Professor Alan Hyde

Rutgers University School of Law

Newark, New Jersey 07102-3192 USA

Self-employment is not a technical term of art for any US labor or employment statute. It is an important concept in the administration of the tax laws. In administering US labor or employment statutes, the question is normally whether an individual, being paid for services, is an "employee" or "independent contractor." All independent contractors are self-employed for purposes of the tax laws. The term self-employment is broader, however, as it includes people who are not paid specifically for rendering services, such as owners of small businesses.

It is important at the outset to understand that, under US tax law, classification as self-employed offers at least three significant advantages to the individual rendering services. First, income taxes are withheld from each paycheck of an employee, but are not withheld from payments to the self-employed, such as independent contractors. The self-employed are liable for taxes on income, including taxes that support the social security system, but payments are not withheld from income as it is earned.

Second, self-employed persons thus have many more opportunities than employees to disguise or conceal income and thus pay no tax on it. For example, they may accept payments in cash or disguised as payments for something else. This is not a cynical observation by a critic of US tax administration, but an accepted and articulated part of the federal budget planning process. For example, a provision of the tax laws makes it difficult for computer programmers to be classified as self-employed, 530(d) of the Revenue Act of 1978, added by 1706 of the Tax Reform Act of 1986. This provision originated when IBM sought a tax break for its overseas operations, which Congress was happy to grant, but which, under Congressional budgeting procedures, had to be offset by a comparable increase in revenue. Since it is generally accepted that employees cheat less on their taxes than the self-employed, by classifying computer programmers as employees, Congress estimated, an additional $60 million would be raised in taxes over five years, enough to offset the break that IBM received. David Cay Johnston, How a Tax Law Helps Insure a Scarcity of Programmers, New York Times, April 27, 1998, at D1.

The US Department of the Treasury estimates that approximately $2.6 billion are lost each year in unpaid social security, Medicare, and federal unemployment insurance taxes by reason of employees misclassified as independent contractors, and that the same misclassification is responsible for an additional annual loss of $1.6 billion in income tax underpayment. Subcommittee on Oversight, House Ways and Means Committee, Hearing on Employment Classification Issues, June 4 and 20, 1996, No. 104-84, at 138 and 139. Employers who purchase services from incorporated independent contractors need not specifically report such payments to the Internal Revenue Service. They are supposed to report payments made to unincorporated independent contractors, but many do not. If an employer is found by the IRS to have misclassified its employees as independent contractors, the IRS may not collect back taxes, or even require reclassification of the workers, if the employer's misclassification followed an IRS ruling, or was standard industry practice, or the employer had been audited in the past for employment tax purposes, without being assessed for the misclassification (Revenue Act of 1978 530, as amended in 1996).

A recent, well-publicized example of such misclassification involved the Microsoft Corporation, which was found by the IRS to have misclassified many employees as independent contractors. Those employees, many of whom have worked for years at Microsoft, have now claimed a retrospective right to participate in such Microsoft employee benefit programs as its savings plan and subsidized stock purchase plan for employees. A federal court of appeal recently ruled that the employees had a right to participate in the stock purchase plan and remanded to the trial court for appropriate relief. Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997). The mechanics of determining which of the misclassified employees would have bought Microsoft stock, and when, defy belief.

Third, self-employed persons may deduct an unlimited range of business expenses from their income, while employees are subject to limitations under Internal Revenue Code 67. Independent contractors, but not employees, are permitted under IRC 162(1) to deduct a specified percentage of their expenses for health insurance, which in the US is privately-obtained (if at all) and often quite expensive.

These tax advantages of self-employment are mentioned here, out of order as it were, to provide some political context for the following discussion. Perhaps in some legal contexts, classification as self-employed is a benefit only to the purchaser of services, who thereby escapes employment regulation, tax liability, or both. These benefits to purchasers of services exist in the US as well. However, in the US, self-employment is not just a subsidy to the purchasers of services, but normally offers substantial benefits to the provider of the services as well. This fact may help explain some of the legal complexity.

For example, maids and child care workers who work in others' homes are frequently engaged as employees or as independent contractors. (The author is unfamiliar with any reliable estimates of the relative popularity of the two forms). If an employee, taxes, including Medicare, social security, and unemployment insurance taxes, will be deducted, so the maid will be able to take full advantage of these programs should she need them. If an independent contractor, she will take home more now, because nothing will be withheld from her pay and she may be able to underreport her income, but if her reported income is too low this may later reduce the amount she will receive in social security or unemployment insurance. Self-employment might be an attractive option, however, if she contemplates leaving the US in the near future, for example to return to a native country. On the other hand, she may simply underestimate the likelihood that she will need Medicare or social security. It is the casual impression of this author that the maid or child care worker is usually the party who specifies which arrangement will be made. Nobody other than the parties to the arrangement will care, unless the purchaser of the services is a woman and later nominated for a position as a federal judge or law enforcer.

Although it is often asserted that self-employment in the US has exploded in recent years, it is difficult to document this claim, which is often anecdotal. As the legal definition of self-employment is complex, census and other surveys normally report self-description, which of course is endogenous to legal and tax regulation. "From 1975 to 1990, the crucial years of the alleged 'renaissance of the self-employed,' the number of (unincorporated) self-employed as a share of all nonagricultural employed rose only marginally--from 6.9 percent to 7.7 percent." Marc Linder, Farewell to the Self-Employed 61 (1992). In 1995, the Bureau of Labor Statistics undertook its first detailed survey of "Contingent and Alternative Employment Arrangements" (Report 900), and reported that some 6.7% of the total work force describe themselves as "independent contractors", "consultants," or "free-lance workers." The revolution in self-employment does not yet appear to have occurred. It is thus unnecessary to discuss any macroeconomic implications of self-employment in the US. In particular, the ease with which purchasers of labor can create relations of self-employment, as opposed to US-style employment relations terminable at will, cannot have had much impact in US rates of job creation or unemployment, given the apparently fairly stable rate of self-employment over the past decades.

1. Definition of self-employment

a. Criteria

The line between employees and the self-employed is a sort of textbook case of vagueness and uncertainty in American law. This observation is not limited to critics of the system; it is commonly made by authoritative lawmakers. The US Supreme Court, for example, recently held that a trash hauler for a county, an independent contractor, allegedly terminated after his public criticism of the county commissioners, might sue under the US Constitution for infringement of his right to free speech, just as if he were a public employee:

The brightline rule proposed by the [county] and the dissent would give the government carte blanche to terminate independent contractors for exercising First Amendment rights. And that brightline rule would leave First Amendment rights unduly dependent on whether state law labels a government service provider's contract as a contract of employment or a contract for services, a distinction which is at best a very poor proxy for the interests at stake. Determining constitutional claims on the basis of such formal distinctions, which can be manipulated largely at the will of the government agencies concerned, is an enterprise that we have consistently eschewed.

Board of County Commissioners v. Umbehr, 518 U.S. 668 (1996).

Unfortunately, despite these fine words, the line between employees and independent contractors, which can indeed "be manipulated largely at the will of the" employer concerned, is invoked for many legal purposes. One book takes a fifteen-page appendix merely to list the tests employed under thirty or more federal statutes to distinguish employees from independent contractors. Marc Linder, The Employment Relationship in Anglo-American Law: A Historical Perspective (1989). Our treatment here must necessarily focus on a few recurring problems.

Certain recurring occupational descriptions seem constantly to be involved in administrative and judicial determinations of whether their practitioners are employees or independent contractors. These include many people who have little or no capital other than human capital and survive entirely by rendering services, often to a single purchaser of those services. Recurring litigation involves insurance agents, "district managers" who function as distributors of goods, truck and taxi drivers, traveling sales personnel, janitors and cleaners, and hairdressers and cosmetologists.

The continuing uncertainty about the legal status of these groups, and indeed over the legal definition of "employee", cannot be understood apart from the US common law tradition. In the US, statutes are drafted in express contemplation of judicial interpretation and application. Legislators understand that standards will be adjusted, by courts, to facts of particular cases. This is true even of statutes, such as tax and employment laws, that will normally be administered by administrative agencies with authority to issue rules and interpretations. Even in such cases, judicial interpretation of the statute is contemplated, and, indeed, is not unusual.

"Employee" is defined in Internal Revenue Code 3121(d)(2) to include individuals who are employees under common law. Other statutes sometimes include even less helpful "definitions" of employee, such as the Employee Retirement Income Security Act 3(6): "The term 'employee' means any individual employed by an employer." The Supreme Court observed that this definition "is completely circular and explains nothing," Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318, 320-21 (1992), and held that, as with the tax laws, common law definitions are to be used.

The most "common" of common law definitions of employee was developed by common law courts to resolve issues (typically) of tort liability for acts of another. It defines an "employee" as one as to whom the hiring party controls "the manner and means by which the product is accomplished." If the truck driver can control the "manner and means" of his driving, such as which routes to follow and when deliveries are made, he may be the only one liable for his torts. However, if the person who hires the driver can control his route and the speed at which he must travel, that hiring person may become an "employer" in this sense, and liable for any torts committed by the driver. In this context, the common law "means and manner" test will achieve different results in different cases of truck drivers (for example), but the different results will bear some relationship to the underlying legal question, here, tort liability.

No reason has ever been advanced why this common law "means and manner" test should also govern such entirely different questions as when taxes must be withheld from income, or when promised retirement benefits have "vested" and can no longer be altered by the purchaser of services. Darden involved the latter question, which, the US Supreme Court held, must be answered by looking to see whether, when Darden had been employed, he or the insurance company controlled the "means and manner" of his work. In that case, the insurance company, whose products Darden had sold, refused to pay his promised retirement benefits when he went into competition with them. This action by the insurance company would violate federal law as to benefits that had "vested" in an employee. The issue was whether Darden was an "employee," as he argued, or rather, as the insurance company argued, he was an "independent contractor." The intermediate court of appeals in that case had proposed developing a definition of "employee" that looked to the purposes of the pension statute, under which Darden would be a statutory "employee" if he could show "that he had a reasonable expectation that he would receive benefits, (2) that he relied on this expectation, and (3) that he lacked the economic power to contract out of [the plan's] forfeiture provisions." Darden v. Nationwide Mutual Ins.Co., 922 F.2d 203, 205 (4th Cir. 1991), reversed 503 U.S. 318 (1992).

The Supreme Court reversed this reading of the statute and substituted the common law approach, developed for entirely different purposes. Then, as if to assure continued uncertainty and litigation, the Court directed courts applying this "common law" test to consider at least twelve independent factors:

(1) the skill required; (2) source of the instrumentalities and tools; (3) location of the work; (4) duration of the relationship between the parties; (5) whether the hiring party has the right to assign additional projects to the hired party; (6) the extent of the hired party's discretion over when and how long to work; (7) the method of payment; (8) the hired party's role in hiring and paying assistants; (9) whether the work is part of the regular business of the hiring party; (10) whether the hiring party is in business; (11) the provision of employee benefits: and (12) the tax treatment of the hired party.

Darden, 503 U.S. at 323-24.

The Darden case has been cited hundreds of times in decisions construing federal employment statutes since 1992. Its common law, multifactor approach, looking to "control of the means and manner" of work, has become the preferred approach for determining the coverage of other federal employment statutes, particularly, statutes against discrimination such as Title VII of the Civil Rights Act of !964 (race, color, religion, sex, and national origin discrimination), the Age Discrimination in Employment Act, and the Americans with Disabilities Act. The common law approach had already become established for determining the scope of the collective bargaining statute, the Labor Management Relations Act. Treatment of these decisions is obviously beyond the scope of this report. Most observers report that the current trend in applying these factors is to find the affected individuals to be self-employed, and therefore excluded from the relevant federal statute. This is almost always the result in cases involving insurance agents.

While the "common law" approach, looking to "control of the means and manner" of work, seems currently the most popular legal approach to defining self-employment, there are, as mentioned, numerous other tests under various federal and state statutes. At least one is worth mentioning, as it is often proposed as an alternative to the "common law" approach. Under the Fair Labor Standard Act 3(g), "'employ' includes to suffer or permit to work." This is "the broadest definition '...ever included in any one act'", United States v. Rosenwasser, 323 U.S. 360, 363 n.3 (1945). Inquiry is to the "economic realities", that is, "whether the individual is economically dependent on the business to which he renders service ... or is, as a matter of economic fact, in business for himself." Dole v. Snell, 875 F.2d 802, 804 (10th Cir. 1989), quoting Doty v. Elias, 733 F.2d 720, 722-23 (10th Cir. 1984). It is likely that, as currently used, this test is a bit likelier to result in a finding that a particular individual is an "employee". For that reason, labor unions and others sympathetic to them have sometimes proposed that the determination of "employee" for purposes of the collective bargaining, pension, and discrimination statutes be made under this "economic realities" test, rather than the "common law" approach set out above. One would have to examine many cases in order to evaluate whether this would really amount to a change in the law. A recent survey is skeptical, reporting that, as currently used, the "economic realities" test is also a mutifactor test that looks more to the right to control the work than to a real inquiry into the economic dependence of the individual on the purchaser of services. Lewis L. Maltby & David C. Yamada, Beyond "Economic Realities": The Case for Amending Federal Employment Discrimination Laws to Include Independent Contractors, 38 Boston Coll. L.Rev. 239 (1997).

b. Subcategories of the self-employed. There do not appear to be any subcategories that have significance for US employment or tax law. Either one is an employee, or one is self-employed. Such common descriptions as "consultant" or "free-lancer" lack legal significance.

c. Labor law protections for the self-employed. It is difficult to generalize about the consequences of finding an individual to be excluded from particular federal employment statutes. In one much-publicized case under the Disabilities Act, a disabled golfer had to be "accommodated" by letting him use a golf cart to move from hole to hole. The golfer was found not to be an employee of the golf tour, but rather an independent contractor. Nevertheless, the tour was held to be a "public accommodation", so fell under the Disabilities Act all the same. Martin v. PGA Tour, Inc., 7 AD Cases 1514, 1998 WL 67529 (D.Or. 1998). On the other hand, independent contractors are rarely successful in claiming that they have been excluded from private employment on racial grounds (see infra).

A labor union of self-employed persons is not necessarily illegal, though it may raise problems under the antitrust laws. Federal Trade Commission v. Superior Court Trial Lawyers Association, 493 U.S. 411 (1990) (refusal of lawyers to accept court appointment to defend indigent criminal defendants). However, such a union would exist outside the National Labor Relations Act: it could not use the law to compel an unwilling employer to recognize or bargain with it.

2. Social Security. Self-employed persons have been included in the Social Security program since the 1950s. This program includes payments to the retired and the disabled. Indeed, Social Security now covers the entire US workforce with the exception of a small number of public employees. Self-employed persons pay both the employer and employee portions of the social security tax. Beginning in 1990, the employer portion is deductible as a business expense. Other specific tax law provisions encourage the self-employed to save for their retirement.

3a. Legal forms of self-employment. Most self-employed people are simply unincorporated individual proprietorships without payroll. For example, the only sector in which the rate of self-employment rose in the 1980s was the service sector. A special 1987 Census of Service Industries revealed that seventy-nine percent were individual proprietorships and seventy percent were individual proprietorships without payroll. Sample percentages for service businesses arranged by type of business: eighty-nine percent of child care businesses were individual proprietorships without payroll; eighty-two percent of building service providers (janitors and cleaners), forty-seven percent of lawyers and thirty-three percent of physicians.

Other forms available for the self-employed to do business include incorporated businesses, professional corporations, partnerships. The choice among these forms is complex and largely driven by tax considerations.

3b. Government measures to encourage self-employment. The most important such "measure" is the ease with which the self-employed can disguise income and underpay tax. However, there have been a few more recent developments. In administering the unemployment insurance system, states have in recent years been given the option of recognizing self-employment as available work, and partly diverting unemployment compensation to assist formation of self-employment. The recent replacement of Aid to Families with Dependent Children and other general welfare programs, by scattered programs allegedly encouraging employment, has also generated a small number of local-level programs to encourage self-employment, though systematic evaluation of these programs has yet to occur.

4. Future Developments. Most political positions have been stable, and stalemated, for many years. Labor unions and their political allies have become increasingly concerned with the broader phenomenon of "contingent workers" who are not in bargaining units, some of whom are classed as self-employed. The main concrete proposal, in the Report and Recommendations of the Commission on the Future of Worker-Management Relations (Dunlop Commission)(December 1994) was for a single concept of employee, derived from the Fair Labor Standards Act's "economic realities" test, and applied to all questions of employment and labor law. As mentioned above, at least some commentators doubt that such a change would really amount to much (Maltby & Yamada, cited above) and recommend rather that independent contractors be specifically included in at least federal discrimination statutes. Such proposals are unlikely to advance in the present Republican Congress.

On the other hand, the House of Representatives last year voted to make it easier for purchasers of services to classify individuals as independent contractors. (Independent Contractor Tax Simplification Act, HR 1972). The proposal was not present in the Senate version of the legislation and thus did not become law last year. It is likely to be reintroduced in the future. While there are several versions of the legislation and the mechanics are too complex for detailed review here, a recent analysis by a committee of the New York State Bar Association's Tax Section concluded that: "Because of the relative ease by which workers can be classified as independent contractors under either Bill, the proposals have, in our view, been accurately described as introducing 'check-the-box' worker classification rules." That Report recommends that broadening the definition of independent contractor be adopted only if linked to measures that encourage better compliance with income reporting and tax payment rules. It also recommends that, ideally, the choice between "employee" and "independent contractor" should be neutral of tax consequences. New York State Bar Association, Tax Section, Report on Recent Developments Regarding Worker Classification With Revised Proposals For Reform, February 24, 1998, 98 Tax Notes Today 39-36.