The DOL Wage and Hour Division recently released a new rule changing how workers are classified under the Fair Labor Standards Act (“FLSA”) (“Final Rule”). The Final Rule replaces DOL’s 2021 final regulation and provides a more comprehensive test for determining a worker’s status that may make it harder to classify workers as independent contractors for FLSA purposes. The Final Rule goes into effect on March 11, 2024 and applies only to FLSA wage and hour requirements. Therefore, it does not currently impact the rules relating to retirement or health and welfare benefits, since those are generally governed by ERISA and the Internal Revenue Code (“Code”). The definition of who is an “employee” under ERISA and the Code does not track the definition of “employee” for purposes of the FLSA.
However, confusion over the new rule and its scope may cause workers and their advisors to make claims for benefits. Thus, it is important for employers to be aware of the Final Rule, and anticipate how worker classification under the FLSA could potentially impact employee benefits.
“Employee” Under the FLSA
Under the Final Rule, whether a worker is an “employee” hinges on whether the worker is “economically dependent” on the employer when considering the “totality of the circumstances.” The DOL primarily looks at six factors when applying this test: (1) opportunity for profit or loss depending on managerial skill; (2) investments by the worker and the potential employer; (3) the degree of permanence of the work relationship; (4) the nature and degree of control; (5) the extent to which the work performed is an integral part of the potential employer’s business; and (6) the worker’s skill and initiative. However, the DOL makes clear that these factors are not exhaustive, and any single factor is not determinative. This new test thus broadens the definition of an employee under the FLSA, so employers might find independent contractors, who would not be employees under the “common law” test, now classified as employees for FSLA purposes.
“Common Law Employee” Under the Code and ERISA
The IRS’ general position on the common law employment test is set forth in three substantially similar Department of Treasury regulations at Treas. Reg. §§ 31.3121(d)-1(c), 31.3231(b)-1(a)(2), 31.3306(i)-1(b), and 31.3401(c)-1(b). Those rules provide that the legal relationship of employer and employee exists “when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.” They also provide that the determination is fact-specific. In IRS Rev. Rul. 87-41, the IRS set forth a 20-factor test that could be used to determine whether sufficient control was present to establish an employer-employee relationship. However, in subsequent guidance, the IRS clarified that the 20-factor test was intended to be an analytical tool for determining whether the employer has the right to direct and control the means and details of the work, as opposed to a new legal standard.
Notably, the United States Supreme Court in National Mutual Insurance Co v. Darden, 503 U.S. 318, 323 (1992) explicitly adopted the common law test for determining who is an “employee” for purposes of ERISA and set forth its own 13-factor test. Therefore, a determination of whether a particular individual is an employee will be based on whether the employer has the right to “control and direct” the worker for Code purposes, with the 13-part test under Darden applicable to the extent ERISA applies.
When workers are reclassified as employees, the possibility arises that they could become entitled to numerous employee benefits. This issue presented itself in the mid-90’s when a group of freelance workers joined a class action against Microsoft. In response, many plans adopted so-called “Microsoft inoculation” language, which is language that expressly prohibits reclassified workers from retroactive entitlement to plan benefits. If a retirement or welfare plan does not have this language in place, employers may find that they are required to grant retroactive benefits to newly reclassified employees.
Other potential impacts are:
The main impact on retirement plans could be an increase in eligible retirement plan participants, particularly if the eligibility rules in the plan are not crafted to exclude reclassified employees. This could further expand the number of employees who are entitled to make contributions to employers’ 401(k) plans, or result in more workers claiming “employee” status under the Code and ERISA rules.
The DOL’s change to FLSA employee classification comes on the heels of legislative expansion of employee access to retirement benefit plans, such as SECURE and SECURE 2.0, which significantly expanded the number of employees who are eligible to make employee deferrals into 401(k) plans. “Long-term part-time” employees now have greater access to employers’ retirement plans. Under SECURE 1.0, for plan years beginning after January 1, 2024, employees who work a minimum of 500 hours for three consecutive 12-month periods are eligible to make deferrals. SECURE 2.0 changed that period from three years to two, effective for plan years after January 1, 2025. The IRS recently issued important proposed guidance and instructive examples on these “long term-part time” worker rules. See our alert here.
With a potential influx of participants, plans that previously qualified under the small plan exception to independent qualified public accountant (“IQPA”) requirements could be over the 100 participant threshold. These plans are subject to additional reporting requirements and must be audited by an independent auditor.
The main potential health plan impact on employers would be the employer mandate and reporting requirements. Employers are “applicable large employers” subject to the employer mandate rules if they employed 50 or more full-time and full-time equivalent employees in the prior calendar year. The employer mandate rules generally require that applicable large employers offer health coverage that is affordable and provides minimum value to their full-time employees or potentially be subject to penalties. And, applicable large employers must annually report to the IRS and full-time employees information about the offer of health coverage. A change to the definition of “employee” under the Code could result in more employers becoming subject to the employer mandate rules and affiliated reporting requirements and applicable large employers potentially subject to penalties for a broader group of employees, some of whom they historically have not offered coverage.
The Final Rule is a significant development for employers, and while retirement and health plans are not directly impacted, it could prompt changes in practices or give rise to claims under the Code and ERISA. Also, many businesses are seeking creative strategies for providing benefits to workers when it is not always clear if those workers are “employees” for purposes of the different federal and state laws—so it is critical to be able to understand and navigate the differing legal standards that may apply.
If you have questions about these issues, please don’t hesitate to reach out to any of the authors or other Groom attorneys.
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