The test used by the U.S. Department of Labor (the “DOL”) for determining whether a worker should be classified as an independent contractor or an employee for purposes of the federal Fair Labor Standards Act (“FLSA”) has been revised several times over the past decade. Now, the DOL is implementing a new final rule to replace the employer-friendly test that was developed in 2021 (the “2021 Independent Contractor Rule”). The new, improved employee-friendly rule takes effect March 11, 2024.

Role of the new final rule

It is unclear to what extent, if any, courts will apply the DOL’s new final rule when weighing employment status issues under the FLSA. This is because the U.S. Supreme Court is currently considering whether to overturn or narrow the Chevron doctrine in two of its pending cases, namely Relentless, Inc. v. Department of Commerce and Loper Bright Enterprises v. Raimondo. Under the Chevron doctrine, courts give deference to an agency’s rule in certain instances. Even if courts are ultimately not required to give any deference to the DOL’s new rule, it may still be influential as persuasive authority. Moreover, it will guide DOL misclassification audits and enforcement actions.

If you are found to have misclassified employees as independent contractors under the FSLA, you may owe back pay if employees were not paid minimum wage or overtime pay, as well as penalties. You also could end up liable for withheld employee benefits and find yourself subject to various federal and state employment laws that apply based on the number of affected employees.

Since the DOL operates independent of the IRS, the DOL’s new rule should have no impact on employment status issues for federal tax purposes. The IRS is expected to continue applying the common law rules for determining employment status issues for tax purposes. In applying the common law rules, the IRS evaluates the 20 evidentiary factors listed in Revenue Ruling 87-41 to determine whether the right to direct and control exists in a worker relationship. The IRS tends to group the evidence gathered into three main categories, namely:

• Behavioral control;
• Financial control; and
• The relationship of the parties.

The replaced test

The 2021 Independent Contractor Rule focuses primarily on whether, as an “economic reality,” workers are dependent on employers for work or are in business for themselves. It examines five factors, and while no single factor is controlling, the 2021 Independent Contractor Rule identifies two so-called “core factors” that are deemed most relevant:

• The nature and degree of the employer’s control over the work; and
• The worker’s opportunity for profit and loss.

If both factors suggest the same classification, it is substantially likely that classification is proper.

The new test

The new final rule continues the notion that a worker is not an independent contractor if, as a matter of economic reality, the individual is economically dependent on the employer for work. The DOL says the rule aligns with both judicial precedent and its own interpretive guidance prior to 2021.

Specifically, the final rule enumerates six factors that will guide DOL analysis of whether a worker is an employee under the FLSA:

1. The worker’s opportunity for profit or loss depending on managerial skill (the lack of such opportunity suggests employee status);
2. Investments by the worker and the potential employer (if the worker makes similar types of investments as the employer, even on a smaller scale, it suggests independent contractor status);
3. Degree of permanence of the work relationship (an indefinite, continuous or exclusive relationship suggests employee status);
4. The employer’s nature and degree of control, whether exercised or just reserved (control over the performance of the work and the relationship’s economic aspects suggests employee status);
5. Extent to which the work performed is an integral part of the employer’s business (if the work is critical, necessary or central to the principal business, the worker is likely an employee); and
6. The worker’s skill and initiative (if the worker brings specialized skills and uses them in connection with business-like initiative, the worker is likely an independent contractor).

In contrast to the 2021 Independent Contractor Rule, all factors will be weighed — no single factor or set of factors will automatically determine a worker’s status.

The final new rule explains that actions that an employer takes solely to comply with specific and applicable federal, state, tribal or local laws or regulations do not indicate “control” suggestive of employee status. However, those that go beyond compliance and instead serve the employer’s own compliance methods, safety, quality control, or contractual or customer service standards may do so.

The final rule also recognizes that a lack of permanence in a work relationship can sometimes be due to operational characteristics unique or intrinsic to particular businesses or industries and the workers they employ. The relevant question is whether the lack of permanence is due to workers exercising their own independent business initiative, which indicates independent contractor status. On the other hand, the seasonal or temporary nature of work alone does not necessarily indicate independent contractor classification.

The return, and clarification, of the factor related to whether the work is integral to the business also is notable. The 2021 Independent Contractor Rule includes a noncore factor that asks only whether the work was part of an integrated unit of production. The final new rule focuses on whether the business function the worker performs is an integral part of the business.

For tax purposes

In a series of Q&As, the DOL addressed the question: Can an individual be an employee for FLSA purposes even if they are an independent contractor for tax purposes? The answer is yes.

The DOL explained that while it considers many of the same factors as the IRS, it added that “the economic reality test for FLSA purposes is based on a specific definition of ’employ’ in the FLSA, which provides that employers ‘employ’ workers if they ‘suffer or permit’ them to work.”

In court cases, this language has been interpreted to be broader than the common law control test. Therefore, some workers who may be classified as contractors for tax purposes may be employees for FLSA purposes because, as a matter of economic reality, they are economically dependent on the employers for work.

Next steps

Not surprisingly, the DOL’s final new rule is already facing court challenges. Nonetheless, you should review your work relationships if you use freelancers and other independent contractors and make any appropriate changes. Remember, too, that states can have different tests, some of which are more stringent than the DOL’s final rule. Contact your employment attorney if you have questions about the DOL’s new rule.

Contact Michael Loesevitz at [email protected] or 312.670.7444 or your ORBA advisor for assistance with any issues you may have regarding independent contractor status for tax purposes.