On October 11, 2022, the United States Department of Labor (DOL) issued its Notice of Proposed Rulemaking (NPRM) seeking to undo the Trump administration’s 2021 independent contractor regulations and revert to the six-factor economic realities test. While the test factors remain the same (for the most part), the DOL’s NPRM advances interpretations of the various factors that support employment status at every turn.
For years, the DOL and federal courts have applied a five or six-factor “economic realities” test looking at the totality of the circumstances. Each factor is reviewed with a lens towards assessing whether the worker is economically dependent on the employer for work or in business for him or herself. These six factors are:
- Worker’s Opportunity for Profit or Loss Depending on Managerial Skill
- Investments by the Worker relative to the Employer’s Investment
- Degree of Permanence of the Work Relationship
- Nature and Degree of Control by the Employer (specifically: scheduling, supervision, price-setting, and ability to work for others)
- Extent to Which the Work Performed is an Integral Part of the Employer’s Business
- Skill and Initiative
While no one factor is to be dispositive or given additional weight, various courts have held that the control factor should be afforded the most weight.
In January 2021, near the end of President Trump’s presidency, the DOL, led by Eugene Scalia at the time, issued a final rule that gave lip service to the economic realities test and instead primarily considered two “core” factors: (1) the degree of control exercised or retained by the employer, and (2) the worker’s opportunity for profit or loss. Under this two-core factor test, an individual was presumptively an independent contractor if he/she exercised substantial control over for whom, when and on which specific projects he/she would work. If the two core factors were not determinative, the DOL instructed the courts and parties to assess three other “guideposts”: (3) the amount of skill required for the work; (4) the degree of permanence of the working relationship between the worker and the employer; and (5) whether the work is part of an integrated unit of production.
Shortly before the DOL rule was set to take effect in March 2021, the Biden administration ushered in new leadership into the DOL naming Marty Walsh as Secretary of Labor, and under Walsh’s leadership, the DOL issued rules seeking to delay the effective date of the previously announced rule and ultimately withdrew it.
On March 14, 2022, the withdrawal plans hit a snag when Judge Marcia Crone of the US District Court of the Eastern District of Texas opined that the DOL had not followed the proper procedures under the Administrative Procedure Act and voided the DOL’s withdrawal plans.
WHY ARE THE PROPOSED REGULATIONS IMPORTANT?
These new proposed regulations signal that the DOL is again attempting to “crack down” on the perceived misclassification of independent contractors by interpreting the economic realities test in a manner that will tilt towards employee status.
It appears from the NPRM that the DOL is laser-focused on undercutting the specific arguments that companies (especially gig industry companies) have successfully advanced in courts to substantiate independent contractor status. The proposed regulations do this in a multitude of ways:
- Control: The DOL not only deemphasizes the control factor (by among other things analyzing it close to last), but it also reformulates how this factor should be analyzed. In language aimed at the gig industry companies, the NPRM emphasizes that “employers may also exercise control in other ways, such as by relying on technology to supervise a workforce, setting prices for services, or restricting a worker’s ability to work for others—actions that can exert control without the traditional use of direct supervision, assignment, or scheduling.” This language is aimed at countering the fact that companies have learned to work with independent contractors without controlling them. The NPRM is also seeking to change the game by contending that the courts should consider as evidence of control “restrictions that result from a companies’ legal, safety, or quality control obligations.” To the DOL, control is control, no matter the reason.
- Integral part of the employer’s business: Conversely, while the DOL is attempting to devalue the control factor, it appears to be placing greater emphasis on the integral to the business component. Indeed, the DOL pronounced that work that is integral to the hiring party’s primary business offering can only be performed by employees.
- Opportunity for profit or loss: The NPRM narrowly construes the contractor’s opportunity for profit or loss in a manner that will make it very difficult for many gig industry workers and sole proprietors to qualify as independent contractors. Towards this end, the DOL delineated the following considerations that they say bear on this inquiry, including (a) whether the worker determines the charge or pay for the work provided (or at least can meaningfully negotiate it); (b) whether the worker accepts or declines jobs or chooses or can meaningfully negotiate the order and/or time in which the jobs are performed; (c) whether the worker engages in marketing, advertising or other efforts to expand their business or secure more work; and (d) whether the worker makes decisions to hire others, purchase materials and equipment and/or rent space (as opposed to the amount and nature of the worker’s investment).
- Investments by workers and the employer: The NPRM requires a comparison of the worker’s investment relative to the hiring party. The DOL explained that any investments by the contractor should “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.” This interpretation is clearly designed to buttress the argument that a solo delivery driver or worker toiling away for a multi-billion-dollar gig company is an employee. To this end, the NPRM makes clear that the use of a personal vehicle that the worker already owns or leases to perform work is not an entrepreneurial investment covered by the spirit of the economic realities.
- Degree of permanence: The DOL remarks on the one hand that “working exclusively for a particular employer speaks to the permanence of the work relationship” but that “working for others and having multiple jobs in which workers are economically dependent on each employer for work— as compared to a worker who is in business for themself and chooses to market their independent services or labor to multiple entities—does not weigh in favor of independent contractor status.” This interpretation is designed to undercut the valid argument that gig economy workers are free to choose which companies they will work with and when they will do so—sometimes working for both at the same time.
WHAT IMPACT WILL THE REGULATIONS HAVE?
If the proposed rules go into effect, it is very likely that industry groups will seek to invalidate the regulations.
Additionally, the new rule, if adopted, will make it harder for companies to establish at the audit stage that individuals are independent contractors. It is also reasonable to expect that the current iteration of the DOL will seek to initiate investigations of companies that engage large groups of independent contractors to serve the same business function.
However, the new rule is unlikely to have any significant impact on how courts analyze the question of whether an individual is an employee or an independent contractor. Courts are unlikely to assign significant deference to the DOL’s frequently shifting positions.
It is also worth noting that the NPRM adopted the economic realities test rather than California’s ABC test which President Biden favored and lauded numerous times on the campaign trail. Under the ABC test, a business must establish that an individual satisfies all three elements in order to be an independent contractor: (a) the worker is free from the control and direction of the hiring party in connection with the performance of the work, both under the contract for the performance of the work and in fact; and (b) that the worker performs work that is outside the usual course of the hiring entity’s business; and (c) that the worker is customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed. The DOL in issuing its NPRM recognized, however, that “because the ABC test is inconsistent with Supreme Court precedent interpreting the FLSA (Fair Labor Standards Act), the Department believes that it could only implement an ABC test if the Supreme Court revisits its precedent or if Congress passes legislation that alters the applicable analysis under the FLSA.”
Of course, employers must continue to ensure that they comply with wage and hour laws in jurisdictions like California and Massachusetts that utilize the ABC tests.
TAX LIABILITIES AND BENEFITS ISSUES
Worker classification issues also impact federal tax liability, especially employment taxes. Generally, if a worker is classified as an employee, the employer must withhold and deposit federal income taxes (FITW) while also withholding and depositing both the employee and employer share of Federal Insurance Contributions Act (FICA) taxes on wage payments. However, if a worker is classified as an independent contractor, this tax liability shifts from the employer to the worker. As such, independent contractors are legally obligated to pay both the employee and employer shares of the FICA taxes (as self-employment (SECA) taxes) while also paying estimated income taxes. Conversely, if the Internal Revenue Service (IRS) reclassifies an independent contractor as an employee, the business faces full-rate tax exposure for these payroll taxes of about 35% of the amounts paid to the independent contractor over the past three years.
In addition, the employer may also be required to provide to the worker certain benefits it makes available to other employees, including retirement and health and welfare benefits. Most health plans and tax-qualified retirement plans exclude independent contractors from coverage. Without an express plan document provision to the contrary, an independent contractor that is reclassified as an employee may become eligible for coverage—including retroactive coverage—under a plan. Some employers address this issue by including express language in their plans that excludes reclassified workers from coverage to protect an employer from claims for retroactive coverage and enable the employer to exclude reclassified workers from future coverage.
It is important to note that the NPRM only addresses whether a worker is an employee or an independent contractor under the FLSA. The IRS has its own set of guidelines to determine worker classification for tax purposes, including payroll and benefits. While the preamble of the NPRM states that employers are likely to keep the status of most workers the same, the determination of worker classification for tax purposes is not bound by the NPRM, even if finalized. Therefore, a worker can be an employee under these proposed rules but remain an independent contractor for tax purposes. While guidance under the IRS and the DOL differ, there is regular communication between these two agencies. Thus, it is reasonable to assume that employee misclassification audits under the IRS might increase over the coming years. Fortunately, proper plan documentation and several statutory and regulatory relief provisions can protect businesses from the draconian effects of IRS independent contractor audits, including one tax law provision that, if satisfied, allows employers to continue to treat workers as independent contractors without any past or future federal employment tax liability, regardless of whether the workers are actual common law employees. This relief provision does not determine whether a worker is an independent contractor or an employee but merely provides employers relief from such employment tax liabilities associated with worker misclassification.
WHAT SHOULD COMPANIES DO NEXT?
Employers have until November 28, 2022, to submit any comments to the DOL on the proposed rule. The rule will likely be effective in late 2023 or early 2024.
Companies should also not wait to audit their practices for engaging independent contractors and implement systems to best protect themselves, especially if independent contractors are a significant component of the company’s workforce. Although the language of an independent contractor agreement is not dispositive, employers should seek counsel to ensure that their agreements reinforce the independent contractor relationship and do not on their face support employment status.