By Lindsay J. Nakagawa, Attorney
Many businesses, especially small businesses or those performing services in a particular industry, retain independent contractors. Utilizing the services of a contractor allows a business to seek outside help without liability or added expense and provides contractors with business expense tax deductions and freedom to set their own schedules. Occasionally, workers are classified as independent contractors but function as employees. However, the previous standard for determining a worker’s employment status left many unanswered questions.
In a recent decision, the California Supreme Court set out a new standard for determining whether independent contractors in California should be classified as employees. While it is expected to have the greatest impact on “gig” workers, such as ride-share drivers, hairstylists, and tattoo artists, the decision applies to all businesses. The new standard, referred to as the “ABC Test”, presumes all workers are employees unless the hiring entity can prove three factors:
(A) the worker is free from control and direction of the hiring entity;
(B) the worker performs work that is outside of the usual course of the hiring entity’s business; and
(C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
It is the hiring entity’s responsibility to prove that the worker is an independent contractor by demonstrating all three ABC test factors have been met.
The new ABC test has resulted in many questions regarding its effect on businesses. Below, we address some of the common questions.
My workers require some direction so they understand the services they are expected to perform. When is a worker “free from control and direction” under factor (A)?
In determining whether a worker is free from control and direction, a number of factors are considered, including whether the hiring entity controlled the worker’s wages, hours, or conditions of employment. Businesses that dictate the time a worker is expected to report for duty, require the worker to adhere to a certain dress code, or set the salary or wages of a worker, are excising control and direction over the worker. Also relevant is whether the worker can perform similar services for competitors of the business, whether the worker is bound by business policies or practices, and whether the worker is retained to complete a specific project.
My business provides very narrowly tailored services. If I hire someone to perform work that is within the same industry, but not the same services provided by my business, is that considered “outside the usual course of business” under factor (B)?
It depends on the services provided by the worker. The State of California takes a broad view to determine what work is outside the usual course of business. For example, the California Supreme Court hypothesized that a cake decorator retained to decorate cakes for a bakery that only bakes, but does not decorate cakes is still providing work within the usual course of business. A bakery is in the business of providing baked goods, including cakes. The service of a cake decorator is viewed as part of that usual course of business, even if the business has never engaged in cake decoration previously. In this situation, the cake decorator should be classified as an employee.
Workers that provide services clearly outside of the usual course of business, such as a plumber, accountant, or marketing firm providing services to the bakery, are independent contractors, so long as the other factors are met.
The worker I hired has her own business cards and signs, but is not registered as a corporation or limited liability company (LLC) with the State of California. Does that mean she is not engaged in an independently established trade, business, or occupation under factor (C)?
Not necessarily. In determining whether an individual is customarily engaged in an independently established trade, occupation, or business, incorporation or organization as an LLC supports a finding of an independent business, but is not required. An individual operating as a sole proprietor may still operate an independently established business if he or she holds any required licenses under the business, advertises his or her business, or generally holds himself or herself out to the public as providing the type of services performed for the hiring entity.
I hired a worker who owns an independent business, provides services unrelated to those offered by my business, and sets his own hours and time. However, the worker provides those services to me on an exclusive basis and does not provide work for anyone else. Is he an independent contractor?
A thorough analysis of the services provided by the worker is necessary to determine the classification, but the worker is probably operating as an employee. Exclusive relationships suggest the worker is not actually operating an independent business, as he or she is not advertising the services or actively holding him or herself out to the public as being engaged in an independent trade.
I may have misclassified some employees as independent contractors, but the State of California will never discover the misclassification, right?
Challenges to independent contractor classification typically arise in one of two ways:
1) the independent contractor makes a claim with the Employment Development Department (EDD), California’s payroll tax collection and unemployment insurance agency, for unemployment insurance benefits, unpaid wages, workers’ compensation coverage, discrimination, or wrongful termination; or
2) the EDD initiates an audit of wage payments, workers’ compensation coverage, or unemployment insurance.
Many employers mistakenly believe the EDD will never discover an independent contractor misclassification. However, workers whose services are no longer required often file for unemployment benefits, especially if the relationship soured. Employees that have been misclassified as independent contractors are not penalized for the misclassification, and thus have nothing to lose when reporting the misclassification to the EDD. It is never safe to assume the misclassification will go unnoticed.
Will I be penalized if the EDD determines I have misclassified workers?
Probably. If the EDD discovers that you have misclassified workers, your business may be subject to significant penalties. Penalties for misclassification are extensive and can include fines for: (a) wage and hour violations, such as unpaid overtime, back wages, minimum wage violations, failure to pay wages in the timeline required by law, failure to comply with record keeping requirements, and failure to provide meal/rest periods; (b) liability for any injuries that would have been covered by workers’ compensation coverage; and (c) failing to make proper employee payroll withholdings and provide legally required benefits, such as paid time off.
In California, misclassification of workers can result in civil penalties between $5,000.00 and $15,000.00 per violation. If the State determines the business has a pattern of misclassification, the penalties are increased to $10,000 to $25,000 per violation. Those penalties are in addition to any penalties issued at the federal level and any other charges to correct underpayment of wages or other violations.
While reclassifying workers as employees may be expensive, the penalties for misclassification are substantial. A mistaken belief that the worker legitimately constituted an independent contractor will not relieve an employer of liability.
I think some of my 1099 independent contractors are misclassified. How do I fix this?
If you retain any independent contractors, give us a call. We can review your business and the services provided by the worker to determine whether a misclassification has occurred. Being proactive and acting quickly to correct a misclassification can save you and your business time and money.
If your independent contractor has been misclassified, we can help you reclassify the worker as an employee, draft an employment agreement and policies, if needed, and prepare any other documents.
I still have questions about the new law.
No problem! Give us a call at (619) 269-5996 and we would be happy to discuss it further.
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