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The employer-employee relationship is being transformed by technology’s impact on business as witnessed by the soaring number of independent contractors. As a percentage of the total workforce it has doubled in the past 10 years to 12.9 percent. Unfortunately, employment classification laws in the United States have failed to keep pace. Government statistics show that 30 percent of companies intentionally or inadvertently misclassify and shortchange workers, making these employers subject to fines, class action lawsuits, and reputational damage. My research recommends that executives make one important change in hiring practices to reduce misclassification and legal jeopardy while securing fair treatment for workers.

Independent contractors are less expensive for companies to engage than traditional employees—sometimes by as much as 30 percent—because they are not counted against a company’s employment tax, the costs of providing health insurance, retirement plans and other benefits, liability insurance and worker’s compensation. However, lawsuits claiming that a business’ economic motivations lead to the inappropriate classification of workers as independent contractors have been filed by numerous gig-economy workers claiming they are really employees. The volume and success of these claims are likely to continue to increase: According to the U.S. Government Accountability Office, 80 percent of large U.S. corporations plan to increase their use of contingent workers at the level of 40 percent of total workers through 2020.

The primary test that managers use to distinguish between employees and independent contractors is the “right-to-control.” If the activities of the workers are controlled by a manager, then the workers are classified as employees, whereas workers are classified as independent contractors if they control their own activities. Other factors are also considered, including the control that the company exercises over the work; whether the worker is engaged in a distinct occupation or business; the skill required of the occupation; who provides the necessary supplies, tools, and the place of work; the length of employment; payment by time or by the job; and whether the work is regular business of the employer.

The growth in the number of independent contractors has greatly increased the legal vulnerability of the companies that engage their services. The designation of an independent contractor has historically been appropriate for entrepreneurial individuals with specialized skills that demanded higher pay on the open market. But recently the designation has been used by employers in home health care, janitorial services and restaurants, where the negotiating strength of individual workers is lower. The combination results in frequent misclassifications of workers as independent contractors when they are actually employees.

Approximately one in three businesses misclassify at least one worker, and the Department of Labor estimates that at least 10 percent of private-sector workers are misclassified. Overall, hundreds of thousands of businesses are exposed to liability claims for failure to comply with labor and tax laws, and hundreds of thousands of workers are being denied employment benefits and have become potential litigants.

Executives can make an important adjustment in their worker classification system to defend against charges that they mislabeled workers to deny them employee benefits that they properly deserve. Since businesses first classify workers and are then second-guessed by government agencies as to their accuracy, executives should consider adopting the most frequently used government system as their own basis for classification. This system is known as the ABC Test, and it has been adopted by 38 states in the United States.

The ABC Test distinguishes employees from independent contractors using three criteria.  The company must show: (A) that “the individual is free from control and direction in connection with the performance of the service,” (B) that “the service is performed outside the usual course of the business of the employer,” and, (C) that “the individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.” By applying the ABC Test as their approach to classifying workers, executives can improve the likelihood that the court system will recognize the legitimacy of the company’s efforts to abide by the law.

In the longer term, corporate employers in the United States should advocate for the modification of the traditional binary classification schemes to include a third category of workers—called dependent contractors—who depend on a single employer or easily identifiable group of employers for the bulk of their annual income. Workers with multiple sources of income would receive the independent contractor designation, while workers who are reliant on one or a few similar employers would be categorized as dependent contractors and would be eligible for many of the benefits provided to the firms’ employees.

As the use of independent contractors continues to expand, companies need to protect themselves against the costly fines, penalties and lawsuits that arise from employee misclassifications. Executives can reduce their firm’s exposure by relying on the factors outlined in the ABC Test, paired with the ability to classify a worker as a dependent contractor. I believe that adding this option will allow firms to hire a flexible workforce while expanding worker protections.

Dr. John A. Pearce II is the VSB endowed chair in strategic management and entrepreneurship at Villanova University. He is co-author of 42 books including “Strategic Management: Planning for Domestic & Global Competition,” 125 articles including 13 law review articles and 50 published business cases. Pearce is the editor for the Business Expert Press on two series: Strategic Management, and Corporate Governance. He is a frequent leader of executive development programs, an active consultant to business, and an experienced expert witness.  

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