THE BLOG
07/30/2015 01:44 pm ET Updated Jul 29, 2016

As the "Gig Economy" Hits the Headlines, What Does it Mean for Small Businesses?

In June, Uber, the ridesharing company that rose to fame and fortune by calling its drivers independent contractors instead of employees, lost a landmark case when the California Labor Commission ruled that a former Uber driver was indeed an employee, not an independent contractor, and ordered Uber to pay the driver $4,152.20 in costs.

That's seat-cushion change for Uber, whose $50 billion valuation makes it the most highly valued private tech company ever, but the ruling raises the specter of immense tax and benefits costs for Uber in years ahead. Some say it puts the future of the company in doubt.

Then, in July, in her first major speech on her economic platform, Hillary Clinton took aim at the on-demand economy, vowing to crack down on "bosses misclassifying workers as contractors."

Most recently, in what many see as a major blow to the on-demand or so-called gig-economy, Homejoy, a cleaning services startup, shut down entirely because of lawsuits over whether its workers should be classified as employees or independent contractors.

IRS beefs up scrutiny of contractors
If you own a small business, chances are good you have hired and still do hire independent contractors. So is this the time to worry? No. The time to worry was when you opened your doors--this is an age-old issue for small-business owners.

But this is the time to start worrying more. Tax experts say the IRS is placing new emphasis on the distinction between employees and self-employed independent contractors.

"We're expecting that there will be greater scrutiny by the IRS of the independent contractor/employee distinction," Jeffrey Saviano, a tax specialist at Ernst & Young, told the New York Times earlier this year. "The stakes are higher for companies and the government because of the implementation of the ACA and the employer mandate taking effect in 2015."

The Affordable Care Act requires that companies with 50 or more full-time employees must offer affordable health coverage to those employees and their dependents, which can increase their costs significantly. Not surprisingly, more than a few small-business owners with 50 or more full-time employees are reclassifying some of them as self-employed contractors to avoid the ACA mandate. Thus the increased scrutiny of the independent contractor/employee distinction by the IRS.

Of course, there are other, long-standing reasons why small-business owners seek to fudge the distinction between contractor and employee. Employees get benefits. They get 50 percent of Social Security and Medicare taxes paid by their employer. They get unemployment insurance and workers' comp insurance. Contractors do not. Besides which, contractors are easier to fire, they don't attach a liability risk to the employer and they don't make overtime.

The temptation to classify workers as independent contractors is powerful. A U.S. Department of Labor study several years ago found 30 percent of employers misclassify workers. But the back taxes, interest and penalties you face if your contractors are reclassified as employees by the government can be crushing. Penalties are based not on the number of misclassified employees but on your entire payroll.

There are stiff penalties for misclassification
It is essential to get classification right. But this is far easier said than done. There is often a very fine line between employee and independent contractor. And, whatever you decide, you're not the final arbiter. The IRS is--and the IRS often disagrees with classifications made by employers.

Tya Bolton is the owner of a small business called Exceptional Business Solutions, a business and event-management agency in Washington, D.C. Last year she wrote an article about her experience hiring independent contractors for the Washington Post titled "Small Business, Big Mistake: Classifying Employees as Independent Contractors."

Her strategy, as owner of a young business, was to hire only contractors until she could get firmly established. So far so good. Then, upon completion of a project, a contractor she no longer needed filed for unemployment benefits. Although Bolton had a signed work agreement with that contractor, approved by an attorney, she received a notice from the Maryland Department of Labor, Licensing and Regulation that she would be audited--for every person she'd ever hired.

You can guess where this is going. After its extensive audit, the Department of Labor decided that the contractor who'd filed for unemployment was indeed an employee--and so were three other contractors. Bolton was ordered to pay thousands of dollars in back taxes.

"I thought I had done my due diligence to develop an understanding of what constitutes an employee versus an independent contractor," she wrote. "Ultimately, though, reading through the Internal Revenue Service's checklist and trying to sort through my state's guidelines on my own didn't prove sufficient."

Bolton suggests calling the IRS to ask for guidance in the matter. You can also file IRS Form SS-8 to request a free determination of the status of a worker.

Or, if you can afford it, you can do what many small-business owners are doing and outsource work to a staffing agency. This is an expensive option but it does relieve you of making the contractor/employee determination. Outsourcing can also help you bring your staff under 50 full-time employees to avoid the ACA mandate.

Small businesses are hiring more contract workers each year. Spending on contract labor increased from 3.5 percent of business expenses at sole proprietorships in 2003 to 6.4 percent in 2011. This rise took place as spending on salaries and wages declined, which indicates that all growth in spending on labor at sole proprietorships these days is focused on contractors.

If you're a small-business owner, chances are you're hiring contractors as well. Just make sure they're not employees. Or else your business expenses could take an unexpected leap--courtesy of the IRS. If you are an entrepreneur and you are not sure if your contractors and employees are categorized correctly, you should check out this handy infographic from Xero partner ZenPayroll to get you started.