More than 60 million Americans work in it – over 40% of the American workforce. But Congress and the IRS consider it an existential threat. California and a handful of other states want to shut much of it down.
We’re referring, of course, to the “gig economy” and the millions of “gig workers” who generate income from it. These workers are engaged in almost every conceivable income-producing activity, from ridesharing or food delivery to renting out a spare room in their home on Airbnb.
The gig economy has huge benefits both for businesses and gig workers. Businesses benefit because unlike employees, gig workers are business associates. Absent a contractual obligation between both parties, a business can end that relationship at their sole discretion. In addition, businesses that use gig workers need not withhold income tax, Medicare tax, or Social Security tax when paying them. Businesses also have no responsibility to pay health insurance premiums or offer other fringe benefits to gig workers.
Gig workers benefit as well. They work for as many or as few businesses as they want and set their own hours. In many cases, they make more money as gig workers than as employees. And since they can deduct business-related expenses from their income, they often pay lower taxes.
Gig workers have a tax classification as “independent contractors.” And there’s a long history of IRS antipathy against them. The agency considers independent contractors to be a threat to the tax withholding system. (Withholding of taxes from employee paychecks was introduced as an “emergency measure” in 1943; it remains law nearly 80 years later.)
Uncle Sam’s main objection to the gig economy is that unlike employees, gig workers don’t prepay their taxes. As early as 1979, the General Accounting Office (GAO) concluded that noncompliance among independent contractors was serious enough to warrant some form of tax withholding on payments to them. In 1984, the IRS estimated that 15% of employers – 756,000 businesses – misclassified 3.4 million workers as independent contractors. From 1988 through 1995, the IRS did 12,983 Employment Tax Examination Program audits, recommending $830 million in taxes and reclassifying 527,000 workers.
The internet turbocharged the gig economy through networks like Airbnb, Lyft, Uber, DoorDash, etc. Its growth only intensified IRS antipathy toward independent contractors. In 2014, the IRS estimated that the Treasury lost $54 billion annually due to “employment tax noncompliance.”
The IRS has numerous tools available to discourage businesses from using independent contractors. If your business misclassifies someone who should be paid as an employee as a gig worker, the agency can force it to pay any taxes the worker should have paid, but didn’t. It can also penalize your business 1.5% of wages, 40% of unwithheld FICA (Social Security and Medicare taxes), and 100% of the matching FICA taxes the employer should have paid.
State tax authorities are beginning to crack down on the gig economy as well. Legislation that came into effect in California in 2020, known as “AB5” or the “gig worker bill,” forces companies to reclassify independent contractors as employees unless they satisfy a three-prong test (the “ABC test”):
Workers are free to perform services without the control or direction of the company.
Workers are performing work tasks that are outside the usual course of the company’s business activities.
Workers are customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
The new requirements generated a huge amount of pushback from businesses and gig workers alike. The California Truckers Association (CTA) sued the state in federal court to prevent the law from reclassifying truck drivers as employees. A federal district court agreed with them, but that ruling was overturned on appeal. But the injunction granted by the district court remains in place for now and the CTA has petitioned the Supreme Court for a final decision.
Publishers began requiring freelancers who cover California to live elsewhere or lose their livelihood. The American Society of Journalists and Authors and the National Press Photographers Association also sued the state when hundreds of them lost their livelihoods as the companies who once used their services turned to out-of-state copywriters and photographers.
In November 2020, California voters overwhelmingly approved a ballot initiative, Proposition 22, to exempt both ridesharing and delivery companies from the AB5 requirements. However, last August, a California court ruled that parts of Proposition 22 were unconstitutional, and the measure was unenforceable. Ridesharing companies Uber and Lyft have appealed the decision and for now, Proposition 22 remains in effect.
Federal law requires businesses who use independent contractors to report “non-employee compensation” that exceeds $600 per year on Form 1099-NEC. Until 2021, third-party payment networks like PayPal, Zelle, or Venmo were required to issue Form 1099-K when someone engaged in more than 200 transactions on the network or were paid $20,000 or more per year. But the American Rescue Plan, which Congress passed last March also reduced that threshold to $600.
Clearly, we haven’t seen the last of federal and state challenges to independent contractors or the businesses that use them. If you’re an independent contractor, make certain you understand the rules that apply to you, including the requirement to report and pay tax on payments not reported on Form 1099 or other income statements. There’s a good guide to get started at this link.
Finally, if you own a business that uses independent contractors, the IRS has numerous resources available to determine if you should reclassify them as employees. A good place to start is the agency’s “Independent Contractor (Self-Employed) or Employee?” page.