifying any contractors as employees and how to mitigate risk when communicating reclassification decisions.

Handling reclassification decisions and implementation with care

Employers should be prepared to explain the reclassification of workers as independent contractors, such as a change in duties, a company policy of converting independent contractors to employment after a certain period of time, or a change in company policy. Supervisors should be advised of changes in advance and briefed on how to handle questions. Contractors will need to agree to the change, so employers should emphasize the upsides, such as participation in employee benefits, incentive compensation plans and equity plans. If the contractor’s pay will be increased to result in the same net take home pay following conversion to employment, this should also be emphasized.

Ensuring proper management of independent contractor relationships

Independent contractor relationships are often initiated by procurement or other business functions that are unaware of the significant legal risks associated with misclassification. To avoid improper use of independent contractors, employers should:

  • Require that all contracts for services are approved by a point person or team in legal or HR scrutinizing for misclassification issues
  • Establish a system for tracking, managing and periodically reviewing independent contractor engagements to ensure contractors are appropriately managed and classified
  • Avoid independent contractor engagements in high risk states or use only sparingly
  • Have protocols for managing independent contractor relationships, and
  • Provide training for supervisors who work with independent contractors to ensure they are not creating additional misclassification risk by using contractors for out-of-scope work or excessively managing their day-to-day work

Takeaways: act now and monitor pending legal challenges

  • We expect companies may receive questions from contractors about their classification status and closer scrutiny of independent contractor classifications from both contractors and regulators. Act now to ensure you are prepared to defend classification decisions and strategically implement reclassifications as appropriate., while keeping watch on legal challenges to the Final Rule.

There are legal challenges to the Final Rule pending in federal district court in Texas, Georgia, Tennessee, and Louisiana–where an appeal of an order denying plaintiffs’ motions for a preliminary injunction and TRO was recently filed to the 5th Circuit. We’re tracking developments, so stay tuned.