August 25, 2020 Practice Point

Employment Classification in an App-Based Nation

By Jennifer D. Thayer, Amye M. Melton, and David R. Grimmett, Austin Peay State University, Clarksville, TN

I. Introduction

The hundred-year-old term ‘gig’ has had a recent resurgence describing a quasi-new economy. The so-called “gig economy” is the aggregate of markets in which workers providing services work on a job-to-job basis: they are not considered an employee of the company that owns the app but are instead classified as independent contractors. The IRS uses the general rule “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.” The gig worker must be willing to participate as a temporary, contract or freelance worker. Zero-hour contracts and forced self-employment are other gig-economy characteristics. In a Mavenlink market study of 300 executives, 79% considered the gig worker key to the on-demand workforce used to establish a competitive advantage.

The 2020 COVID-19 economic uncertainty will likely make contract employees even more attractive to owners and managers. Managers constantly seek ways to cut costs and labor is typically on the short list. The flexibility of gig workers makes them especially attractive to multi-state organizations. Contract workers generally cost businesses less in payroll taxes and benefits, since independent contractors obtain none of the labor law benefits and must assume work-related costs as well as insurance, taxes, and retirement. Classification as independent contractors can be beneficial to both workers and businesses, but misclassification can be harmful both to the individual worker and in creating an unfair competitive advantage for the business over competitors that properly classify similar workers as employees. As positions are created or vacated during the pandemic, managers may choose to hire independent contractors at least until markets stabilize.

Nonetheless, employment classification is changing, and managers can no longer rely solely on federal labor laws to determine classification. The IRS has moved to a stricter standard, and since 2018 states have begun implementing stricter labor law employment classification standards that are intended to provide better protection to workers and to ensure that companies pay their fair share of payroll taxes. A significant factor in this change is the Uber ruling which set a precedence of state law differing from federal law. The differences can impact multistate organizations and how they classify workers, so both workers and companies need to be aware of the legal ramifications.

II. Worker Classification Tests

Technology advancements have created the opportunities for increasing the number of gig workers. Technology apps allow gig workers to be on the move, no longer relegated to one location or even one employer. App-based employment has thus contributed to the growth of the gig economy. As the use of app-based workers becomes more popular, companies will need to clearly identify the difference between an independent contractor and an employee—i.e., determining what defines someone as an employee or as an independent contractor, freelancer or temporary employee. The IRS, court cases, and state laws have attempted to answer these questions, with sometimes conflicting results.

A. The IRS Three-Pronged Test

In 2020, the IRS added a webpage called the Gig Economy Tax Center to assist gig workers and gig employers to answer these questions. In addition, IRS Publication 15-A is a 2020 supplement to the agency’s “Employer’s Tax Guide” that includes guidance to assist employers in determining the status of their workers. The federal determination is significant, since employers are required to withhold federal income taxes, withhold and pay over Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In contrast, businesses generally do not have to withhold or pay over any federal taxes on payments to independent contractors. That distinction is one of the reasons that gig employers want to claim that their workers are independent contractors rather than employees—the savings on thousands of workers across the country is a significant addition to the companies’ bottom line (and a cost to the workers).

Section 2 of the publication, titled “Employee or Independent Contractor,” sets out the key differences between those two worker categories and provides illustrative examples from various occupations. The publication sets out three “categories” of facts (sometimes called a ‘three-pronged test”) that provide evidence of the degree of control that the employer has as compared to the independence of the worker. The three categories are behavioral control (“whether the business has a right to direct and control how the worker does the task for which the worker is hired”), financial control (“whether the business has a right to control the business aspects of the worker’s job”) and type of relationship (shown by written contracts, benefits, permanency and whether those worker services are a key aspect of the company’s regular business activity). Examples provided cover building and construction, trucking, computer programming, automobile sales and repairs, legal services, taxicab drivers, and salespersons.

B. The Common Law Test

Prior to the development of the three-pronged test outlined above, the IRS used a 20-factor test to classify workers as independent contractors or employees. Its switch to the current “three-pronged test” aligned with common law rules. The terms ‘three-pronged test’ and ‘common law test’ are often used interchangeably. This test is applied in 16 states: AL, AZ, DC, FL, IA, KY, MI, MN, MO, MS, NC, ND, NY, SC, SD, TX.

As noted from the IRS publication, behavioral control, financial control, and the relationship between the parties are the three categories examined under the common-law rules. Behavioral control analyzes the level of control the employer has on directing and determining how the worker does the task. Controlling the worker’s performance includes instructions given to the worker; training provided to the worker; direction on when and where to do the work; tools to use; where to purchase supplies or services to complete the work; and the order in which the work must be completed.

Financial control considers the level of control the employer has over the economic aspects of the business by looking at items such as whether the worker has unreimbursed business expenses; if the worker has an investment in the facilities or tools being used; if the worker can pursue and complete other work in the relevant market; and if the worker can realize a profit or loss.

When examining the relationship under the third category, it is less likely an independent contractor relationship exists if the business provides the worker with employee-type benefits, such as paid sick and vacation days, insurance, or a retirement plan.

A recent Tax Court case, Donald T. and Marlene B. Robinson v. Comm’r (affirmed in a 2012 non-precedential opinion by the Court of Appeals for the Third Circuit), considered the question of employee or independent contractor in the case of a vocational instructor for Temple University, which treated him as an employee for tax purposes during the years at issue. Donald T. Robinson was employed as a full-time professor at Rowan University, but he also taught classes and created a curriculum for training programs provided at Temple under a contract with the state. Temple managed the enrollment in the classes, provided classroom space, and paid Robinson an hourly rate for teaching and flat rate for development of the curriculum as instructed, so Robinson had no risk of loss or opportunity for a profit in excess of his agreed-upon compensation. Robinson reported his income as an independent contractor. Using the three-pronged test, the IRS concluded Robinson was an adjunct professor and, as such, classified him as an employee as opposed to an independent contractor.

C. The ABC Test

A slightly different ABC test applies in 27 states: AK, AR, CA, CT, DE, GA, HI, IL, IN, KS, LA, MA, MD, ME, NE, NH, NJ, NM, NV, OH, OR, RI, TN, UT, VT, WA,WV. It places the burden of proof on the employer. Under the ABC test, the default classification of a worker is as an employee. A worker is treated as an independent contractor only if the worker satisfies each of the following factors: (a) the worker has complete control regarding work performance both by contract and in fact; (b) the work is performed outside the usual course of the hiring entity’s business; and (c) the worker has an independent business that customarily conducts the type of work being contracted. The ABC test is thus considered the most stringent of the tests for qualifying a worker as an independent contractor, which may explain why many states have adopted it.

The California Supreme Court provided a landmark decision in the Dynamex case in 2018 when it concluded that the ABC test should be applied when determining whether workers should be classified as employees or independent contractors for purposes of California wage orders that apply obligations relating to minimum wages, maximum hours, and certain limited basic working conditions such as meal and rest breaks for California employees. The case involved delivery drivers who alleged that the national package and document delivery company had inappropriately misclassified its delivery drivers as independent contractors, though it had classified them as employees prior to 2004. The court considered the “suffer or permit to work” definition of employee in the California wage order and applied the ABC test as the standard for distinguishing employees from independent contractors, noting that the worker will be classified as an employee unless the hiring entity can establish each of the three required factors.

This [ABC] standard, whose objective is to create a simpler, clearer test for determining whether the worker is an employee or an independent contractor, presumes a worker hired by an entity is an employee and places the burden on the hirer to establish that the worker is an independent contractor.

Additionally, the court suggested the second and third factors may be examined first, before the “free from control” factor because the “outside the usual course of business” factor and the “engaged in an independently established trade” factor may be easier to determine.

Since the ruling in the Dynamex case, California Assembly Bill 5 was enacted in September 2019 and became effective January 1, 2020. AB5 codified and extended the ABC test to all wage and hour Labor Code violations, unemployment insurance, and workers’ compensation. Its enactment forces app-based companies such as Uber and Lyft to treat workers as employees under California law. The list of exemptions to Assembly Bill 5 make it apparent that the bill was passed with app-based businesses at the forefront of considerations.

With Dynamex and the codification (and expansion) of the ABC test for independent contractor status in California, California businesses that treat some workers as independent contractors may need to review their relationship under the ABC test to determine whether there is a need to reclassify those workers as employees. While this only directly affects California businesses, other states may well follow suit, including New Jersey, Oregon, Washington and New York. In late 2019, New Jersey’s Department of Labor and Workforce Development demanded Uber pay back taxes and interest for $649 million on unpaid unemployment and disability insurance from the misclassification of its drivers over a four-year period. The Massachusetts legislature had earlier passed a statute adopting the ABC test to clarify the classification status of employees versus independent contractors.

SB Nation, a sports broadcasting company owned by Vox Media, announced plans to terminate the contracts of its independent contractors with the passage of Assembly Bill 5 and re-staff with full-time employees. Other app-run businesses like Postmates are refusing to comply with the new California law. Part C of the ABC test is the most contentious, since it requires the worker to be engaged in an independently established trade, occupation, or business of the same nature as the work performed for the business at issue. Consider a person who signs up to be an Uber driver who likely did not have an established business as a driver before signing up with Uber. This factor clearly limits the ability of Uber to treat the driver as an independent contractor in California even though they can likely do so in Arizona. Uber, Lyft and other large gig companies are pushing back in these states by working with lawmakers and labor unions with the hope to gain some type of exception or new class of worker. California has a vote coming up in November that would exclude app-based drivers from Assembly Bill 5. The gig companies are also filing lawsuits to challenge these types of state laws in federal court.

D. The A&C Variant of the ABC Test

Another 8 states—CO, ID, MT, OK, PA, VA, WI, WY—have chosen to use a modified version of the ABC test. Parts A and C remain the same, but Part B is disregarded. Where the work takes place is no longer a consideration. Multistate organizations may find these states friendlier for their operations. In these states, the worker would be classified as an independent contractor under these terms:

  • the worker has control or could set the direction in connection with the completion of the service, and
  • the individual conducts an independent business of similar work.

III. Practice Points for Business Owners

A. For Senior Level Executives

Executives will need to understand the differences in employment classification standards when considering whether to continue or open businesses in various locations. Organizations with business strategies dependent on contract employees may want to avoid states that go beyond the IRS’s common law test. On the other hand, it may be preferable to recognize the high cost to Uber in New Jersey: companies may choose to withhold payroll taxes and pay unemployment and disability insurance as they go to avoid paying penalties and taxes later. This choice also may provide a more stable workforce, as employees earn enough to remain in the position.

B. For Management and Human Resources Practitioners

Those responsible for human resource policies will need to pay special attention to state statutes and cases outlining worker classification requirements. State law governs classification more than federal guidelines. If the state allows independent contractor classification for app-based workers, then practitioners should be prepared to issue a 1099-MISC to these workers for amounts of $600 or more paid to them. On the other hand, businesses must ensure that appropriate payroll taxes are remitted to state and federal governments for W-2 workers.

To assist practitioners in appropriately categorizing workers, the following map reflects state use of the ABC or Common Law test.

State Use of the ABC or Common Law Test

State Use of the ABC or Common Law Test

C. Considerations for Management, Human Resources, and Accounting Practitioners

An organization without a high-risk tolerance for litigation will want to err on the side that benefits the worker. If your organization chooses to continue the practice of hiring independent contractors, it would be prudent to ensure at a minimum that the worker has a business license. The business license will provide some evidence of the existence of an independent established business. Other recommendations include ensuring that such workers have a home office, set their own hours, have some opportunity for earning a profit or incurring losses because of their investment, and maintain the ability to compete.

Two businesses providing the same service can have different tax obligations. For example, a company with more independent contractors will gain a competitive advantage over a similar business that treats its workers as employees because of lower taxes, resulting in a higher bottom line. The higher bottom line is the main reason that managers prefer to use independent contractors. An example of the different tax obligations can be found in Figure 1, which shows a $10,000 difference on $60,000 of compensation. States that are addressing the issue are attempting to even the playing field among businesses, protect workers, and generate state tax revenues.

Figure 1
Employer/Employee Scenario
Independent Contractor Scenario
  Owner/Employer
  Owner
Compensation Paid1
$ 60,000
Contract compensation Paid1
$ 60,000
FICA Taxes2
$ 4,590
   
FUTA Tax3
$ 420
   
Employer Portion - Avg Health Ins4
$ 5,477
  $ -
Cost in Tax & Benefits
$ 10,487
Cost in Tax & Benefits
$ -
Total Employer Costs
 $ 70,487
Total Employer Costs
$ 60,000
In the employer/employee scenario, the total cost of one employee to the employer is $70,487. The employer has total payroll taxes of $5,010. The cost to the employer of additional benefits (health insurance) is $5,477. In the Independent Contractor Scenario, the business owner would not have any tax or benefits costs so the only cost to the business owner would be the $60,000 for the contract.
1. November 2017 average weekly salary for Professional and Business Services is $1,150.51. Based on a 52 work-week year, this rounds to an annual salary of $60,000.
2. FICA taxes are 7.65% for both the employee and employer. This includes a 6.2% Social Security tax and a 1.45% Medicare tax.
3. FUTA tax is the employer responsibility on the first $7,000 of each employees’ wages.
4. Average health insurance is based on information provided by the Department of Health and Human Services.

A multi-state corporation will need to consider how its workers will be treated in each state. If the company is in California and Arizona, it would use two different rules to assign employment classification status since California uses the strict ABC test and Arizona uses the Common Law test.

IV. Conclusion

Research is replete with information about changing workplaces and the unclear lines separating employment classifications. So long as the states and the federal government lack a universal standard for worker classification, uncertainty will persist. The likely push to hire more contractors when businesses rehire following the pandemic may cause a resurgence of the gig economy and the independent contractor classification of its workers, with lasting effects on the labor market, workers, competition, and the overall economy. The classification controversy at this point is focused primarily on app-based businesses. Because of the workers’ interests and states’ need for increased revenues following the revenue losses during the pandemic, it is possible that states will generally decide to expand the use of the ABC test to treat more workers as employees. 

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