When business owners recognize that they need more help, they sometimes struggle with the decision of whether to hire an independent contractor or an employee. Making that decision isn’t the end of the matter, though. You also need to understand the legal requirements for independent contractor status—because simply designating someone with the status in a written independent contractor agreement won’t cut it.
The U.S. Department of Labor (DOL) recently updated the federal test for determining whether a worker is an independent contractor or an employee for purposes of the federal Fair Labor Standards Act (FLSA). The final rule that explains the new test went into effect on March 11, 2024 (although it faces legal challenges in federal court).
The new rule could make it harder for you to legally classify and treat workers as independent contractors—and leave you more vulnerable to charges of employee misclassification. Here’s what you need to know.
The appeal of independent contractors
Independent contractors provide several benefits for employers. The main attraction for cost-conscious business owners is often their lower price tag.
When you bring on a contractor, you don’t have to worry about paying for payroll taxes or employee benefits. You’re also not subject to various employment-related laws when it comes to contractors, so you’re spared the costs of compliance, as well as the risk of lawsuits over alleged violations. These laws include the FLSA with its minimum wage and overtime pay requirements, the National Labor Relations Act, and other federal and state mandated protections, such as occupational health and safety, workers’ compensation, and unemployment insurance laws.
You generally don’t have to provide the supervision, tools, supplies, and training employers typically must give their employees. Contractors also offer greater flexibility and scalability so you aren’t paying for employees when you don’t have enough work to keep them busy.
For all of the potential savings, misclassification of an employee as an independent worker can lead to costly consequences. You could, for example, end up on the hook for back pay under the FLSA, as well as withheld benefits, payroll taxes, attorneys’ fees if you go to court, and penalties and interest. And the risk is there even if a worker has agreed to be treated as an independent contractor.
An evolving standard
The test for determining the proper worker classification has gone through several iterations in the last decade, shifting approaches as different political parties have cycled through the White House.
The Trump administration test, which took effect in 2021, focused largely on whether, as an “economic reality,” the worker is dependent on the employer for work or is in business for himself. It listed five factors, although courts and the DOL had previously applied five or more overlapping factors in a “totality of the circumstances” test to determine the economic reality.
While no single factor was decisive, the 2021 rule identified two so-called “core factors” that it deemed most relevant to worker classification:
- The nature and degree of the employer’s control over the work, and
- The worker’s opportunity for profit and loss.
If both factors suggested the same classification, it was considered substantially likely that the classification was proper.
The non-core factors were:
- The amount of skill required for the work,
- The degree of permanence of the working relationship between the worker and the employer, and
- Whether the work was part of an integrated unit of production.
The regulations for this test stated that these factors were “highly unlikely” to outweigh the combined weight of the two core factors when the core factors pointed to the same classification.
After President Biden took office, the DOL proposed a new rule that would weigh all factors and doesn’t give the core factors more predetermined weight than the others. The DOL’s comment period for the proposed rule closed in December 2022, with more than 55,000 comments submitted.
The new test
The DOL says the latest test is still based on economic dependence—a worker isn’t an independent contractor if, as a matter of economic reality, they’re economically dependent on the employer for work.
The new test, however, resurrects the totality of the circumstances approach. All factors will be weighed, and no single factor or set of factors will automatically determine a worker’s status.
The final rule lays out a six-factor test that will guide DOL analysis of whether a worker is truly an independent contractor under the FLSA or whether they’ve been misclassified:
1) The worker’s opportunity for profit or loss depending on managerial skill
If a worker can exercise their managerial skill to directly affect their profit or loss, this factor suggests they’re an independent contractor.
Relevant facts include whether the worker:
- Determines or can negotiate the compensation for the work,
- Accepts or declines jobs or chooses the order and/or time in which jobs are performed,
- Engages in marketing, advertising, or other efforts to expand their business or secure more work, and
- Makes decisions to hire others, purchase materials and equipment, and/or rent space.
Note: Some decisions by a worker that can affect the amount of pay received (for example, the decision to work more hours or take more jobs when paid a fixed rate per hour or per job) generally won’t reflect the exercise of managerial skill that indicates independent contractor status under this factor.
2) Investments by the worker and the employer
If the worker makes similar types of investments as the employer makes, it suggests independent contractor status.
The relevant worker investments under this factor must be capital or entrepreneurial. These investments generally support an independent business and serve a business-like function, such as increasing the worker’s ability to do different types of or more work, reducing costs, or extending market reach. They don’t include the cost of tools and equipment to perform a specific job, the costs of workers’ labor, or costs the employer imposes unilaterally on the worker.
The worker’s investments should be considered on a relative basis with the employer’s investments in its overall business, rather than comparing them only in terms of the dollar values of investments or the sizes of the worker and the employer. Rather, the question is whether the worker is making similar types of investments as the employer—even if on a smaller scale—in a way that suggests that the worker is operating independently.
3) Degree of permanence of the work relationship
An indefinite, continuous, or exclusive relationship suggests employee status. On the other hand, if the work relationship is defined in duration, non-exclusive, project-based, or sporadic because the worker is in business for themselves and markets their services to multiple entities, it indicates independent contractor status.
The latter situation might include regularly occurring fixed periods of work, but the seasonal or temporary nature of work alone doesn’t necessarily indicate independent contractor classification. In addition, when the lack of permanence is due to operational characteristics that are unique or intrinsic to particular businesses or industries and the workers they employ, it doesn’t necessarily indicate independent contractor status. For example, the short duration of work relationships in oil and gas pipeline construction work is intrinsic to the industry rather than a choice by the workers.
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.
Facts relevant to employer control include whether the employer:
- Sets the worker’s schedule,
- Supervises the work (including through technological means, such as with a device or electronically),
- Explicitly limits the worker’s ability to work for others,
- Reserves the right to supervise or discipline workers,
- Places demands or restrictions on workers that don’t allow them to work for others or when they choose, or
- Controls economic aspects of the work relationship, including prices or rates for services and the marketing of the worker’s services or products.
Of course, sometimes employers are legally required to exercise some types of “control.” The DOL recognizes that actions you take for the sole purpose of complying with a specific and applicable federal, state, tribal, or local law or regulation don’t indicate control. So, for example, a magazine could require a freelance writer to comply with libel law.
Be careful about going beyond strict legal compliance, though. Actions taken to serve your own compliance methods, safety, quality control, or contractual or customer service standards may indicate control. For example, a home healthcare agency’s requirement of extensive provider qualifications, such as fulfilling comprehensive training requirements beyond the training required for relevant licenses, could be evidence of control.
5) The extent to which the work performed is an integral part of the employer’s business
The worker is probably an employee under this factor if the work is critical, necessary, or central to the principal business.
The focus now isn’t on whether the worker in particular is an integral part of the business, but rather whether the function they perform is an integral part of the business. For example, a farm that distributes tomatoes pays workers to pick the harvest. Because picking tomatoes is an integral part of farming tomatoes, and the company is in the business of farming tomatoes, the pickers are integral to the business. An accountant who provides non-payroll accounting support, however, doesn’t do work that’s critical, necessary, or central to farming tomatoes.
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. When the worker doesn’t use such skills to perform their work or depends on training from the employer to do the work, employee status is indicated.
But independent contractor status isn’t indicated simply because a worker brings specialized skills—developed separate and apart from the employer—to the work relationship. After all, both employees and contractors can be skilled workers. What matters is the worker’s use of these specialized skills in connection with business-like initiatives.
So what is business-like initiative? Say a highly skilled welder works for a construction firm and is told what work to do and where to do it. He doesn’t make any independent judgments on the job site beyond those necessary to do the assigned work. Although the welder is highly skilled, he’s not using the skills in a manner that shows business-like initiative, meaning this factor suggests employee status.
Now suppose this same worker provides a specialty welding service for a variety of construction firms in the area. He uses the skills for marketing purposes, to generate new business, and to obtain work from multiple companies. In this scenario, the welder is both technically skilled and uses and markets his skills in a way that indicates business-like initiative, in turn indicating independent contractor status.
Note: The final rule states that additional factors may also come into play in the DOL analysis if they indicate whether the worker is in business for themself.
Other critical tests
It’s important to realize that the final rule changes only the DOL test under the FLSA. It has no effect on other legal tests and standards for employee classification—and there are several, both federal and state.
For example, some states apply the so-called ABC test. Under that test, a worker generally is an independent contractor only if the worker:
- Is free from the control and direction of the employer as far as how the work is performed, both under the contract for the performance of the work and in reality,
- Performs work that’s outside the usual course of the employer’s business, and
- Is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work.
California and New Jersey are examples of states that apply the ABC test.
The IRS test considers a variety of facts that provide evidence of the degree of control and independence. The facts fall into three categories: behavioral, financial, and the type of relationship.
Like the DOL test, the test applied by the National Labor Relations Board recently returned to a stricter standard applied before the Trump administration. Going forward (for the near future, at least), the board’s analysis will be guided by a nonexhaustive list of factors developed by courts.
Payroll for independent contractors
The complexity of working with independent contractors doesn’t end when you determine a worker is indeed an independent contractor. You also have to deal with payroll issues unique to contractors, and Gusto can help.
