‘Economic reality’ check: worker classification issues in the US

Laura D Smolowe

Akin Gump Strauss Hauer & Feld LLP, Los Angeles

lsmolowe@akingump.com

Juliette E West

Akin Gump Strauss Hauer & Feld LLP, Los Angeles

jwest@akingump.com

Introduction

In 2024, a federal judge in California observed that ‘[d]rawing the line between “employee” and “independent contractor” is a difficult task, with significant consequences for workers and businesses, that has long vexed courts and lawmakers across the country’.[1] Labour and employment attorneys keeping pace with this ever-changing area of law may also count themselves among the vexed. To help explain why this area of law has frustrated so many for so long, this article provides an overview of the concept of worker classification, discusses its significance to various stakeholders and identifies several recent inflection points in the debate regarding independent contractor status in the US.

Misclassification defined

In the US, employers must ‘classify’ – that is, categorise – each worker as either an employee or an independent contractor. In doing so, they must follow both federal and state classification rules. If a state rule is more favourable to employee classification than the federal rule, the state rule still applies. In other words, if a worker qualifies as an independent contractor under the federal rule but as an employee under the state rule, the employer must nonetheless treat them as an employee.

Misclassification occurs when an employer improperly designates an employee as an independent contractor. Such conduct may result in a variety of state and federal penalties: the US Department of Labor (DOL) may impose back wages, civil penalties and pursue criminal prosecution under the Fair Labor Standards Act (FLSA),[2] while the Internal Revenue Service may demand back taxes and assess fines and fraud penalties. Depending on where an employer is located, the extent of the violation and whether the misclassification is deemed intentional, state-level penalties may also include retroactive benefit payments, state tax liability with interest, significant fines that can reach thousands of dollars per violation, criminal charges and, in the event of a lawsuit, potential settlement or litigation costs.[3] Virginia, Minnesota and Vermont also recognise a private cause of action for misclassification, and California allows workers who believe they have been misclassified to bring a representative claim on behalf of the state and similarly situated individuals via the Private Attorneys General Act (PAGA). If a worker prevails under PAGA, he or she can collect 35 per cent of the employer’s civil penalty payout in addition to obtaining attorneys’ fees, litigation costs and injunctive relief.

Worker classification affects a range of stakeholders beyond the worker. For employers, it determines whether they must provide minimum wage, overtime pay and certain employee benefits. For federal and state governments, it affects tax revenue as well as demand for public services and publicly funded healthcare. Employees generally generate more tax revenue than independent contractors because both the employee and the employer contribute employment-related taxes. Classification also affects workers’ access to unemployment insurance and employer-sponsored health care, which are seldom available to independent contractors.

Employee or independent contractor?

Most American workers are employees,[4] meaning an employer controls how, when and where they work. Employees are covered by the FLSA, which mandates a federal minimum wage, overtime pay, child labour protections and carries recordkeeping requirements. Under separate federal and state laws, an employee may be eligible for certain additional benefits, including unemployment insurance, workers’ compensation, union and bargaining rights and paid sick and family leave. Certain states, such as California and New Jersey, have adopted particularly robust employee protections, including expansive anti-discrimination protections,[5] requirements regarding so-called ‘stay-or-pay’ agreements,[6] protections during mass layoffs,[7] ‘know your rights’ obligations,[8] expanded family leave,[9] leave for victims of violence or abuse[10] and wage and promotion transparency.[11]

While employees work at the direction of an employer, independent contractors are in business for themselves and control the manner of their work. They decide their own hours, use their own tools and set the terms of their projects. Because independent contractors fall outside the FLSA, they are generally not eligible for minimum wage or overtime pay. Independent contractors are often not eligible for unemployment insurance and workers’ compensation, must pay their own self-employment taxes and are typically compensated by the hour or by project.

Fluctuations in federal guidance

It is settled law that a worker must be classified according to the ‘economic reality’ of his or her actual working relationship with his or her employer, rather than title alone. But how to interpret that economic reality is the subject of substantial debate. Prior to the Obama administration, federal court decisions applying what is known as the ‘economic reality test’ provided the primary guidance regarding worker classification.[12] But since the Obama administration, each presidential administration’s DOL has recalibrated the federal guidance regarding independent contractor classification. It is important to note that changes to DOL guidance do not alter what protections the FLSA affords employees, but rather who meets the criteria to access them.

In the last decade, the federal government has seesawed between broad, multi-factor tests that favour employee status and narrow, streamlined tests that facilitate independent contractor designation. In 2015, Obama’s DOL issued Administrator’s Interpretation No 2015-1, which interpreted the FLSA’s definition of ‘employ’ broadly and stated that ‘most workers are employees under the FLSA’.[13] The interpretation introduced a six-factor worker classification test where no single factor was dispositive. Under this test, even if one factor was indicative of independent contractor status, the five other factors could still tip the scales toward employee status. Two years later, President Trump’s DOL reversed course, announcing that it would immediately withdraw the expansive Obama-era guidance. In 2021, shortly before President Biden took office, the Trump DOL finalised a more restrictive independent contractor rule that replaced the six factors with just two ‘core’ factors: control and opportunity for profit or loss. In elevating control and opportunity for profit or loss above the three secondary factors identified in the new rule, this approach arguably made it easier to classify workers as independent contractors. Biden delayed and eventually rescinded Trump’s rule, which had not yet gone into effect by the time he took office. Biden then revived the holistic six-factor balancing approach, only for the DOL to issue, during Trump’s second term, a Notice of Proposed Rulemaking proposing an iteration of the earlier two-factor test. Comments to the rule closed in April 2026, and, as of writing, the rule has not been implemented.

The role of the gig economy in the classification debate

With the advent of the ‘gig economy’, rideshare drivers and food delivery couriers quickly became the public faces of the classification debate. The matter of how to classify gig workers was not easily resolved and resulted in an ongoing and costly push-and-pull among workers, employers and government.

Federal regulators initially signaled that many gig workers could be properly classified as independent contractors. In 2019, before it issued its new classification rule, the Trump DOL published an advisory Opinion Letter[14] stating that it considered gig economy workers who source work via platforms to be independent contractors. As it did with the two-factor test, the Biden DOL withdrew that letter in 2021 without issuing a replacement. The Trump DOL reinstated the 2019 Opinion Letter verbatim in 2025.[15]

States soon endeavoured to answer the gig worker question for themselves. California – arguably the epicentre of the gig economy – was at the forefront of this effort. In 2018, the California Supreme Court adopted the employee-friendly ‘ABC test’[16] for measuring independent contractor status in Dynamex Operations West Inc v Superior Court.[17] The California Legislature codified that test through Assembly Bill (AB) 5, which went into effect on 1 January 2020.[18] A few years later, the Court of Appeals for the Ninth Circuit rejected a challenge to AB 5 in Olson v California.[19] There, the plaintiffs unsuccessfully argued that the law unconstitutionally singled out ‘network companies’ – that is, companies such as Uber and Postmates that connect consumers with drivers for ride-hailing or delivery services – for disfavoured treatment. The US Supreme Court denied certiorari in Olson in 2024. Soon thereafter, rideshare and delivery companies sponsored a California ballot measure called Proposition (‘Prop’) 22, which legally classified app-based ride-share and delivery drivers as independent contractors. Prop 22 passed, but because AB 5 remains the law in California, Prop 22 operates as an exemption for specific app-based workers. In 2024, the California Supreme Court rejected a challenge to Prop 22.[20] Most recently, California Governor, Gavin Newsom, signed AB 1340, effective January 2026, which preserves independent contractor status for rideshare drivers but grants them certain rights regarding unionisation and collective bargaining. While these rights relate to the National Labor Relations Act (NLRA), not the FLSA, AB 1340 is notable because independent contractors are typically exempt from the NLRA.

Other states that use the ABC test, including Massachusetts and New Jersey, followed in California’s footsteps. In 2020, Massachusetts brought a lawsuit challenging rideshare companies’ classification of their drivers that resulted in a $175m settlement.[21] Under the terms of the settlement, Uber and Lyft abandoned a proposed ballot initiative to classify app-based drivers as independent contractors and agreed, among other things, to provide drivers with guaranteed paid sick leave and a health insurance stipend, and to make them eligible for occupational accident insurance. Similarly, New Jersey’s DOL reached a $100m misclassification settlement with Uber in 2022[22] and a $19.4m misclassification settlement with Lyft in 2025.[23] Both settlements required the rideshare companies to pay into the state’s unemployment trust fund. Some states, however, moved in the opposite direction: Florida and Texas, for instance, codified laws classifying rideshare and delivery platform workers as independent contractors.[24]

AI and worker classification: unanswered questions

Executive orders and laws at the intersection of artificial intelligence and labour have recently proliferated throughout the US. California, for example, has adopted regulations regarding the use of AI in hiring,[25] ordered a review of AI’s impact on the workforce,[26] and now regulates the use of AI for consequential hiring and firing decisions.[27] Connecticut,[28] Colorado,[29] Illinois[30] and New York City[31] have likewise taken measures to regulate employer use of AI in consequential employment decisions such as hiring and firing. At the federal level, the proposed AI-Related Jobs Clarity Act[32] would require reporting on AI’s impact on the American workforce. Yet despite this growing body of regulation, neither state nor federal authorities have addressed how AI may affect worker-classification analyses.[33] The omission is notable because AI is already reshaping the workplace in a variety of ways, including automating certain employment decisions, training and managing workers, supporting research and administrative tasks and even assisting in the task of worker classification. If past is prologue, this paradigm-shifting technology may factor into the worker classification debate. It remains to be seen precisely how.