United States: Be Warned: Federal Guidance On Misclassification States That "Most Workers Are Employees," Not Independent Contractors

Last Updated: September 9 2015
Article by John E. Pueschel

On July 15, 2015, the United States Department of Labor ("DOL") released official guidance addressing the misclassification of employees as independent contractors. The guidance, Administrator's Interpretation No. 2015-1 ("AI 2015-1"), explains how the legal test for classifying workers as either employees or contractors will be interpreted by the DOL, and states that most workers are employees covered by the Fair Labor Standards Act ("FLSA"), which is the federal wage and hour law.

Strictly speaking, AI 2015-1 is not a new statute or regulation. Rather, it sets forth how the DOL will apply the FLSA and the "economic realities test" used to determine whether a worker is a contractor or employee under the law. The guidance makes clear that when the DOL considers the issue of classification in an enforcement action, employers will face a higher bar to establish that a worker should be treated as an independent contractor. In addition, because the guidance is an official pronouncement of the agency charged with administering and enforcing the FLSA, courts will give weight to the DOL's interpretation. To the extent that courts consider and defer to the guidance, defending such classifications in lawsuits will be more difficult.

What is Misclassification?

Generally speaking, workers are deemed to be either employees or independent contractors, and different legal rules apply to each class. Employees are subject to host of legal protections related to minimum wage and overtime pay, benefits, equal employment opportunity, on-the-job injuries and other issues. Likewise, businesses are obligated to pay certain state and federal taxes for their employees. On the other hand, workers who are contractors are considered independent of the business that engages them for work. As such, contractors lack the legal protections afforded to employees, and no employment or payroll taxes are paid for contractors.

There is an increasing focus by state and federal agencies, as well as by lawyers for workers who are treated as independent contractors, to challenge the classification of the contractors. In those challenges, the worker is alleged to have been misclassified as a contractor when in reality, the worker should have been classified as an employee. The exposure to the business for which he or she worked is often significant, in terms of claimed damages for unpaid wages, overtime pay, employment law violations, etc., as well as often substantial back-tax and penalty liabilities arising from the improper classification of the work for tax purposes. The largest risk is for companies that use large numbers of similarly situated workers classified as contractors. In those cases, a company may face the risk of a large, collective action suit that can imperil its entire business model.

The Economic Realities Test

The legal test to determine whether a worker is an employee or a contractor varies depending on the legal context, as there can be varying tests applied under tax law, employment law, workers' compensation law, etc., and those tests can be different from state to state. At bottom, the analysis typically turns on control, i.e., whether the worker is truly an independent agent who controls his or her own work (contractor), or whether the worker's service was controlled and directed by the business (employee).

Relevant to this discussion, AI 2015-1 starts with the proposition that under the FLSA, the definition of "employ" includes to "suffer or permit to work." The FLSA's "suffer or permit to work" standard is construed broadly, and brings within the coverage of the FLSA not only work that an employer directly requests or demands of an employee, but also work that the employer allows (i.e., suffers or permits) to be performed.

When analyzing whether there is an employment relationship under the FLSA, courts follow "the economic realities test." This test requires an analysis of all of the relevant factors concerning the work relationship. As AI 2015-1 notes, under the economic realities test, the factors include: "(A) the extent to which the work performed is an integral part of the employer's business; (B) the worker's opportunity for profit or loss depending on his or her managerial skill; (C) the extent of the relative investments of the employer and the worker; (D) whether the work performed requires special skills and initiative; (E) the permanency of the relationship; and (F) the degree of control exercised or retained by the employer." The test is a flexible one, judged on a case-by-case basis. While all of the factors are to be considered, none are determinative.

AI 2015-1

The DOL's interpretation announced in AI 2015-1 does not change the formulation of the economic realities test. However, as it explains how the factors under the test should be considered, AI 2015-1 makes clear that the DOL's interpretation will result in most workers being classified as employees under the FLSA. As AI 2015-1 states:

All of the factors must be considered in each case, and no one factor (particularly the control factor) is determinative of whether a worker is an employee. Moreover, the factors themselves should not be applied in a mechanical fashion, but with an understanding that the factors are indicators of the broader concept of economic dependence. Ultimately, the goal is not simply to tally which factors are met, but to determine whether the worker is economically dependent on the employer (and thus its employee) or is really in business for him or herself (and thus its independent contractor). The factors are a guide to make this ultimate determination of economic dependence or independence.

As the DOL applies the test, "a worker who is economically dependent on an employer is suffered or permitted to work by the employer." Accordingly, in the DOL's view, such workers fall within the FLSA's "suffer or permit to work" standard, and should thus be treated as employees.

What is perhaps dramatic, but certainly not unexpected to those who have been following the issue of misclassification, is the DOL's conclusion that in most cases, the economic realities test will demonstrate economic dependence (rather than independence). As the DOL directly states: "[A]pplying the economic realities test in view of the expansive definition of 'employ' under the Act, most workers are employees under the FLSA." Id. (emphasis added).

AI 2015-1 provides specific examples of workers in hypothetical cases and how the DOL says the cases should be analyzed under each of the six factors of the economic realities test. These examples demonstrate that many typical facts (at least in the DOL's view) necessarily weigh in favor of classification of workers as employees. Indeed, following the DOL's guidance on each factor of the test will, in most cases, make it very challenging to reach a conclusion other than the worker should be classified as an employee. In addition, it seems plain that AI 2015-1 will serve to assist workers and plaintiffs' attorneys with arguments and citations when bringing misclassification claims.

Unsurprisingly, reactions to the Administrator's Interpretation have varied, with businesses and industry groups expressing concern and workers and advocates expressing approval. For example, The Wall Street Journal reported that the National Association of Home Builders "blasted the new guidance as improperly introduced without public vetting and a boon to labor unions seeking to organize various industries." Melanie Trottman, Employees vs. Independent Contractors: U.S. Weighs In on Debate Over How to Classify Workers, Wall Street Journal, July 15, 2015. On the other hand, National Employment Law Project ("NELP") Executive Director Christine Owens praised the guidance, stating that it is "a wake-up reminder to companies playing fast and loose with labels and overusing 1099 hiring." NELP Commends U.S. Department of Labor's Independent Contractor Misclassification Guidance, NELP.org (July 15, 2015), http://nelp.org/news-releases/nelp-commends-u-s-department-of-labors-independent-contractor-misclassification-guidance/.

AI 2015-1 can be found in its entirety at http://www.dol.gov/whd/workers/Misclassification/AI-2015_1.htm.

Action Items

As we have been suggesting to businesses for some time, and as AI 2015-1 underscores, it is imperative for businesses who classify any workers as contractors to evaluate whether there is a risk of misclassification. The ideal time to address the issue (and correct any misclassification) is before the business is faced with a tax audit, DOL complaint or investigation, or a lawsuit. For businesses whose model is premised on contract labor, particularly those with many similarly situated workers, they must understand that the legal environment is a hostile one and take steps to ameliorate the risks to the extent possible. Dealing with these issues is never easy, but becomes exceedingly more difficult when trying to address them in the midst of a government investigation or a lawsuit

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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