The Paradoxical Consequences of the Employee–Contractor Designation

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A proposed rule may expand platform workers’ compensation options but not their access to other benefits.

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The U.S. gig economy, fueled by platform workers, including Uber drivers and Instacart shoppers, contributes more than $1 trillion to the U.S. economy. Last November, the U.S. Securities and Exchange Commission (SEC) proposed a rule that could pave the way for these platform workers—commonly known as gig workers—to receive equity compensation just like employees and other categories of independent contractors.

If the SEC issues its proposed rule, such a change would allow platform workers to profit from growth in business just as traditional freelancers, such as consultants and advisors, have for some time. Ironically, the flexibility in the proposed rule that would allow company stock awards to nonemployees would not apply to benefits that may be of greater value to platform workers—for example, participation in traditional employer-sponsored retirement plans. Compensation in the form of company stock would not trigger employee status for platform workers.

Even if the proposed rule were issued by the SEC, a company that provides other employee benefits to nonemployees could incur fines and penalties from the Internal Revenue Service (IRS) and the U.S. Department of Labor.

But if the SEC’s proposed rule were coupled with the lifting of the classification restriction for certain benefits, such as an employer-sponsored 401(k) plan, businesses could offer a combination of stock compensation and access to a company retirement plan to nonemployees—making platform workers truly better off.

Although it may be sensible to give platform workers the same equity opportunities available to other contractors, the United States’ system of employee-independent contractor classification is not designed to work holistically in the interest of platform workers.

The grant of equity compensation to platform workers presents an opportunity to modernize how the employment system operates in providing both workers and companies with more input in negotiating workplace benefits while preserving the flexibility that both parties value. To do so, regulators must achieve a balance between pushing companies to pay proper taxes and providing incentives for companies to make benefits, such as retirement plans, available to platform workers.

The proposed rule would make amendments that are consistent with the compensatory purposes of Rule 701, which exempts certain sales of securities made to compensate consultants and advisors. Under the proposed rule, employers would have to treat platform workers similarly to these types of workers. Platform workers, however, would be subject to stricter percentage and dollar amount constraints concerning the equity compensation that they receive, as compared to other independent contractors. Arguably, these limits are in place to protect platform workers from capital raising and other purposes incompatible with the rule’s purpose.

Another stark difference between platform workers and the other groups that would be impacted by the proposed rule is the ability to negotiate the terms of the equity compensation—platform workers would be explicitly prevented from individually bargaining for the amount and terms of any securities issued.

The irony is that it is in the interest of many platform workers to be diversified in terms of retirement investments. Indeed, it is better for workers not to rely on the stock of the companies they work for because their human capital is already tied to their company. If a company’s stock value declines, both jobs and investments are in jeopardy.

Employee stock is easier to provide than access to a 401(k) plan because some compensatory stock awards are not tax-deferred, so they do not trigger employee classification issues. By contrast, when employers try to offer traditional employer-sponsored benefits, such as access to a 401(k) plan, they are hindered by labor laws and run into legal issues surrounding employee classification.

Because 401(k) plans are governed by the Employment Retirement Income Security Act, an employer would violate the exclusive benefit rule if it offered independent contractors access to its 401(k) plan. The exclusive benefit rule requires that plans be maintained and operated for the exclusive benefit and in the best interest of a company’s employees.

By providing coverage to nonemployees, such as platform workers, a plan sponsor violates this rule and becomes liable for civil penalties. These penalties can be significant—even exceeding the coverage of taxes owed to the government as a result of the misclassification. Noncompliance with the rule could also lead to the 401(k) plan becoming non-qualified and losing its tax-deferred status altogether. Although the IRS provides self-correcting options that enable the employer to preserve the plan’s tax-favored status, these options are obviously not practical to rely on for broadscale inclusion of contractors into retirement plans.

Modernization of the employee-independent contractor classification is fundamental, and the scope of such reforms should consider how companies use workplace benefits to attract and retain talent.

Currently, employers are restricted to making a wholesale choice when it comes to offering, or not offering, benefits. What if there were no misclassification penalties for employees and contractors, but rather the employer was simply responsible for working with the employee or contractor to ensure that the correct taxes are paid in a timely way?

Is it reasonable, provided that the government receives accurate data on each individual’s employee or contractor status, to subject employers to IRS misclassification penalties when permitting a nonemployee access to its 401(k)?

These penalties can be significant depending on the wages of the employee and the timing of the delay in determining the misclassification. Instead of having a reactive policy, why not report upfront whether an individual is an employee or a contractor, allow participation in retirement plans, and collect the appropriate taxes?

Without these penalties, businesses could offer—or even be required to offer—benefits such as participation in retirement plans if using stock compensation. In this way, those receiving company stock have the ability to diversify into other assets through the company.

Rather than penalizing and providing strong disincentives for companies to treat platform workers well, employers should have the ability to use different workplace perks to recruit traditional contractors and platform workers just as they do with employees—not just stock compensation but access to a reliable retirement plan. Employers could compete for nonemployees with benefits, giving these platform workers more leverage and negotiating power; such changes would empower individuals far more than the current proposed rule.

If the SEC decides to move forward with the proposed rule, we believe that the Commission should work with the IRS and the Labor Department to make companion changes so that the net effect is empowerment for platform workers, rather than financially limiting them to receive only highly undiversified investments.

Jasmin Sethi

Jasmin Sethi is the CEO of Sethi Clarity Advisers.

Megan Gallagher

Megan Gallagher is a student at Brooklyn Law School.