Written by Dylan B. Saul from Fredrikson & Byron PA on April 2, 2024
On January 10, 2024, the U.S. Department of Labor issued final regulations announcing a new “economic reality” test for classifying workers as employees versus independent contractors under the Fair Labor Standards Act. The new test provides additional clarity and important worker protections, but it went into effect quickly—on March 11, 2024—leaving employers scrambling to ensure that their workers are properly classified.
Under the new “economic reality” test, employers should classify workers as independent contractors only if the workers are truly “in business for themselves.” Employers should determine this by applying the six factors outlined below. The Department of Labor has emphasized that these six factors are not exhaustive, and no one factor is determinative:
1. Opportunity for profit or loss depending on managerial skill
Workers are more likely independent contractors if their success depends on their “business acumen” or “initiative.”
2. Investments by the worker and potential employer
Workers are more likely independent contractors if they make “capital or entrepreneurial” investments in their own business.
3. Degree of permanence of the work relationship
Workers are more likely independent contractors if their working relationship with the employer is “non-exclusive, project-based, or sporadic.”
4. Nature and degree of control
Workers are more likely independent contractors if they are unsupervised, can set their own schedules, can work for others, and can negotiate their pay rates.
5. Extent to which the work performed is an integral part of the potential employer’s business
Workers are more likely independent contractors if their work is not “critical, necessary, or central” to the employer’s business.
6. Skill and initiative
Workers are more likely independent contractors if they pair “specialized skills” with “business-like initiative” to market their services to other clients.
It is important to remember that the new “economic reality” test only governs whether workers are employees or independent contractors for purposes of the Fair Labor Standards Act. The FLSA grants certain protections to employees, like minimum wage assurances and overtime pay. These protections do not apply to independent contractors. Moreover, the FLSA’s minimum wage and overtime pay protections do not apply to most executive, administrative, professional, outside sales, or computer professional employees. Many states have their own versions of the FLSA, or similar “wage and hour laws,” which may exempt different classes of employees or impose additional requirements on employers.
For payroll tax purposes, by contrast, the IRS continues to apply its traditional twenty-factor common law test to determine whether a worker is an employee who should be issued a W-2, or an independent contractor who should be issued a 1099. Some states, like Minnesota, also use the IRS’s twenty-factor test. But other states impose their own worker classification tests, such as California’s stringent “ABC” test or New Jersey’s “right to control” test.
Adding to the complexity, states use a wide variety of tests to determine whether a worker is an employee or an independent contractor for worker’s compensation and unemployment insurance purposes. For example, when determining eligibility for worker’s compensation, Illinois looks to whether the alleged employer had the “right to control” the worker. But Illinois applies the “ABC” test to unemployment insurance claims.
The ever-evolving maze of different legal standards imposes significant administrative burdens on employers seeking to remain compliant—especially in today’s remote-work world, where even small and mid-size businesses often have workers in multiple jurisdictions.
As always, preparation is half the battle. Consulting with a trusted advisor on the front end can help your business keep up to date with regulatory requirements and prepare you for an audit down the road.
