A California regulator has dealt a serious blow to Uber, ruling that an Uber driver is legally an employee of the company. California Labor Commissioner Julie Su rejected Uber's argument that drivers are independent contractors.

If the ruling is upheld by the courts, it would have big implications for Uber and other companies that have emulated Uber's business model. Employees enjoy a number of legal rights that are not available to independent contractors. Classifying Uber drivers as employees could entitle them to minimum wage and overtime pay, compensation for expenses incurred on the job, workers' compensation and unemployment benefits, and more.

But transforming Uber drivers — and others who work in the so-called "sharing economy" — into full-blown employees might also create some problems. Uber drivers are free to set their own hours, working as many or as few hours as they like in any particular week. Classifying workers as employees could force Uber to place limits on when and how much drivers work, which could be bad for everyone.

The difference between an employee and a contractor

The law in California (and other states) draws a fundamental distinction between employees and independent contractors. Employees have a direct, long-lasting relationship with their employers, and as a consequence they are eligible for a number of benefits and legal protections.

Independent contractors, on the other hand, are service providers with an arms-length relationship to their customers. For example, if you hire a plumber or electrician to do work on your house, that person might be classified as an independent contractor. It wouldn't make sense for the law to treat everyone who pays for outside help on their house as an employer.

Whether a worker is an employee or an independent contractor is an issue that's decided by regulators and the courts. Employers can't opt out of the legal requirements of labor law merely by getting employees to agree to call themselves independent contractors.

Uber was pushing the boundaries of labor law

Uber has been pushing the boundaries of the independent contractor classification. There are a number of ways that Uber drivers seem a lot like conventional employees. Uber drivers must undergo a lengthy application and background checking process before they can begin work. Many drivers treat Uber as a full-time job, working 40 or more hours per week for months at a time.

Uber sets a wide variety of rules governing how drivers should provide services to Uber passengers. Drivers' fees are fixed by Uber, and Uber sometimes provides drivers with bonuses, minimum earning guarantees, and other forms of compensation that don't come directly from customers.

On the other hand, there were a few characteristics that — in Uber's view — distinguished its drivers from conventional employees. Normally, employers set their employees' schedules, requiring them to work a minimum number of hours and often dictating when and where to report for work. By contrast, Uber drivers set their own schedules. They can work as much or as little as they want, and they decide which parts of town to work in.

Employees generally use equipment supplied by their employers, while independent contractors usually supply their own tools. Uber cited the fact that drivers supplied their own vehicles as evidence that they were independent contractors. Uber argued that it merely provided a kind of online marketplace — like an eBay for transportation services — connecting independent ride providers with customers who wanted to purchase their services.

Why the California Labor Commissioner ruled against Uber

But the California Labor Commissioner rejected Uber's arguments. Su ruled that regardless of what Uber chooses to call its workers, they still meet California's definition of employees.

"Defendants [e.g. Uber] hold themselves out as nothing more than a neutral technological platform, designed simply to enable drivers and passengers to transact the business of transportation," the California regulators wrote.

Regardless of what Uber chooses to call its workers, they still meet California's definition of employees

"The reality, however, is that Defendants are involved in every aspect of the operation. Drivers cannot use Defendants' application unless they pass Defendants' background and DMV checks. Defendants control the tools the drivers use. Defendants monitor the Transportation Drivers' approval ratings and terminate their access to the application if the rating falls below a specific level."

The Labor Commissioner concluded that the plaintiff, a San Francisco Uber driver named Barbara Berwick, was an Uber employee.

Classifying drivers as employees has big consequences

The reason this question matters so much is that a lot of legal obligations hinge on whether a worker is classified as an employee.

Employees are entitled to earn a minimum wage, and to overtime if they work long hours

Berwick's complaint focused on one particular labor law requirement: employers must reimburse employees for expenses incurred on the job. She drove 6,468 miles as an Uber driver, which at standard IRS reimbursement rates corresponds to $3,622 in vehicle maintenance costs. She also incurred $256 in tolls. The Labor Commissioner ordered Uber to pay this amount to Berwick.

And according to Rebecca Smith of the National Employment Law Project, classifying Uber drivers as employees could trigger a number of other requirements. Employees are entitled to earn a minimum wage, and to overtime if they work long hours. Employees have collective bargaining rights. Employees can also be eligible for workers' compensation and unemployment benefits.

If this week's ruling is upheld by the courts, it will create opportunities for other drivers to file complaints about Uber's labor practices, forcing Uber to provide its employees with more employment benefits and protections.

This week's ruling is part of a larger fight

Berwick isn't the only Uber driver seeking to be classified as an employee. And Uber isn't the only company facing this kind of legal challenge.

Uber is facing a separate class-action lawsuit from Uber drivers who want employee status. This week's ruling will provide a helpful precedent for the plaintiffs in that case, but its outcome is uncertain. Uber's main competitor, Lyft, is facing similar suit.

Other companies have also faced litigation over charges that they misclassified their employees. This week, FedEx agreed to pay $228 million to settle charges it had improperly classified its delivery drivers in California as independent contractors.

The fundamental question here is how closely regulators and the courts should scrutinize a company's unilateral declaration that its workers are independent contractors rather than employees. Uber's defenders argue that the flexibility of independent contractor status is important for startups that are trying to create new types of businesses.

Wage and hour regulations are one area where applying conventional labor law could prove counterproductive. Unlike a conventional employer, Uber doesn't tell employees when or how much they have to work. Employees are free to work as few or as many hours as they want, and they're free to work at times of peak demand, or at times that are most convenient to their schedules.

If Uber was subjected to minimum wage and overtime laws, this would likely lead to new restrictions on when and how much workers can drive. Workers might be prohibited from working more than 40 hours per week, to avoid triggering overtime pay requirements. And Uber might limit how many drivers log in during low-demand period to guarantee that workers earn at least the minimum rate during those hours.

Ian Adams, an analyst at the free-market R Street Institute, argues that the best solution would be to create a new legal category for people who work for on-demand services like Uber and Lyft. This category would provide workers with some benefits of employees — such as expense reimbursements and worker's compensation — but wouldn't provide other benefits such as sick leave and unemployment benefits.

The ruling probably won't destroy Uber's business model

Obviously, a ruling that reduces Uber's flexibility and forces it to provide more generous benefits to its drivers isn't great for the company. But there's reason to be skeptical of fears that treating drivers as employees will doom the business model of Uber or "sharing economy" companies more generally.

Uber is a big enough company that it can easily afford to comply with California's labor regulations. And while those regulations may increase Uber's costs somewhat, Uber should be able to pass on those costs to consumers — especially because competitors will likely be forced to bear the same costs. Where the ruling could hurt Uber is by reducing its ability to experiment with different scheduling and compensation models.

A key point here is that while the ruling would force Uber to pay its employees more for things like expense reimbursement, this won't necessarily have a big effect on drivers' take-home compensation. Right now, drivers deduct their expenses from their gross pay. If Uber has to start reimbursing drivers for their expenses, the company should be able to reduce drivers' base compensation by a corresponding amount, leaving drivers' net pay little changed.

Many of the costs of the ruling could fall on parties other than Uber. One is the drivers themselves. Obviously, many drivers will benefit from the protections afforded by labor law. But others might be harmed. For example, Uber might limit drivers' freedom to choose when and how much to work to ensure that they do not run afoul of minimum wage, overtime, and other rules tied to workers' schedules.

The ruling could also harm would-be Uber competitors, especially if it is emulated in other states. Uber is a big enough company that it can easily absorb the costs of complying with labor laws in 50 states. Smaller companies trying to pursue an Uber-like business model might find the administrative burden too much. Ironically, then, the ruling against Uber could provide Uber with a modest barrier against new competitors in the long run.

And ultimately, the costs of the ruling may be passed on to consumers in the form of higher fares.

Correction: I originally referred to "the California Labor Commission," but there's no such body. The ruling came from California Labor Commissioner Julie Su. Also, I changed the headline to say "an Uber driver," rather than "Uber drivers," is an employee.