What’s the difference between an employee and an independent contractor (IC)? Trying to make this determination has been an ongoing battle on both the state and federal level. With the rise of the gig economy, this issue has become even more difficult. California, for example, is at the forefront of a legal battle over how Uber and Lyft drivers should be classified, and the U.S. Department of Labor (DOL) is reconsidering its worker classification system.
Independent Contractor vs. Employee—Why It Matters
The DOL and the Internal Revenue Service (IRS) consider the IC vs. employee issue a “misclassification” problem, meaning that employees are being misclassified as contractors. State and federal laws and the federal courts assume that the worker is an employee; if the employer incorrectly classifies the worker as an IC, the worker loses the benefits due to employees.
Businesses tend to classify workers as ICs because they are cheaper (no benefits to pay) and the relationship can be broken more easily.
Major Issues With Misclassification of Workers as Independent Contractors
- They aren’t covered for minimum wages, overtime, retirement benefits, and other labor law protections.
- They aren’t usually eligible for unemployment insurance or workers compensation.
- They aren’t covered under anti-discrimination, OSHA, and other employment laws.
- They must pay their own self-employment tax (Social Security/Medicare). (Note: As an IC, you can deduct half of the total when figuring your adjusted gross income, but you can still count the full amount for benefit purposes.)
Businesses that misclassify workers as ICs instead of employees can be subject to fines, penalties, repayment of employment taxes, and imprisonment by federal or state agencies.
On the other hand, some workers, like ride-sharing drivers, enjoy the freedom of being self-employed, choosing where and when they work, and deducting expenses to reduce their taxes.
Federal Laws and Regulations for Independent Contractors
The IRS considers ICs as separate businesses in a contractual relationship with a hiring company. IRS regulations follow a set of common law rules (behavioral, financial, and type of relationship) in making a determination on worker classification for tax purposes.
The DOL, meanwhile, sets rules for determining worker classification for the purpose of benefits and work rules. These rules don’t use the common law test used by the IRS. In 2019, the DOL issued an opinion letter stating that workers employed by a “virtual marketplace” company (including transportation and delivery services) are ICs, not employees.
In September, 2020, the DOL announced a proposed “economic reality” test to determine whether a worker is an employee or IC. The test has two core factors:
- The nature and degree of the worker’s control over the work
- The worker’s opportunity for profit or loss based on initiative and/or investment
It also looks at several other factors, including:
- The amount of skill required for the work
- The permanence of the working relationship between employer and employee
- Whether the work is part of an integrated unit of production
State Laws and Regulations for Independent Contractors
Workers can be considered employees under state law even if they are not considered employees under federal law, and several states have more strict definitions for ICs.
The ABC test considers a worker to be an employee unless all of the three criteria are satisfied:
A: The worker is free from control and direction of the hiring entity
B: The worker performs work outside the entity’s usual course of business
C: The worker is customarily engaged in an independent trade, occupation, or business of the same nature as the work performed for the hiring entity
As of October 2019, 33 states had implemented the ABC test or a slight variation of it. Check with your state’s labor department for information on its test for classifying workers.
Classification of Ride-Hailing Drivers
Ever since ride sharing became more prevalent in the late 2000s, states have been dealing with issues of driver classification, and the increase in unemployment has escalated the argument. App-based ride-sharing companies like Uber, Lyft, and Doordash have maintained that drivers are self-employed ICs.
The classification issue has been playing out in various regulations and lawsuits in recent years.
In April 2019, the National Labor Relations Board (NLRB) ruled that Uber drivers are ICs and they are not protected under the National Labor Relations Act (meaning, they can’t form unions).
In July 2020, Uber drivers and the New York Taxi Workers Alliance successfully sued New York state and city officials for failing to pay unemployment benefits. The New York Department of Labor had previously determined that the drivers were employees of Uber for those benefits.
California, meanwhile, has been engaged in legal battles with Uber, Lyft, and other app-based rideshare companies over the status of their drivers. Effective January 1, 2020, California Assembly Bill (AB) 5 made the ABC test officially part of state law (it was previously part of a court case). The ride-sharing companies refused to comply with the law (AB5), and a California Superior Court judge ruled in August 2020 that “ride-hailing drivers” of Uber and Lyft couldn’t be classified as ICs.
The companies retaliated by putting a referendum, Proposition 22, on the Nov. 3, 2020 ballot. The proposition, which was ultimately approved by California voters, allows app-based transportation (rideshare) and delivery drivers to be defined as ICs in California.
Proposition 22 is an exception to the ABC test for a specific type of worker, and only in California; all other classifications of workers in California must comply with the provisions of AB5.
Other states have addressed this issue in different ways:
- Florida classifies ride-sharing drivers as ICs.
- Oregon classifies these drivers as employees.
- The Pennsylvania Supreme Court has ruled that an Uber driver should be considered an employee.
- Massachusetts filed a lawsuit in July 2020 against Uber and Lyft, seeking a court ruling that these drivers are employees under the state’s wage and hour laws.
Independent Contractor Laws May Vary
To make things more complex, different federal agencies and states have different criteria for ICs for different types of situations. For example, someone can be classified as an IC for labor law (Fair Labor Standards Act) purposes, but be classified differently for tax and state law purposes.
If there’s a conflict between federal and state law, you must comply with the law that applies a stricter standard for ICs and is more protective of workers’ rights.
In addition, each situation is judged on a case-by-case basis. The U.S. Supreme Court has indicated that it’s the “total activity or situation which controls,” and state and appellate courts also may rule differently in specific situations.
Independent contractor laws and regulations are changing, due in part to the increase in remote workers, drivers, and unemployment benefit issues. If you aren’t sure if your workers are classified correctly, discuss your situation with your attorney, or get a ruling from federal and state entities.