The Definition of Independent Contractor Is About To Change

How the proposed rule change affects employee classification

Back in October, the U.S. Department of Labor proposed a new rule that would greatly impact the way that companies relying on gig workers, like Uber or Lyft, do business.

If put into effect in 2023, the new proposal would reclassify workers that are “economically dependent” on a company so they’re considered employees instead of contractors, therefore entitling them to more benefits and legal protections. Unlike the 2021 IC Rule, this proposed rule considers economic factors that accumulate in an investment of work, which can include scheduling, supervision, price-setting and the ability to work for other employers. It also considers whether the work is integral to the employer’s business. 

The misclassification of workers as independent contractors has presented issues when it comes to workers rights. Employees are protected under federal labor standards and laws that prevent wage theft. The rise of gig economy work has shined a light on possible issues around the relationship between employers and those that work for them. 

What defines an independent contractor?

Currently, the Internal Revenue Service (IRS) defines who is considered an independent contractor and who is an employee. This definition predates the rise of the gig economy, which has enabled companies that rely on gig work to avoid extending benefits and perks like paid time off to workers, even if they perform gigs for the platforms on a full time basis.

As it stands, the IRS maintains the following employee classification rules that apply to contractors and employees:

“The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.”

Independent contractors are paid on an hourly or per-project basis and are not entitled to healthcare benefits, employee retirement benefits or labor protections under laws like the Fair Labor Standards Act (FLSA). However, the rise of the gig economy has created a class of worker that effectively works full time for a company but is still considered an independent contractor. The proposed rule would change that, availing these workers of benefits and labor protections under federal law.

The difference between independent contractors and employees

There are important differences between independent contractors and full-time employees, including how employers relate to these workers, how they are taxed, and the benefits and protections they are entitled to. Here’s a look at some of the biggest differences between contractors and employees.

Taxation

The IRS has developed clear guidelines on what constitutes an independent contractor versus an employee. 

For an independent contractor, the payer only controls the results of the hired work and doesn’t necessarily dictate how the work should be completed. The independent contractor completes an IRS Form W-9 and receives a 1099 form for reporting their income. 

Filing taxes as a freelance worker or independent contractor means you must pay the taxes you owe yourself, which includes income tax and the self-employment tax (your contributions to Social Security and Medicare). This process can be tricky, so it is important to research and plan ahead. 

For an employee, the payer is involved in all steps in the process, and federal and state taxes are taken out without any extra effort on the employee’s part. Any possible overpayment will lead to an employee getting a tax refund. Employees fill out the W-4 tax form.

Execution of work

Another difference between independent contractors and employees is how the work is completed. The DOL analyzes the type of work and the type of relationship that exists between employer and the worker to determine whether the worker is an independent contractor or an employee.

Independent contractors are self-employed, meaning their service is being paid for a limited time period or for a specific project. They supply their own work tools and must submit invoices to the employer to receive payment. Their work time is determined based on project status and agreed-upon deadlines, which do not tie them to employer schedules and possible benefits. 

Employees perform services controlled by an employer, including what work must be done and how it should be completed, even if that employee is granted autonomy in how to achieve the required result. Employers provide work-related tools and the necessary gear to complete the job. Employees typically fill out timecards to record hours worked, negating the need for monthly invoices. 

Payable benefits

Another key difference that highlights dependence versus independence is any benefits paid into by the employee and employer. An employee that is hired by a company may have access to benefits such as health insurance and employee retirement plans (usually in the form of a 401(k) plan that sometimes includes employer matching) or more personalized benefits like paid time off or educational resources (e.g., paid-for classes and certifications). The workplace may also offer indirect benefits like company parties, events or office refreshments.

Independent contractors typically don’t receive those benefits. There are ways to set up a retirement plan for yourself as a self-employed worker, including multiple IRA options. 

Employee protections

A crucial distinction between employee and independent contractor is the protections workers receive when employed by a company.

Employees are eligible for certain employment protections provided by the federal and state government. One of these provisions is the Family and Medical Leave Act, which allows eligible employees to take unpaid leave for specific family or medical reasons without the fear of being let go. Covered employees can get up to 12 weeks of work during any 12-month period, and up to 26 work weeks during a single 12-month period.

Employers are not legally required to provide employment protections to independent contractors, who can be let go at any time as long as that is in accordance with any agreement or contract the employer signed. Independent contractors are typically not entitled to unemployment insurance either.

A history of misclassifying employees and independent contractors

The Fair Labor Standards Act, which was passed originally in 1938, guaranteed a minimum wage, prohibited child labor laws, and granted overtime of “time-and-a-half pay” for anyone working over 40 hours in a single work week time. Since the act’s adoption, it has undergone many amendments and updates. The most recent was in 2007 to bring the federal minimum wage to $7.25 an hour by 2009. While the Fair Labor Standards Act sets guidelines for what constitutes an employee, it doesn’t clearly define independent contractors. 

In a 2009 report presented by the U.S. Government Accountability Office (GAO), the office cited a history of employee misclassification and possible tax revenue loss as a result. An example the report presents was the tax year of 1984, when the IRS estimated that a total of 3.4 million employees were misclassified, resulting in an estimated revenue loss of $1.6 billion, which equates to $4.47 billion when adjusted for inflation.

In the decades that followed, the IRS has been the driving force behind these issues. In addition to conducting general employment tax examinations, the agency focuses on identifying employers that may be misclassifying employees. Its Determination of Worker Status Program produced Form SS-8, which allows workers or employers to request that the IRS determine the tax nature of their specific work relationship as either an employee or an independent contractor. The Employment Tax Examination Program (ETEP) is a guide the IRS uses as a dedicated parameter to examine employers that have a high risk of misclassifying employees. 

Even with all these additions, the IRS is falling behind the problem. As the IRS dedicates more resources to sorting through the independent contractor issue, the use of independent contractors hasn’t stopped, and the rise of the gig economy has only exacerbated the issue. In 2021, Pew Research reported that 16% of Americans earned money from an online gig platform.

What are the consequences of misclassifying employees?

Misclassification of independent contractor status robs workers of potential financial benefits and only works in the favor of employers who are hoping to avoid those expenses. When an employer classifies workers as independent contractors, it avoids paying taxes, which includes unemployment insurance taxes. It also prevents workers from filing for workers’ compensation if they are injured on the job.

Misclassifying employees as independent contractors means employers aren’t paying as much in taxes, reducing revenue to the state and federal government and shifting the burden to the workers. That’s why the IRS is one of the primary agencies leading the charge against the misclassification of employees. 

How would the labor proposal affect employees?

With this new labor proposal, millions of workers could gain employee status.

The positives of being classified as an employee include better wage stability, overtime protections, and the possibility of receiving benefits like health insurance. It also avails workers of unemployment insurance if they lose their jobs.

The potential negatives include reduced flexibility in work schedules and less opportunity to work for multiple employers at once. Additionally, if the rule change is adopted, many companies may simply reduce their workforce to avoid shouldering such a large added expense, which means many may find themselves out of work rather than receiving the benefits of employee classification.

What would the rule change mean for employers?

The rule change could cost some companies millions of dollars in added expenses if adopted. For example, the number of drivers for ridesharing giant Uber increased by 31% globally last year. The company now employs 5 million drivers worldwide, 3 million of whom operate in the U.S. Those drivers are currently classified as independent contractors, but, if the rule change were adopted, many could become employees, leaving the company on the hook to provide benefits and set up a regulatory compliance program covering all of them.

Small businesses could end up feeling the greatest impact; many have increased their workforce by using independent contractors. In fact, independent contractor hires have significantly outpaced employee hires. The rule change may mean small businesses need to reconsider their business model and shift away from heavy reliance on independent contractors.

Impacts of the DOL classification rule change

The new labor proposal aimed to reduce misclassification of employees could affect more than 50 million Americans. Workers reclassified as employees who keep their jobs would receive more stable wages and better protections. However, many companies currently employing gig workers are expected to lay off most of their workers to avoid the additional expenses should the change occur. Overall, the rule change could be significant enough to dramatically alter the shape of the gig economy as we know it.