The DOL’s New “Economic Realities” Test to Determine Employee Status: ERISA Considerations for Benefit Plan Sponsors

The Department of Labor (DOL) Wage and Hour Division issued final regulations, effective March 11, 2024, which are intended to serve as a practical guide to employers on how the DOL determines whether a worker is an employee or independent contractor under the Fair Labor Standards Act (FLSA) [29 CFR part 795]. This new guidance may impact employee classification under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), because the federal law is premised upon the existence of the employee-employer relationship [29 USC §1001]. ERISA governs the operation and administration of covered health and welfare and pension benefit plans by imposing minimum coverage and vesting requirements as well as heightened fiduciary responsibility for plan sponsors. It requires reasonable claims procedures and gives participants the rights necessary to enforce their benefit entitlement under ERISA covered plans.

ERISA defines “employee” as an individual employed by an employer, language which provides inadequate guidance to employers in the administration of their ERISA covered employee benefit plans [29 USC §1002(6)]. For this reason, plan sponsors often rely upon federal common law to determine whether a worker qualifies as an employee and is therefore eligible to participate in employer-sponsored employee benefit plans. Employee status is also central to determining whether an arrangement is actually subject to ERISA. Although the new rules are intended to provide worker classification guidance for purposes of minimum wage and overtime pay eligibility under the FLSA, plan sponsors are encouraged to use the guidance as a resource when analyzing a worker’s employee or independent contractor status under ERISA.

Economic Realities Test

The new regulations articulate an “economic realities” test to determine employee versus independent contractor status, a test based on the worker’s entire working relationship with the employer. If the economic realities demonstrate that the worker is economically dependent on the employer for work, then the worker is an employee. If the economic realities show that the worker is in business for herself, then the worker is an independent contractor. The following facts and circumstances are required to be considered in making the foregoing assessments, with the totality of the circumstances being determinative.

• Opportunity for profit or loss depending on managerial skill, which considers whether a worker can earn profits or suffer losses through their own independent effort and decision making. Relevant facts include whether the worker negotiates their pay, decides to accept or decline work, hires their own workers, purchases material and equipment, or engages in other efforts to expand a business or secure more work [29 CFR part 795.110(b)(1)];
• Investments by the worker and the employer, which examines whether the worker makes investments that are capital or entrepreneurial in nature. Investments by a worker that support the growth of a business, including by increasing the number of clients, reducing costs, extending market reach, or increasing sales, weigh in favor of independent contractor status. A lack of such capital or entrepreneurial investments weighs in favor of employee status [29 CFR part 795.110(b)(2)];
• Permanence of the work relationship, which considers the nature and length of the work relationship. The regulations provide that work that is sporadic or project-based with a fixed ending date (or regularly occurring fixed periods of work), where the worker may make a business decision to take on multiple different jobs, indicates independent contractor status. Employee status may be present when the work is continuous, does not have a fixed ending date, or may be the worker’s only work relationship [29 CFR part 795.110(b)(3)];
• Nature and degree of control, which takes into consideration factors that demonstrate the potential employer’s level of control of the worker’s performance of services and the economic aspects of the relationship, including:

o Hiring, firing, scheduling, pricing, or pay rates;

o Supervision of the performance of the work (including via technological means);

o Whether the worker has the right to supervise or discipline other workers; and

o Whether the potential employer has the right to take actions that limit the worker’s ability to work for others [29 CFR part 795.110(b)(4)];

• Whether the work performed is integral to the employer’s business, which examines whether the work is critical, necessary, or central to the potential employer’s principal business, which would indicate employee status. This factor weighs in favor of independent contractor status if the work performed by the worker is not critical, necessary, or central to the potential employer’s principal business [29 CFR part 795.110(b)(5)]; and
• Skill and initiative, which considers whether the worker uses their own specialized skills together with business planning and effort to perform the work and support or grow a business. The absence of the need for a worker to use specialized skills (for example, the worker relies on the employer to provide training for the job) indicates that the worker is an employee. Both employees and independent contractors can be skilled. Accordingly, this factor focuses on whether the worker uses their skills in connection with business initiatives, which would indicate independent contractor rather than employee status [29 CFR part 795.110(b)(6)].

A worker’s status as an employee versus an independent contractor under the new FLSA guidance is a purely functional test. None of the following is determinative of a worker’s status:

• The assignment of a label by an employer;
• The existence of a worker’s employment or independent contractor agreement; or
• The manner in which a worker is paid.

ERISA Considerations

The identification of employees and independent contractors is critical in not only determining ERISA coverage, but also in connection with employee benefit plan regulatory compliance. The following points reflect helpful guidance in this regard.

1. ERISA Coverage

Employee benefit plans subject to ERISA include both employee welfare and pension benefits plans, which are established and maintained by employers or employee organizations to provide benefits to participants and their beneficiaries. ERISA regulations provide that the term “employee benefit plan” does not include any plan, fund, or program, other than an apprenticeship or other training program, under which no employees are participants covered under the plan [29 CFR § 2510.3-3 (b)]. “Participants” are defined under ERISA, in part, to include any employee or former employee of an employer, who is or becomes eligible for benefits under an ERISA covered plan [29 USC § 1002(7)]. Accordingly, an employer- employee relationship must exist as a precondition to an arrangement being subject to ERISA. As indicated above, the definition of employee under ERISA lacks substance [29 USC §1002(6)]. Furthermore, the ERISA regulations define an employee by exclusion, indicating that the term employee does include an individual with respect to a trade or business owned by the individual or their spouse or a partner in a partnership, which is not helpful for making determinations outside those individuals listed [29 CFR § 2510.3-3 (c)].

Due to the absence of statutory guidance in defining employee under ERISA, plan sponsors have often defaulted to the definition of employee under the Internal Revenue Code of 1986, as amended, which defines an employee as an individual who performs services for the employer as a common law employee [26 CFR § 1.410(b)-9]. The common law employee test is articulated in the Nationwide Mutual Ins. Co. v. Darden decision, and it has been criticized as producing inconclusive results, especially in light of the prevalence of remote workers [503 U.S. 318 (1992)]. The use of the new economic realities test to determine the existence of an employee-employer relationship may simplify the analysis for plan sponsors and provide a more definitive classification.

2. Participation Eligibility

ERISA requires that every plan be established and maintained pursuant to a written instrument which identifies the fiduciaries with the authority to interpret the plan [29 USC §1102]. Plan fiduciaries are required to administer a plan pursuant to its terms, which requires that plan fiduciaries interpret operative terms that govern plan participation eligibility [29 USC 1104(a)(1)(D)]. An employer’s workforce may include independent contractors and employees. However, participation eligibility in employer-sponsored benefit plans is typically limited to employees. In designing employee benefits programs, defining, and properly classifying employees is therefore crucial, because an improper exclusion of an individual from benefit eligibility, based on an incorrect classification, can result in costly litigation and issues with the DOL and Internal Revenue Service (IRS). The plan document, which governs the operation and administration of the plan, should contain a clear definition of employee to ensure operation of the plan consistent with the plan document. Employers should also have a compliance program that considers worker classification. In the event a plan sponsor chooses to determine employee status based on the economic realities test, the plan document must be amended to reflect the factors referenced above.

3. Retirement Plans

ERISA requires that retirement plans annually file a Form 5500, Annual Return/Report of Employee Benefit Plan (“Form 5500”) with the DOL and IRS. The form summarizes the operation of the plan for the plan year [29 USC §1023]. Form 5500 is required to be filed annually without regard to the number of participants in the plan, but the employee count determines whether the plan must be audited by an independent qualified public accountant. Retirement plans with 100 or more participants are subject to this requirement, with the report accompanying the Form 5500 filing [29 USC § 1023(a)(3)(C)]. Additionally, if the number of participants reported on Form 5500 is between 80 and 120, and a Form 5500 was filed for the prior plan year, an employer may elect to complete the Form 5500 in the same category (‘‘large plan’’ or ‘‘small plan’’) as was filed in the prior Form 5500 filing [29 CFR §2520.103,1(d)]. Accordingly, the number of employees with account balances must be calculated to determine whether the audited financial statement is required.

4. Health Plans

As with retirement plans, ERISA covered health plans are subject to a Form 5500 filing obligation depending upon the size of the plan. Health plans with fewer than 100 participants at the beginning of the plan year, whether self-funded or fully-insured, are exempt from the Form 5500 filing requirement [29 CFR §2520.104-20]. The proper classification of employees, who are then extended participation eligibility, indirectly determines the compliance obligation.

Conclusion

Due to the absence of a meaningful definition of employee under ERISA, the economic realities test is a good alternative for plan sponsors to use in their analysis and classification of employee status. As indicated above, the existence of the employee-employer relationship in connection with employee benefit plans determines both ERISA coverage and certain compliance obligations. If the economic realities test is going to be used in the design and administration of the benefit arrangements they sponsor, plan sponsors must update their plan documents to reflect their definition of employee, using the economic realities test, as defined by the new DOL guidance.