Employees vs. Independent Contractors and the Gig Economy: Understanding the Legal Implications

As an HR professional or small business owner, understanding the differences between employees and independent contractors is crucial for navigating legal compliance. Many hiring managers don’t think through the pluses and minuses of defining employees vs. contractors. Many just wing it and do what makes sense financially or allow a long-term project to extend indefinitely.  Moreover, in the post-COVID workforce, gig work is all the rage. 

The IRS website even defines the new gig economy as the following: “The gig economy—also called sharing economy or access economy—is the activity where people earn income providing on-demand work, services or goods. Often, it’s through a digital platform like an app or website.“   Gig economy tax center | Internal Revenue Service (irs.gov). And according to McKinsey’s 2022 American Opportunity Survey, a full 36 percent of employed respondents—roughly 58 million Americans—identify as independent workers. That’s a significant increase from 2016 when McKinsey research estimated that 27 percent of the workforce was independent. For this reason, employer audits, specifically about this topic, are on the rise, so it is important for employers to consider the definitions and details.

Employees are individuals who work for an employer and are subject to direct control and oversight, while independent contractors are self-employed individuals who provide services to multiple businesses under a contract with specific deliverables.

Classifying workers correctly is essential, as misclassification can have significant legal implications.  Employers must comply with various laws and regulations, including tax laws, wage and hour laws, and worker’s compensation laws, depending on the classification of their workers. Additionally, misclassification can lead to penalties, fines, and legal disputes with workers or government agencies. Why? Because the Department of Labor laws attempt to protect companies from knowingly or unknowingly taking advantage of employees by withholding benefits or skirting laws established to protect those classified as employees.  

By understanding these nuances, businesses can make informed decisions and mitigate potential legal liabilities.

Tax Implications of Classification

Classifying workers as either employees or contractors can have significant tax implications for businesses and individuals who may not understand their obligations to report income. The IRS specifically states, “Gig Economy Income is Taxable. You must report income earned from the gig economy on a tax return, even if the income is from part-time, temporary, or side work/not reported on an information return form — like a Form 1099-K, 1099-MISC, 1099-NEC, W-2, or other income statement/paid in any form, including cash, property, goods, or virtual currency.

Understanding these implications is essential for proper tax compliance and financial planning.

Tax Implications for Employees

• Payroll Taxes: Businesses are responsible for withholding and paying payroll taxes for employees, including Social Security and Medicare and other potential state taxes.
• Benefits: Employers may have additional tax obligations related to providing benefits such as health insurance, retirement plans, and paid time off.
• Income Tax: Employers must withhold federal and state income taxes from employee paychecks and file tax forms on their behalf.

Tax Implications for Independent Contractors

• Self-Employment Taxes: Independent contractors are responsible for paying self-employment taxes, which include Social Security and Medicare taxes.
• 1099 Forms: Employers must issue Form 1099 to contractors who earn more than $600 in a calendar year, reporting their income to the IRS.
• No Withholding: Employers are not required to withhold taxes from independent contractor payments, making it the contractor’s responsibility to pay taxes quarterly.

Consult with a tax professional or legal advisor to determine the correct classification for your workers.

Employee or Independent Contractor?

When it comes to determining how to classify a worker, there are several factors to consider to ensure compliance with labor laws and regulations.  

Things to Consider

1. Nature of the work: Is the worker providing services that are essential to the core business operations?  The closer the work is to the essential operations of the business, the more likely the individuals are employees. 

2. Control over work: Does the employer dictate how, when, and where the work is performed?  If the answer is yes, this individual is likely an employee. 

3. Relationship between parties: Is there an ongoing relationship, or is the work project-based? Independent contractors have work assigned that theoretically has a beginning and end. If the relationship with the employer is unspecified or open-ended, be sure to examine whether or not workers should be coded as permanent employees. 

4. Benefits and resources: Does the worker receive benefits or have access to company resources?  Has the employer distributed a company laptop or parking pass?  Has the worker been invited to off-site internal meetings like a quarterly kick-off?  The more the worker behaves or is included in benefits allotted for employees, the more likely they should be classified as such. The U.S. Department of Labor provides the following chart to help employers discern classifications: 

Compliance with Labor Laws and Regulations 

It is recommended that you consult an employment or labor attorney if you are debating employment classification, as there can be serious legal risks to missteps in this area.  According to ADP, “Both criminal penalties and liability for back wages may be levied against employers and executives found in violation of FLSA laws.” They go on to state that “This is an area of intense focus by the DOL, which has recently hired many new investigators to review wage compliance, which would include ensuring that employers are not improperly classifying workers as independent contractors.”

Explanation of Labor Laws and Regulations for Employees

Employees are entitled to various rights and protections under labor laws, such as minimum wage, overtime pay, workplace safety, and anti-discrimination laws. Employers are responsible for providing a safe work environment, complying with wage and hour laws, and ensuring that employees receive all benefits and protections they are entitled to.

Explanation of Labor Laws and Regulations for Contractors

Contractors, on the other hand, are considered independent workers and are not covered by the same labor laws and regulations as employees. They are responsible for managing their own taxes, insurance, and other financial obligations. Contractors are not eligible for benefits such as health insurance, retirement plans, or paid time off.

Tips for Ensuring Compliance

• Proper Classification: It is important to correctly classify workers as either employees or contractors to avoid legal issues. Consult with legal experts or HR professionals to ensure compliance.
• Contract Agreements: Clearly outline the terms of the contract, including payment terms, scope of work, and legal responsibilities, to avoid misunderstandings.
• Regular Internal Audits: Conduct regular audits of your workforce classification to ensure that all workers are properly classified and in compliance with labor laws.
• Training: Provide training for managers and staff on labor laws and regulations to ensure understanding and compliance in day-to-day operations.

Benefits and Drawbacks of Hiring Employees vs. Independent Contractors

Hiring Employees

Benefits:

• Greater control and supervision over work
• Potential for long-term commitment and loyalty and institutional knowledge that builds over time
• Ability to manage performance, skill development, and career advancement

Drawbacks:

• Higher costs for salaries, benefits, and taxes
• Added administrative responsibilities such as payroll and compliance
• Less agility and flexibility in adjusting workforce size based on changing business needs

Hiring Independent Contractors

Benefits:

• Potentially more cost-effective as contractors are responsible for their own taxes and benefits
• Flexibility in hiring for short-term projects or specialized skills
• Reduced administrative burden with less paperwork and compliance

Drawbacks:

• Less control over work quality and schedule
• Potential for lack of loyalty and commitment to the business
• Employees could view contractors as ‘outsiders’, which could limit teamwork potential
• Potential legal risks if misclassified as contractors instead of employees

Conclusion

HR professionals are encouraged to review and update their classification practices to ensure compliance and efficiency in their workforce management. Understanding the legal differences between employees and contractors is essential for compliance with labor laws and regulations, particularly while the trend toward gig work is increasing and penalties remain significant. There are pluses and minuses to hiring employees, contractors or gig workers. Examine the needs of your business and consider the tax implications of worker classification.  Choose carefully, as these decisions can impact your bottom line and your company’s legal responsibilities.

Sources:

9 Consequences of Misclassifying Your 1099 Contractors | SPARK Blog | ADP

Gig economy tax center | Internal Revenue Service (irs.gov)

What is the gig economy? | McKinsey