Employers Face Greater Misclassification Risk Under Resurrected Federal Independent Contractor Rule, Opening Door to Substantial Liability

From JDSupra, Julia Judish, Laura Killalea, Andrea Milano, Rebecca Carr Rizzo, and Kenneth Taber provide an outstanding review of the new independent contractor rule and while I disagree that the new rule will result in substantial liability, I appreciate the breadth and depth of their analysis. Julia, Laura, Andrea, Rebecca and Kenneth write:

TAKEAWAYS

  • On January 10, 2024, the U.S. Department of Labor published a final rule (the Rule) replacing the current test for determining whether a worker is an employee or independent contractor under the Fair Labor Standards Act.
  • The Rule returns to the Obama era “economic realities” test, making it harder for employers to classify workers as independent contractors.
  • Under the Rule, which goes into effect on March 11, 2024, many workers currently treated as independent contractors may need to be reclassified as employees.

The Fair Labor Standards Act (FLSA) requires employers to provide minimum wage and overtime pay to qualified employees—but not to independent contractors. Many 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 as employees can therefore result in substantial damages and penalties, even if the misclassification is unintentional, as described in more detail below. Correctly classifying workers is therefore of significant importance.

For decades, the Department of Labor (DOL) and the courts have generally applied an “economic realities” test to determine whether a worker is an employee or an independent contractor under the FLSA. In 2015, under the Obama Administration, the Wage and Hour Division of the DOL issued “Administrator’s Interpretation 2015-1,” expanding on the “economic realities” test and identifying the issue of a worker’s economic dependence as the most important factor in distinguishing between independent contractors and employees under the FLSA. In 2021, however, the DOL under the Trump Administration issued a rule (the 2021 Rule) codifying an independent contractor analysis under the FLSA that was largely seen as a business-friendly departure from the traditional “economic realities” test. The 2021 Rule identified two “core factors” that should be weighed most heavily in the analysis: 1) the employer’s degree of control over the work, and 2) the worker’s opportunity for profit or loss. The 2021 Rule was widely seen as making it much easier to classify a worker as an independent contractor.

On January 10, 2024, the Biden Administration’s DOL rescinded the 2021 Rule, replacing it with the traditional “economic realities” test.

The New Rule and the Economic Realities Test

The Rule codifies the “economic realities” test as the definitive analysis for classifying workers under the FLSA. The Rule looks to the totality of the circumstances, considering six factors to determine the degree of a worker’s economic dependence on an employer or customer. As the Rule explains, economic dependence does not focus on the amount of income workers earn or whether a worker has other sources of income. The key issue is whether workers are economically dependent on a potential employer for work—and therefore employees, or in business for themselves—and therefore independent contractors.

The Rule makes it clear that no single factor is dispositive. The six factors should not be applied mechanically, but instead should be viewed alongside one another with an eye towards the ultimate inquiry: whether the worker is economically independent or dependent. This is a flexible, fact-specific inquiry which requires careful consideration on a case-by-case basis. The Rule provides helpful explanations and examples applying each of the six factors, as we describe below.

I. Opportunity for Profit or Loss Depending on Managerial Skill

This factor considers the worker’s opportunity to earn profits or incur losses based on managerial skill that affects the worker’s economic success. If a worker has an opportunity to earn profits or incur losses based on their exercise of initiative, business acumen, or judgment, they are more likely to be deemed an independent contractor. Facts relevant to this analysis include: (i) whether the worker determines or can meaningfully negotiate the charge or pay for the work provided; (ii) whether the worker accepts or declines jobs or chooses the order and/or time in which the jobs are performed; (iii) whether the worker engages in marketing, advertising or other efforts to expand their business or secure more work; and (iv) whether the worker makes decisions to hire others, purchase materials and equipment, and/or rent space.

By way of example, the Rule describes a worker for a landscaping company who performs assignments only as determined by the company for its corporate clients. This worker does not independently choose assignments, solicit additional work from other clients, advertise the worker’s landscaping services, or endeavor to reduce costs. This worker does regularly agree to work additional hours to earn more money. Based on this scenario, this factor indicates employment status because the worker is not exercising managerial skill affecting their profit or loss; rather, the worker’s earnings fluctuate based solely on the amount of work available and their own willingness to work more.

In contrast, a worker who provides landscaping services directly to corporate clients and who produces their own advertising, negotiates contracts, decides which jobs to perform and when to perform them, and decides when and whether to hire helpers, exercises managerial skill affecting their opportunity for profit or loss, and, therefore, supports classification as an independent contractor.

II. Investments By the Worker and the Potential Employer

Where a worker bears investments that are “capital or entrepreneurial in nature,” serving a “business-like” function (such as increasing the worker’s ability to do diverse work or reduce their costs), the worker is more likely to be an independent contractor. The Rule clarifies that investments made by a worker that reflect a unilateral contractual demand by the potential employer, rather than an investment decision or negotiation between the parties, should not be probative of a worker’s independent contractor status. In addition, the Rule clarifies that the worker’s investments need not be equal to the potential employer’s investments. The focus instead should be on whether the worker is making investments similar to the potential employer, which would indicate that the worker is operating independently.

The Rule provides the following example. A graphic designer renders design services to a commercial design firm that provides the designer with software, a computer, office space, and all necessary equipment and supplies. The firm invests in marketing and finding clients and maintains a central office from which to manage services. The designer occasionally uses their own preferred drafting tools for certain jobs. In this scenario, the designer’s minor investment in supplies is not capital in nature and does little to further the designer’s business beyond completing specific jobs. These facts, therefore, indicate employee status under the investment factor.

On the other hand, a graphic designer who occasionally completes specialty design projects for this same firm, but who purchases their own design software, computer, and drafting tools, rents an office in a co-working space, and spends money to market their services, is clearly making investments that support an independent business and are capital in nature (by enabling the worker to do more work and extend their market reach). These facts support a finding of independent contractor status.

III. Degree of Permanence of the Work Relationship

This factor requires consideration of whether the work relationship is continuous, indefinite or exclusive of work for other employers (and therefore more likely an employment relationship) or definite in duration, non-exclusive, sporadic or project-based (and therefore more likely an independent contractor relationship). The Rule clarifies that a lack of permanence is not dispositive, as it may be inherent in certain jobs, including temporary and seasonal work. Further, a lack of permanence dictated by operational needs unique to a particular entity or industry does not on its own indicate independent contractor status. The Rule also recognizes the possibility that a worker operates as an independent contractor but relies on repeat business and long-term clients. With this idea in mind, the DOL explains that the “permanence” inquiry should not be reduced to a “simple long-term/short-term question.”

The Rule posits the following scenarios to illustrate the permanence factor. A cook has prepared meals for an entertainment venue continuously for several years. The cook prepares meals as directed by the venue, depending on the size and specifics of the event. The cook only prepares food for the entertainment venue, which holds regularly scheduled events each week. This relationship is, thus, characterized by a high degree of permanence and exclusivity, indicating employee status under the permanence factor.

A different cook who has also prepared meals for an entertainment venue over the course of three years, but who has done so only intermittently, and also markets their meal preparation services to multiple venues and private individuals, and turns down work for any reason, including because the cook is too busy with other meal preparation jobs, has only a sporadic or project-based nonexclusive relationship with the entertainment venue. These facts support independent contractor status.

IV. The Nature and Degree of the Worker’s Control over the Work

If the potential employer exercises control over key aspects of the worker’s performance, the worker is likely to be classified as an employee. Indications of a potential employer’s control over work include setting the worker’s schedule, supervising the work, and limiting the worker’s ability to work for others. Additionally, a prospective employer’s prescription of standards that go beyond specific legal or regulatory requirements, such as requiring a worker to fulfill comprehensive training requirements (beyond training required by law, rule, or regulation), may be probative of control. The Rule clarifies, however, that actions taken by the potential employer for the sole purpose of complying with a specific law or regulation, such as requiring a writer to comply with libel law, is not probative of the potential employer’s control over the worker. By contrast, where a worker has the ability to set their own schedule, work for others and set or negotiate their own prices for services rendered, they will more likely be deemed an independent contractor.

The Rule uses the example of a registered nurse to illustrate this factor. A registered nurse who provides nursing care for a nursing home that sets the work schedule with input from staff, is prohibited from working for other nursing homes, and is supervised through regular check-ins with managers, is likely to be considered an employee.

By contrast, a registered nurse providing specialty movement therapy to residents at a nursing home, who maintains a website where pricing is set, who was contacted by the nursing home to assist its residents, and who provides therapy on a schedule agreed upon between the nurse and the resident, is likely to be considered an independent contractor.

V. The Extent to Which the Work Performed Is an Integral Part of the Potential Employer’s Business

This factor turns on whether the function the worker performs is an integral part of the business. A worker is more likely to be considered an employee when they perform work that is critical, necessary or central to the potential employer’s principal business. If the potential employer could not function without the worker’s service, then that service is integral, and the worker is more likely an employee. Importantly, work can be integral to a business even if the work is just one facet of the business and/or the work is performed by large numbers of workers.

The Rule provides an illustrative example based on a large farm. In the first scenario, the large farm grows tomatoes that it sells to distributors. The farm pays workers to pick the tomatoes during the harvest season. Because picking tomatoes is an integral part of farming tomatoes, the tomato pickers are considered integral to the farm’s business, supporting employee status.

In the second scenario, this same large farm pays an accountant to provide non-payroll accounting support, including filing its annual tax return. This accounting support is not critical, necessary or central to the principal business of the farm (farming tomatoes), and, thus, the accountant’s work is not integral to the farm’s business, supporting independent contractor status.

VI. Whether the Work Performed Requires Special Skills and Initiative

Last but not least, the factor assessing whether a worker uses specialized skill to perform the work also bears on the proper classification of the worker. Employee status is indicated where the worker does not use specialized skills or is dependent on training from the potential employer to perform the work. Bringing specialized skills to the working relationship, however, does not, on its own, indicate independent contractor status, because many employees also may be highly skilled. Rather, it is the worker’s use of such specialized skills in connection with business-like initiative that indicates independent contractor status.

For example, a highly skilled welder providing welding services for a construction firm, who does not make any independent judgments at the job site beyond the decisions necessary to do the work assigned, is likely an employee. By contrast, a highly skilled welder providing a specialty welding service to a variety of area construction companies, and who uses these skills for marketing purposes to generate new business, is likely an independent contractor.

Potential Additional Factors

In addition to the six factors described above, the Rule explains that, in some circumstances, “additional factors” may also be considered if they are relevant to the overall question of economic dependence. The Rule does not enumerate any specific additional factors, but according to the DOL, this additional flexibility is reflective of “the necessity of considering all facts that are relevant to the question of economic dependence or independence, regardless of whether those facts fit within one of the six enumerated factors.”

Employers Must Also Consider State Law

Compliance with the federal FLSA is not always sufficient for purposes of compliance with wage and hour law. Employers must also comply with any applicable state law regarding worker classification in order to avoid legal liability. For example, multiple states use a far stricter test—the “ABC test”—which weighs heavily in favor of classifying workers as employees. Generally speaking, the ABC test focuses on three separate criteria that a worker must meet to be properly classified as an independent contractor:

  • The worker is free from the company’s control or direction;
  • The worker works outside the usual course of the company’s business; and
  • The worker is engaged in an independent trade, occupation, profession or business.

California, Illinois, Maryland, New Jersey, Ohio, and Oregon each use their own version of an ABC test.

Substantial Penalties for Misclassification

Misclassification of workers as independent contractors, whether intentionally or willfully, can result in significant liability by the employer under the FLSA and other applicable employment and employee benefit laws.

Under the FLSA, an employer can be liable to the misclassified worker for back overtime for a two-year period (or for three years, if the misclassification is deemed willful) and for liquidated damages. Even workers who, had they been hired as employees, might have qualified as exempt from overtime requirements under the FLSA, may be eligible for back-overtime wages if, as putative independent contractors, they were not paid a guaranteed weekly salary. The FLSA also authorizes attorneys’ fees awards to successful plaintiffs. In addition, the FLSA allows for individual liability for managers or executives who make compensation or classification decisions, as do some state wage-and-hour laws.

There are other sources of potential liability and monetary penalties as well. Improper classification of workers as independent contractors often excludes them from participation in employee benefit plans for which they would have been eligible if classified as employees. Misclassified workers can sue to recover the value of the benefits they were denied. Such improper exclusions can also jeopardize a plan’s tax-qualified status under ERISA. With respect to group health insurance plans, worker misclassification can lead to penalties under the Patient Protection and Affordable Care Act for failure to properly calculate the number of employees to determine applicable large employer status, as well as for failure to offer any health coverage or to offer adequate or affordable coverage to workers who should have been classified as full-time employees and to their dependents. Likewise, an individual who applies for workers’ compensation or unemployment benefits following the end of a service relationship may be entitled to benefits if the state agency determines they were misclassified as an independent contractor. Such applications may also trigger further investigation or audit by a state agency into a company’s classification practices, which can result in financial and legal liability.

Because employment status also carries federal tax deduction obligations for income tax withholding and Social Security and Medicare taxes, employers that fail to withhold these amounts from workers who have been misclassified as independent contractors can be liable for up to the full amount of income tax that should have been withheld, both the employer and employee shares for FICA, and interest and penalties, computed on far larger amounts in the case of an intentional misclassification. In addition to back taxes, criminal and civil penalties may be issued. Even for unintentional misclassification, the penalties can be large, with additional amounts due if an employer has not filed information returns that were required, such as the Form 1099.

That a worker prefers an independent contractor arrangement is no guarantee that the employer will escape liability for misclassification. Challenges to independent contractor classification can arise from a number of sources, making the practical risk of liability from misclassification higher. Because the federal and state governments lose tax revenue and contributions to unemployment insurance when an employer misclassifies a worker as an independent contractor, a company can be subject to routine audits of its classification practices. Such audits are also prompted when a putative independent contractor files a claim for unemployment benefits after the end of a work assignment. In addition, the worker personally may bring a claim seeking the value of employee benefits or back overtime wages that he or she was denied because of misclassification as an independent contractor, even if the worker signed an independent contractor agreement and initially expressed a preference for that form of engagement.

Next Steps for Employers

Given the substantial legal exposure for incorrectly classifying workers as independent contractors rather than employees under the FLSA, employers will want to confirm that their independent contractors are indeed correctly so classified under the FLSA’s revitalized “economic realities” test. In light of the factor relating to whether the work is an integral part of an employer’s business, employers should be particularly mindful of potential misclassification risks where an independent contractor and the company’s own employees perform similar duties for an extended period of time, or if a worker separates from employment but then is engaged as a consultant to perform substantially the same duties that the worker previously provided as an employee. Because the potential liability arising from misclassification is so very high, employers would be prudent to take a careful and conservative approach to worker classification decisions and to seek legal counsel if a potential independent contractor candidate does not clearly satisfy the six factors of the “economic realities” test.

As noted above, employers should also assess compliance with applicable state law. Employers with workers in multiple jurisdictions may especially need legal counsel to ensure they understand the applicable test of independent contractor status in those jurisdictions.

Source: Employers Face Greater Misclassification Risk Under Resurrected Federal Independent Contractor Rule, Opening Door to Substantial Liability | Pillsbury Winthrop Shaw Pittman LLP – JDSupra

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