Are They Employees or Independent Contractors? The Test for Classifying Independent Contractors is Shifting Away from “Economic Reality”

The Trump administration’s U.S. Department of Labor (DOL) rang in May by publishing guidance directing DOL to stop enforcing a Biden-era rule (that itself had rescinded a DOL rule created during the first Trump administration) on the factors distinguishing independent contractors from employees. Although the Biden-era rule remains “on the books” for now while the DOL considers replacing it, the no-enforcement transitional period leaves employers to deal with uncertainty in classifying who are employees and who are independent contractors. This article seeks to provide employers with a better understanding of where the law has been and where it might be headed. 

Why Does Independent Contractor Classification Matter?

The DOL administers and enforces the Fair Labor Standards Act (FLSA). Under the FLSA, employees generally enjoy enhanced protections on matters such as minimum wage and overtime pay, unemployment insurance, workers’ compensation coverage, employer recordkeeping, and employer contributions to Social Security and Medicare. Independent contractors do not receive these same FLSA benefits; independent contractors bear their own obligations and risk regarding income taxes, insurance, and other business expenses.  

An employer that misclassifies employees as independent contractors can be hit with sanctions such as back pay for unpaid overtime or minimum wage and unpaid payroll taxes, on top of penalties from the IRS and DOL. If the misclassification is pervasive, class action lawsuits could multiply these liabilities. For these reasons, getting these classifications correct matters for the employer’s financial, legal, and reputational well-being. 

Where We’ve Been: the 2021 and 2024 Rules

The employee-independent contractor distinction derives from the FLSA’s connected definitions of “employ,” “employee,” and “employer” that boil down to whether the individual at issue is one whom an employer causes to “suffer or permit[s]” to work on the employer’s behalf. But what does it mean to “suffer or permit to work”? That is the question these DOL rules seek to answer. 

Prior to 2021, federal courts interpreting the FLSA developed a multi-factor balancing test to determine if workers were “employees” as a matter of economic reality. Deciding whether specific workers were economically dependent on the employer or instead in business for themselves turned on the totality of several non-dispositive circumstances: 

• The nature and degree of control exercised by the employer over the worker; 

• The worker’s opportunity for profit or loss depending on managerial skill;  

• The worker’s investment in equipment or materials required for the task; 

• The degree of permanence of the working relationship; 

• The integral nature of the work to the employer’s business; and 

• The skill and initiative required for the work. 

The first Trump administration’s DOL departed from this precedent in its published 2021 Independent Contractor Rule. Seeking a streamlined analysis providing clearer classification outcomes, the 2021 rule adopted a non-exhaustive five-factor test that gave greatest weight to two “core factors”: 

• The nature and degree of control over the work (core factor); 

• The worker’s opportunity for profit or loss (core factor); 

• The amount of skill required for the work; 

• The degree of permanence of the working relationship; and 

• Whether the work is part of an integrated unit of production. 

In response to criticisms that the 2021 rule would disproportionately harm workers by enabling employers to more easily classify and treat more low-income workers—particularly gig-economy workers—as independent contractors rather than employees, the Biden administration rescinded the 2021 rule and replaced it with his own in 2024. The 2024 Independent Contractor Rule purports to return to and reinstate the pre-2021 analysis, embracing once again a totality-of-the-circumstances approach as opposed to giving greater weight to any particular factors over any of the others.  

Where We’re Headed and Walking with Caution Over Shifting Sands

When the government explicitly says it is not prosecuting the law currently in effect, how should an employer proceed? With caution and counsel. The second Trump administration’s diversion of prosecutorial resources away from enforcing the 2024 rule signals DOL’s momentum toward yet another rule change—likely a reversion to Trump administration’s 2021 rule. But any formal change will take time, on the order of a year or more, before the rulemaking process (such as notice and comment) results in a replacement of the current 2024 rule. In the meantime, employers should be mindful that this non-enforcement guidance is not necessarily permission to aggressively reclassify workers as independent contractors. One administration’s guidance that a rule will not be enforced may not prevent the next administration from reaching back in time to prosecute employers for misclassification violations committed during the previous administration.  

In addition, employers must also follow state laws as they relate to independent contractors, and misclassification of an independent contractor who is subsequently deemed an employee can have severe consequences.  For example, a misclassified employee may suffer an employment related injury and may not be covered by worker’s compensation insurance.  Similarly, the independent contractor may be deemed an employee for unemployment insurance. 

Bottom Line

The bottom line is that if you’re an employer facing worker classification issues or considering reclassifying segments of your workforce from employees to independent contractors, you should consider seeking legal counsel during this transitional period about how to maintain FLSA compliance and mitigate misclassification’s serious legal risks, with an appreciation of where the “economic reality” test has been and where it might be headed.  

This article, slightly modified to note recent updates, was featured online in the Great Lakes Employment Law Letter and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.