One of the many advantages of hiring independent contractors instead of employees is that contractors are notprotected by most federal and state labor laws.
This includes the federal Fair Labor Standards Act (FLSA), which establishes a national minimum wage andovertime standards for covered employees.
But in a concerted effort to require more businesses to pay overtime to workers, the U.S. Department of Labor(DOL) has acted to make it harder to classify workers as independent contractors for labor law purposes.
As a result, hiring firms could end up having to pay time-and-a-half to workers they previously thought were exemptfrom the requirement.
The FLSA
If you hire workers to help in your business, you are likely subject to the FLSA, which establishes a nationalminimum wage and overtime standards for covered employees.
The FLSA applies to all businesses
with $500,000 or more in annual sales, or
that are engaged in interstate commerce.
This covers nearly all workplaces, because the courts have broadly interpreted what constitutes interstatecommerce.
The FLSA requires employers to pay all non-exempt employees one and one-half times their regular rate of pay forall hours of work over 40 hours in a week.
If an employer fails to do so, it could be liable for back overtime pay for two years (three years if themisclassification is found to be intentional) along with liquidated damages. The FLSA is enforced both by the DOLand by workers themselves, who may bring lawsuits for violations.
Certain types of workers are exempt from the FLSA—that is, their employers need not pay them time-and-a-half (orthe federal minimum wage).
These include bona fide executive, administrative, and professional employees, as well as computer employeesand outside sales employees.
To be exempt, an employee must be paid over a minimum amount.
The DOL has substantially increased this amount effective July 1, 2024, to $43,888 per year, and the amount willbe increased again in 2025, to $58,656. As a result, an additional 3.5 million employees will be covered by theFLSA.
The New DOL Independent Contractor Rule
No matter what they do or how much they are paid, independent contractors are not covered by the FLSA. Theyneed not be paid time-and-a-half for overtime or even the minimum wage. The question is, who is an independentcontractor?
The FLSA does not define the term “independent contractor.” Courts have held that for FLSA purposes thequestion is whether,as a matter of economic reality, the workers are economically dependent
on the hiring firm forwork or are in business for themselves.
Workers who are dependent on the hiring firm are employees; those who are not are independent contractors.
A new DOL Final Rule on worker classification took effect on March 11, 2024, replacing a much more business-friendly rule. Under the DOL’s new rule, six factors must be considered when determining whether a worker is anemployee or an independent contractor. No single factor is determinative, and all should be considered.
1. Opportunity for profit or loss. Independent contractors can earn a profit or incur a loss through their ownindependent effort and decision-making. Lack of opportunity for profit or loss suggests that a worker is anemployee. Factors to be considered include whether the worker.
- negotiates his or her pay;
- decides to accept or decline work;
- hires his or her own workers;
- purchases materials and equipment; or
- performs marketing, advertising, or other efforts to get work.
2.Investment in facilities and equipment.
Independent contractors typically invest in their own tools,equipment, and workspaces. A lack of such capital or entrepreneurial investments weighs in favor of employeestatus.
3.Permanency of the relationship.
Independent contractors typically work on a sporadic or project basis, or for aspecific duration. Long-term, continuous, or indefinite working relationships indicate employee status.
4.Nature and degree of control.
A hiring firm’s “control” over an independent contractor is limited to accepting orrejecting the final results the contractor achieves. In contrast, employers have the right to control how theiremployees perform their work.
Relevant facts include whether the hiring firm controls hiring, firing, scheduling, prices, or pay rates; supervises theperformance of the work; has the right to supervise or discipline workers; and takes actions that limit the worker’sability to work for others.
Requiring a worker to comply with applicable government regulations (such as safety regulations) does notconstitute control.
5.Integration into the employer’s business.
If the work performed by a worker is critical, necessary, or central tothe hiring firm’s principal business, then the worker is more likely an employee. In other words, if a worker’s labor ispart of the goods or services your company offers (as opposed to a tangential service that worker also offers andprovides to others), he or she is more likely an employee.
6.Skill and initiative required.
This factor focuses on whether the worker uses his or her own specialized skills,together with business planning and effort, to perform the work and support or grow a business. Workers who doso are more likely independent contractors. Workers who do not have specialized skills or who are dependent ontraining from the hiring firm are more likely employees.
Difficulty Applying the New Test
The new DOL Final Rule establishes a complex and hard-to-apply test. The DOL says that no one factor or subsetof factors determines whether a worker is an employee or independent contractor. Rather, all the circumstances ofthe relationship must be examined.
Unfortunately, the DOL gives no guidance for how to weigh any specific factor or weigh any factor against another.It simply says that the weight given to each factor depends on the facts and circumstances of the particularrelationship. Also, additional factors beyond the six described in the rule may be relevant if they help show thatworkers are in business for themselves as opposed to being economically dependent on the hiring firm for thework.
It’s no wonder that some commentators have called this test an “impenetrable fog.”
The DOL Worker Classification Test Is One of Many
There is no single test for determining worker classification. Federal, state, and local government agencies eachhave different tests, with some stricter than others.
The new DOL test is the most restrictive used by the federal government.
The test used by the IRS, for example, is more business friendly. The IRS does not use an “economic reality” testfocusing on the worker’s economic dependence on the hiring firm. Rather, it uses a “common law” right-to-controltest.
Under the IRS test, the determining factor is whether the hiring firm has the right to direct and control the way theworker performs—both as to the final results and regarding the details of when, where, and how the work is done.To determine control, the IRS looks at three categories of factors:
- Behavioral
- Financial
- Type of relationship
On the other hand, many states (including California, Massachusetts, and New Jersey) use an ABC test forpurposes of state unemployment, workers’ compensation, and state wage and hour laws. This test is even stricterthan the DOL test. Under this test, to be classified as an independent contractor, a worker must
be free from the company’s control or direction;
carry out work outside the hiring firm’s usual business; and be engaged in an independent trade, occupation, profession, or business.
It is quite possible, therefore, for a worker to qualify as an independent contractor under the IRS test, but beconsidered an employee under the DOL economic reality test and state ABC tests.
In theory, a hiring firm can treat a worker as an independent contractor for tax and other purposes, while treatinghim or her as an employee for FLSA and state law purposes.
In practice, however, few hiring firms do this. They classify workers an employees or independent contractors for alllegal purposes. It’s too complicated to do otherwise.
The Uncertain Future of the DOL’s New Test
It’s far from clear that the DOL’s new test will be permanent. The test is being challenged in the courts, which couldalter the test or reject it entirely. These legal challenges are unlikely to be resolved anytime soon.
But there is yet another threat to the DOL test: if there is a change in presidential administrations in 2025, it is quitepossible the test will be watered down or replaced.
The Bottom Line: Worker Classification Is a Mess
The rules for classifying workers as employees or independent contractors have been a mess for years, and theDOL is making it even worse.
To determine how to classify a worker, you should ask yourself the following questions:
- Does your company control when and where the contractor works and for how long?
- Does the company give the worker detailed instructions, which are not required by law, or supervisethe worker’s performance?
- Does the company control the economic aspects of the relationship, such as setting rates for theworker’s services?
- Does the company supply equipment and materials to help the worker do his or her job?
- Does the agreement with the worker continue indefinitely?
- Do you require that the worker work only with you and no one else?
- Is the function that the worker performs critical, necessary, or central to your company’s principalbusiness (as opposed a tangential service the worker also offers and provides on a regular basis toothers)?
- Is the worker dependent on training by your company to perform the work?
Does the worker lack entrepreneurial or capital investments in their activity?
A “yes” answer to any of these questions indicates that the worker is an employee, not an independent contractor.The more yes answers, the more likely the worker is an employee under any legal test.
Hiring firms that use many independent contractors should always have them sign an independent contractoragreement that contains a clause waiving the right to bring or join any class action suit against the company,including suing for misclassification as an independent contractor.
Since suing a hiring firm for worker misclassification is difficult and expensive, the only way it usually can be doneis via a class action suit where the claims of an entire class of claimants are joined. The legal validity of such classaction waivers has been upheld by the U.S. Supreme Court.
Incorporated Workers
Although not bulletproof, the practice of hiring workers who operate as corporations or LLCs can increase yourchances that those workers are independent contractors.
But hiring workers who operate as a corporation or LLC does not automatically make that person an independentcontractor. Tax and labor authorities can attack such a relationship as “misclassification through incorporation.”
Takeaways
Independent contractors are not protected by most federal and state labor laws, including the FLSA, whichestablishes a national minimum wage and overtime standards for covered employees.
The U.S. Department of Labor has undertaken a concerted effort to require more businesses to pay overtime toworkers. It has narrowed the exemptions from the FLSA overtime requirements and adopted a new, morerestrictive test hiring firms must use to determine whether to classify workers as employees or independentcontractors for FLSA purposes.
For FLSA purposes, workers are employees if,
as a matter of economic reality, they are economically dependent on the hiring firm. The DOL has established a complex six-factor test that hiring firms must consider to determine aworker’s status. The test explores the following factors:
- Opportunity for profit or loss
- Investment in facilities and equipment
- Permanency of the relationship
- Degree of control by the hiring firm
- Integration into the employer’s business
- Skill and initiative required
No one factor is determinative.
The DOL test is only one of many used to determine workers’ employment status. The IRS uses a more employer-friendly right-of-control test. But many states use an even more restrictive ABC test.
Businesses that use many independent contractors should always have them sign an independent contractoragreement that contains a clause waiving the right to bring or join any class action suit against the company forworker misclassification.
