Employee vs. independent contractor: The state of worker classification

Distinguishing employees from contract workers seems simple enough. The first group is listed on an employer's benefits payroll and the second group, well, isn't. But that distinction isn't enough under the Fair Labor Standards Act — or the IRS, for that matter.

The basis of what employers need to know

The FLSA gives employers and workers a 6-point list of considerations to help determine the difference:

If the work performed is an integral part of the employer's business, the worker is likely an employee.
If workers' managerial skills present opportunities for profit or loss, they're probably employees.
If an employer and worker invest in the employer’s facilities and equipment, the worker is most likely an independent contractor.
If the work performed requires special abilities and initiative, it could be a toss-up.
If the relationship between employer and worker is relatively permanent, the worker is likely an employee.
If the employer exercises or retains much control over a worker, the latter is likely an employee.

The IRS has an extensive 20-point checklist for classifying workers that can be boiled down to three points:

Behavioral: Do business owners control or have the right to control what workers do and how they do their jobs?
Financial: Are the business aspects of workers' jobs controlled by the business owner (including how workers are paid, whether expenses are reimbursed and who provides tools, supplies, etc.)?
Type of Relationship: Are there written contracts or employee type benefits such as pensions, insurance or vacation pay? Is the work performed a key aspect of the business? Will the relationship continue?

FLSA and IRS considerations can leave employers perplexed, but some differences are unquestionably clear:

Employers pay employees a net wage after withholding income tax, Social Security and Medicare tax under the Federal Insurance Contributions Act (FICA). Independent contractors aren’t subject to tax or FICA withholdings, but pay their own self-employment taxes.
State and federal wage and hour laws covering overtime pay and minimum wages protect employees. These laws don’t cover independent contractors.
Employees typically receive healthcare benefits, vacation pay, pensions, workers' compensation or other employee perquisites, and might be eligible for unemployment compensation. Independent contractors aren’t entitled to these benefits.
Workplace safety and anti-discrimination laws protect employees. Independent contractors aren't typically protected by these laws.
Employees may join or form a union at their employer's place of business. Independent contractors may not.

Enter the "gig" economy

Congress passed FLSA in 1938 when most workers were on a company's payroll. Today, a growing number of workers are independent contractors and include freelancers, temporary workers and consultants. With on-demand companies, including transportation services like Uber and Lyft, independent workers make up the "gig" economy.

The late Dan Mabry Lacey, labor-market expert, predicted a massive change in the U.S. workforce in his 1988 book, Paycheck Disruption: Finding success in the Workplace of the 90's. He wrote that workers wouldn't be able to depend on traditional 9-to-5 employment in the near future and therefore must find independent ways of making a living.

Studies show that that's already happening. In a Randstad U.S. survey, 70% of workers and 68% of employers think the "gig" economy will dominate the workforce by 2025. Employers are hiring more independent contractors than ever before to stay productive while cutting costs. And workers are opting for more flexibility and control over their jobs.

Is classifying workers still relevant?

Employers and workers know change has already occurred. Why don't lawmakers? Jack Schaedel, a Los Angeles attorney with the Dykema law firm, cites paternalism as a possible root of some of the problem. The government still thinks it knows better than citizens what's best for them, he says. It continues classifying workers on the side of employees because independent workers don’t always pay taxes. And no tax payments mean revenue losses for the IRS.

Another problem lies in the law. Schaedel says California law requires employers to prove a worker isn't an independent contractor. Misclassification can cost a business between $5,000 and $25,000 per violation, plus penalties for not writing contracts for independent workers or tracking their hours.

Technology has changed the way work gets done, so shouldn't the law reflect that? Ravin Jesuthasan, managing director at Willis Towers Watson and co-author of Lead the Work (2015) with John Boudreaux, says that artificial intelligence and robotics could eliminate some full- and part-time positions, but also create a more flexible, highly compensated pool of independent workers.

"Companies have discovered that they can get the work done in less than 1/6th of the time by hiring independent workers," says Jesuthasan. Through job reconstruction, he says employers can divide a traditional position into three components and hire three specialists to work more efficiently and cost-effectively on each part.

Also, the FLSA doesn't seem to be in touch with what independent workers want. Some have had trouble getting full- or part-time work, but many chose to be independent workers for the flexibility and control over their careers. A major drawback is that important employment-law protections aren't extended to them.

Redefining "independent contractor"

Schaedel says the law needs to redefine "independent contractor" to give employers more hiring flexibility without penalty and independent workers some important protections. He says employers could agree to split benefits with independent contractors.

"Employers must decide how much control over independent workers they're willing to give up," says Schaedel.

Jesuthasan agrees that antiquated laws must go. He says employers can take advantage of the technology, especially artificial intelligence and robotics, to control costs and bring on the highly skilled specialists that are needed to do the job.

Will lawmakers update or overturn the mandates on classifying workers?

Schaedel and Jesuthasan agree that employers will need to wait and see what will happen under the Trump administration. Schaedel says the new Labor Department secretary nominee, Alex Acosta, if affirmed, will likely roll back some of the Obama administration's mandates on worker classification.