The Department of Labor Issues New Rules on Employee Classifications

On January 10, 2024, the U.S. Department of Labor (DOL) published its highly anticipated “final rule” on independent contractor classifications.[1] As expected, they adopted the “totality of the circumstances” test which means that many more workers will be found to be w-2 employees as opposed to 1099 independent contractors. This rule takes effect on March 11, 2024, and is anticipated to have a significant impact across many industries that rely on contract workers, including government contractors. Under the new rule, many independent contractors will likely be reclassified as employees, which will financially impact employers by way of potential entitlement to company benefits, additional tax implications, and possible exposure to employment-based lawsuits, etc. Furthermore, if a worker is misclassified as an independent contractor but is later determined to be your employee, there is an additional risk of back wages that could be assessed for unpaid overtime, particularly in light of the changes DOL has in store regarding the salary basis for exempt employees. Those proposed changes will be discussed at the end of this article.

This new “Final Rule” has been a long time coming. The Biden Administration rescinded the Trump Administration’s “Final Rule” effective May 6, 2021. If you are interested in the background on the different iterations of the independent contractor rule, please check out our article, “Are you SURE all of your workers are properly classified?”

DOL’s Final Rule on independent contractor classification recognizes the Fair Labor Standards Act (FLSA) definition of an “employee” as any individual whom an employer “suffers, permits, or otherwise employs to work.” However, this new Rule broadens the definition and states that the term “employee” is intended to “encompass as employees all workers who, as a matter of economic reality, are economically dependent on an employer for work.” In contrast, the Rule states that an “independent contractor” is a worker who is, “as a matter of economic reality, in business for themself.”

The Six-Factor “Test”

The Final Rule establishes a non-exhaustive, six-factor economic realities test under which no one factor is considered to be dispositive. These factors are:

1. “Opportunity for profit or loss depending on managerial skill.” This factor considers several elements to determine whether the worker uses “managerial skill” that affects his/her economic success or failure, such as whether the worker determines or can meaningfully negotiate the charges or pay for the work provided; whether the worker accepts or declines jobs or chooses the order and/or time in which the jobs are performed; and whether the worker makes decisions to hire others, purchase materials and equipment, and/or rent space.
2. “Investments by the worker and the employer.” This factor examines whether a worker’s investment is considered to be “capital or entrepreneurial in nature.” However, DOL clarifies that just because a worker purchases their own tools or equipment to perform the job does not mean that such personal “investment” confirms that the worker is not an employee. Rather, the worker’s investment should be considered on a relative basis along with the company’s investment in its overall business.
3. “Degree of permanence of the work relationship.” This factor weighs heavily in favor of a finding that the worker is an employee when the work relationship is “indefinite in duration or continuous.” A work relationship that has s specific, defined duration (such as one that is project-based) and is clearly non-exclusive, is strong evidence of independent contractor status. However, just because work is seasonal or temporary in nature does not mean there will be a finding of independent contractor status.
4. “Nature and degree of control.” This factor reviews the company’s control, including reserved, indirect control, over the performance of the work and the economic aspects of the working relationship. Facts that are examined here include whether the company sets the worker’s schedule, supervises the performance of the work, or explicitly limits the worker’s ability to work for others. The company’s control may also be established by evidence of “indirect control.”
5. “Extent to which the work performed is an integral part of the employer’s business.” Here, if the work being performed is an integral, central part of the company’s business, a finding of employee status is more likely. If, however, the work that the worker is performing is not critical, necessary or central to the company’s business, it may be easier to establish an independent contractor relationship.
6. “Skill and initiative.” Typically, true independent contractor status involves a worker who uses specialized skills to perform the work and those skills contribute to “business-like initiative.”  Employee status is more likely where a worker is not using specialized skills in performing the work and/or a worker depends on training from the company to perform the work.

As you can see, these factors require a detailed analysis on a case-by-case basis and I would argue, reasonable persons could easily disagree on the outcome. The majority of employer-side experts do agree, however, that this Final Rule will ultimately make it much more difficult to support classification of workers as independent contractors if questioned by DOL. Click here to view and read the complete Final Rule published by DOL’s Wage and Hour Division in the Federal Register.

Proposed Changes to the Salary Basis Test for Exempt Classifications

Earlier in this blog I mentioned additional proposed changes by DOL which should also be on your radar. On September 8, 2023, DOL announced publication of a Notice of Proposed Rulemaking (NPRM) entitled Defining and Delimiting the Exemptions for Executive, Administrative, Professional, Outside Sales and Computer Employees. Proposed revisions include increasing the salary level for exempt status and inclusion of triannual automatic updates to these levels. The last time DOL increased the salary threshold was January 1, 2020, when the threshold was raised from $466 a week ($24,232 annually) to $684 a week ($35,568 annually), which was almost a 50% increase.[2] If finalized in its current form, the 2023 proposed rule would increase the minimum salary threshold for exempt status to at least $1059/week ($55,068 annually), which is almost a $20,000 increase in annual compensation! This means that any employee who is classified as exempt from the overtime provisions of the FLSA would have to make at least $55,068/year in order to still qualify for such an exemption. Clearly, this is a huge change and will be very challenging for most businesses.

The NPRM also includes, for the first time, automatic, triannual updates to the salary levels. This means that DOL would update the salary levels using the most recently available four quarters of data as published by the Bureau of Labor Statistics every three years. The proposed rule does not include any changes to the “duties tests” for exempt classifications.

The comment period for this proposed rule closed on November 7, 2023, and reportedly more than 26,000 comments were received. The rule also faces some legal challenges. Regardless, there are indicators that DOL plans to finalize this rule as early as spring or summer of this year, which will require companies to conduct a detailed review of employee exemption classifications to ensure they meet these higher thresholds.

You can read the NPRM here: Federal Register :: Defining and Delimiting the Exemptions for Executive, Administrative, Professional, Outside Sales, and Computer Employees

Double Trouble?

The combination of DOL’s new definition of “independent contractor” coupled with the proposed increase to the salary basis for exempt employees could spell “double trouble.” Consider this scenario: You have an independent contractor agreement with worker X who has been working with you for several years and bills you monthly for a flat rate. DOL initiates an investigation into your company and per their standard requests, ask to see all of your 1099 documentation. DOL determines that worker X was misclassified as a 1099 contractor and should have been treated as your employee. Furthermore, the hourly rate paid to X (calculated based upon the hours worked and the monthly amount paid to X) does not meet the salary basis required by FLSA to qualify for exempt status. Worker X has time records indicating that she has worked 45 hours/week every week she has performed work for you. DOL finds that your company owes X (who is now your employee) thousands of dollars of back wages for unpaid overtime.

This is just one simple example as to why it is crucial that all businesses regularly evaluate their internal classifications of exempt/non-exempt status as well as whether those workers who are classified as 1099 contractors meet the requirements as defined by DOL. Our Redstone GCI team is available to assist you in properly classifying your workers so that you can avoid the costly consequences of misclassification which may include back taxes to the IRS, state unemployment taxes, unpaid worker's compensation premiums, and even possible unpaid overtime or minimum wages, medical expenses and vacation and sick pay and other benefits.

[1] DOL received and reviewed approximately 55,400 comments on the Proposed Rule from interested parties before issuing the Final Rule.

[2] For those of you who followed the history of the FLSA changes, you will recall that the Obama administration originally proposed an increase to $913/week or $47,476 per year in 2016.