How Are Independent Contractors Classified in the US? The Final Ruling

The US Department of Labour has issued a final ruling on how independent contractors are classified. This comes in the wake of much incoherence and confusion, with high-profile lawsuits like Uber’s case in California. The new law will come into effect on March 8th, 2021.

Generally speaking, an independent contractor is economically independent and does not rely on an employer for work. How and whether a country defines contractors at all varies considerably - there is no ‘one size fits all’ solution.

Under the Fair Labor Standards Act (FLSA), the revised regulation defines the status of US-based independent contractors according to a 5-factor test. This will determine whether an individual in a working relationship with another person or entity is really a contractor or an employee.

The purpose of the ruling is to ensure certainty for stakeholders and to reduce lawsuits. Much of it continues with the language of the FLSA from the 20th century. On the one hand, the regulation provides clarity, but this may have its limits. Compliance will continue to be an issue for companies hiring independent contractors. Here we lay down what to expect from the new FLSA regulation and how you can stay compliant.

An Independent Contractor Is NOT an Employee

An independent contractor is categorically different from an employee. However, an independent contractor is not clearly defined in the FLSA, though definitions are given for employees and employers. An independent contractor is therefore defined in relation to an employee. This is fairly standard but it will become more clear once you understand the term ‘economic reality’.

‘Economic Reality’

The economic reality of a person refers to their economic dependence on or independence in relation to an employer. The new regulation specifies what is meant by the idea ‘economic reality’. Previously, this was very vague. Unlike an employee, a contractor is not economically dependent on one employer for work and as their primary source of income. 

The law describes that contractors are doing work for their own business, rather than for somebody else’s (i.e. an employer). Specifically, rather than being defined as wage earners, who are dependent on others to give them work in order to survive, contractors are rather classified as entrepreneurs who make work opportunities for themselves.

The 5-Factor Test:

To help determine the economic reality of an individual, the US Department of Labor has initiated a 5-factor test. The first two are the most important.

1. The Nature & Degree of Individual’s control over their work

‍A contractor, while not having sole control over the work done, has substantial control over their own work performance. This includes things like setting one’s own schedule, choosing one’s own assignments, working without supervision, and working for other clients, including competitors.

2. The “Opportunity for Profit or Loss”

‍A person is classified as an independent contractor if they have opportunity for profit or loss based on either or 1 of 2 factors: (a) the exercise of personal initiative (business acumen, networking, management) and (b) investments (such as in employees, an office, equipment).

3. Skill Required

‍An independent contractor is somebody who requires specialised skills or training to complete their work. These skills or training are NOT provided by the employer. If they are provided by an employer, then the individual will be classified as an employee.

4. Permanence of Working Relationship

The new regulation understands permanence quite literally and does not consider the exclusivity of the employment relationship. Instead, a person is classified as an independent contractor if the relationship to the employer is sporadic or limited to a specific time period. A continuous and indefinite working relationship would lead to a person being classified as an employee.

5. Integration in the Business

The new regulation uses the original idea of a production line as a guiding image. If a person’s work is dependent on a wider production process, this means they will be classified as an employee. A production process means different people are working together towards a combined purpose and their work is interrelated. On the other hand, a person is classified as an independent contractor if their work can be done without depending on the employer’s production process.

While this test is very similar to the way that independent contractors are generally assessed around the world, it provides clarity regarding the particular legal language used in the FLSA. Some countries, such as Argentina, don’t or rarely recognise independent contractors, so contracting is largely avoided altogether. In the US, independent contracting is very much a practice and this test is meant to make the legal status of contractors more clear.

The Myth of Contracting

Despite trying to make the legal language more clear, the Department of Labor’s new regulation cannot definitively resolve the issue of classification. There will still be room for contestations. 

If you are hiring contractors in the US, this could put your company at risk of non-compliance. While hiring contractors is often considered cheaper and less of a bureaucratic hassle, being caught up in legal battles regarding this relationship can be enormously expensive and lengthy. A remote contractor can also trigger Permanent Establishment (PE) risk for you, depending on the kind of work they are doing for you. So it is not a guarantee and actually leaves you open to a lot of unnecessary risk.