The Final Rule: Employee or Independent Contractor Classification

The Final Rule: Employee or Independent Contractor Classification

The U.S. Department of Labor’s New Rule Clarifies the Distinction

In the dynamic landscape of federal regulations, significant changes have emerged in 2024 that businesses need to be aware of. One of these changes includes redefining the classification of “independent contractors” under the Fair Labor Standards Act (FLSA). The U.S. Department of Labor issued this new final rule to reduce “the risk that employees are misclassified as independent contractors.” Ultimately, this final new rule – that went into effect on March 11, 2024 – makes it more difficult to classify workers as independent contractors. Aspects of the rule may differ depending on the state in which you are located.

Many companies need help classifying someone providing services to the company as an employee or an independent contractor. While sometimes it may seem more convenient or cost-effective to classify service providers as contractors, if challenged, the cost and headache of defending a misclassification claim could far outweigh the possible savings. The new rule has been challenged in the courts. Still, regardless of what ultimately happens, this reflects a trend across the country, led by states like California, New Jersey, and New York, making it more difficult to classify workers as independent contractors legally.

The DOL’s New Rule: How It Works
The new rule replaces a 2021 rule and adopts a six-factor test focusing on the economic reality of the relationship between a potential employer and a worker and a return to a totality-of-the-circumstances analysis of the economic reality test.

This final rule reiterates that economic dependence is the ultimate inquiry into whether a worker is an employee or an independent contractor, meaning that a worker is independent if they are in business for themselves. Also, these six factors in the text work as a guide to assessing the economic realities of the working relationship, but not one factor is necessarily determinative. The six economic reality factors to be considered include:

  1. The opportunity for profit or loss—does the service provider have the skill and ability to control how much they earn in this arrangement?
  2. Investments by the worker and the potential employer – who has invested in the tools and equipment required to perform the services?
  3. The degree of permanence of the working relationship – is the relationship between the company and service provider finite or continuous, exclusive or not, sporadic or ongoing?
  4. The nature and degree of control – Who controls when and how the work is done, what are the economic aspects of the relationship, and to what extent does the company supervise, train, or discipline the service provider?
  5. The extent to which the work performed is integral to the potential employer’s business – is the service provider doing work central to the entity’s core business? Or is it an ancillary service? For example, this could be the difference between an accounting firm hiring an individual accountant during the busy season and a manufacturing company hiring a fractional CFO.
  6. Use of the worker’s skill and initiative in the business relationship—Does the service provider use specialized skills developed on their own that contribute to their business, or is that individual dependent on training from the entity?

Why the Definition Matters:

The distinction between employees and independent contractors determines coverage under federal wage-and-hour law, including minimum wages, overtime, and record-keeping requirements. This means that the language of your service agreement (“employment agreement” or “independent contractor agreement”) is not determinative of whether the IRS or other regulatory agencies find that you have correctly classified your employees or contractors. Instead, the IRS and other regulatory agencies may audit your business and review your contracts to determine if you mischaracterized your employees as contractors and potentially penalize you. If the IRS finds that your misclassification of employees and failure to pay wages was unintentional, then you, as the employer, face at least the following penalties:

  • $50 for each Form W-2 that should have been filed;
  • A penalty of 1.5% of the wages, plus 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee and 100% of the matching FICA taxes the employer should have paid;
  • Interest also accrues on these penalties daily from the date they should have been deposited;
  • A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month, up to 25% of the total tax liability; and
  • If the IRS finds fraud or intentional misconduct, it can impose additional fines and penalties that include 20% of all wages paid, plus 100% of the FICA taxes, both the employee’s and the employer’s share, plus criminal penalties of up to $1,000 per misclassified worker and one year in jail against the person responsible for withholding taxes, who could also be held personally liable for any uncollected tax.

Beyond the IRS and regulatory agencies, an independent contractor could sue you for, among other things, unpaid minimum wage and overtime that could result in substantial back pay owed to employees and liability to misclassified workers for the value of benefit plan contributions that should have been made had the workers been correctly classified as employees and for the costs that they incurred when they were sick or injured and were not able to utilize the employer’s group health insurance plan that would have covered them but for the misclassification.

Fundamental Changes in the Final Rule:

  • Legal Compliance: The control necessary to comply with specific legal requirements does not necessarily indicate employee status. Additional control for convenience may affect the analysis.
  • Relative Investments: Comparison of relative investments rather than absolute dollar-for-dollar comparison.
  • Tools and Equipment: Limitation on costs unilaterally imposed by the potential employer.
  • Earning More by Working More: When paid a fixed rate per hour or job, a worker’s ability to earn more is not considered entrepreneurial.
  • Specialized Skills: Specialized skills alone do not determine independent contractor status; relevance lies in using specialized skills with business-like initiative.

What does this mean for employers?

The final rule may result in more workers being classified as employees rather than independent contractors under the FLSA. This could increase the employer costs associated with benefits, such as health care and paid leave. While it is too early to see the extent of the impact it will have, the final rule could potentially cause further complications for other federal and state laws that rely on a worker classification system, such as coverage under the Affordable Care Act, state wage/hour requirements, and income and employment tax withholding. Ultimately, employers that may struggle to make the classification decisions must decide whether to wait and take the conservative approach in leaning towards an employee classification or wait and see how this new rule plays out in litigation.

Considering the shifting legal landscape and the significant risks of getting it wrong, companies should consult with counsel to understand the implications of using and retaining independent contractors.

If you need help or have any questions, please get in touch with Allan RooneySteve WilanskySumangali Rudrakumaror Lauri O’Callaghan, or call us at +1 212 545 8022.

 

Read more insights from the Rooney Law team here.

 

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