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Mistaking an Employee as an Independent Contractor is Costly in California

Prepared By: Melissa C. Marsh, Los Angeles Employment Attorney
Written: October 2008 - Last Updated: November 2011

Is your worker an employee or independent contractor?
If a worker is classified as an independent contractor, the employer is not required to withhold or pay Social Security and Medicare (FICA), State and Federal income taxes, unemployment insurance taxes (FUTA), workers' compensation, overtime, or a host of other benefits. If a worker is properly classified as an independent contractor, the employer is also free from a myriad of onerous legal obligations pertaining to California's wage and hour laws, anti-discrimination laws, state and federal OSHA (safety) regulations, etc. In an effort to avoid these responsibilities, many employers try to classify their workers as independent contractors. The problem is…if an employee is misclassified as an "independent contractor," the employer is potentially liable for such things as:

  • Unpaid employment taxes and penalties;

  • Unpaid unemployment and disability insurance and penalties;

  • Unpaid workers' compensation coverage; and

  • A host of Labor Code violations and penalties for such items as unpaid overtime, meal and/or rest break violations, pay stub violations, etc.. See, California Penalties For Failing To Pay Overtime To Non-Exempt Employees, which provides a typical example of some of the penalties that can be assessed when California employees are not paid properly; and now
  • The California Labor Commissioner, or a Court, can assess large civil penalties under Labor Code Sections 226.8 and 2753 which imposes fines that range from $5,000 to $15,000 for each misclassification violation for first time offenders, in addition to any other penalties or fines permitted by law.

It should also be noted that pursuant to California case law, the existence of a written agreement stating that the worker is an independent contractor is not determinative, nor is the fact that that the worker was issued a 1099. See, S. G. Borello & Sons, Inc. v Dept. of Industrial Relations, 48 Cal.3d 341 (1989) and Toyota Motor Sales v. Superior Court, 220 Cal.App.3d 864, 877 (1990).

So what determines if a worker is an employee versus independent contractor?
Unfortunately, in California it is very difficult to determine if a worker is an employee or independent contactor because the IRS and each state agency applies its own set of factors to make the determination. It is therefore possible for one agency to classify a worker as an employee and for another to determine that the same worker is an independent contractor. In addition to the IRS, the state agencies most involved with the determination of whether a worker is an employee vs. independent contractor are: the Employment Development Department (EDD), the Division of Labor Standards and Enforcement (DLSE), the Franchise Tax Board (FTB), the Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB).

Despite the multitude of tests, each of which is examined below, in general, a worker is appropriately classified as an independent contractor if:

  1. the owner-employer neither controls, nor directs, the worker's work;

  2. the work performed by the alleged independent contractor is different from the employer's work, and is performed at another location; and

  3. the worker has an independently established business with regular clients.

The remainder of this article will set forth how the DLSE, the EDD, and the IRS each determine whether a worker is an employee or an independent contractor.

The DLSE and EDD Both Use The Economic Realities Test to Determine if a Worker is an Employee or Independent Contractor.

The DLSE, which is concerned with whether the employer has followed California's wage, hour and workers' compensation laws, starts with the presumption that the worker is an employee. See, California Labor Code §3357. The DLSE then applies California's "5 Pronged Economic Realities Test" adopted by the California Supreme Court in S. G. Borello & Sons, Inc. v Dept. of Industrial Relations, 48 Cal.3d 341 (1989). Under this multi-factor test, the most significant factor is whether the employer has control, or the right to control, the worker and the manner and means by which the work is performed. Additional factors include:

  1. Whether the worker is engaged in an occupation or business distinct from that of the alleged employer;

  2. Whether the work is a part of the regular business of the alleged employer;

  3. Whether the alleged employer supplied the worker with supplies, tools, and a place for the worker to perform the work;

  4. Whether the worker made his or her own investment in the equipment or materials required to perform the work;

  5. Whether the work performed requires a special skill;

  6. Whether the type of work performed is usually done under the direction of an employer or by a specialist without supervision;

  7. Whether the worker's managerial skill would impact his or her opportunity for profit or loss;

  8. The length of time for which the work was to be performed for the alleged employer;

  9. The degree of permanence of the working relationship; and

  10. The method of payment, whether by time or by the job.

Under the DLSE's Multi-Factor Test, even where the adjudicating officer determines there is an absence of control over work details, the DLSE will find an employer-employee relationship if: (1) the alleged employer retained pervasive control over the operation as a whole, (2) the worker’s duties were an integral part of the business owner's operation, and (3) the nature of the work makes detailed control unnecessary. See, Yellow Cab Cooperative v. Workers Compensation Appeals Board, 226 Cal.App.3d 1288 (1991).

The EDD Uses the "Control Test" to Determine if a Worker is an Employee or Independent Contractor.

To determine whether a worker is an employee or independent contractor, the EDD uses the "Control Test" pursuant to which an individual is an employee if: (1) the law defines the worker as an employee (statutory employee) or (2) the employer has the right to exercise control over the manner and means by which the worker performs his/her services (common law employee). See, Independent Contractor Misconceptions published by the EDD. For the EDD, the right to discharge a worker at will and without cause is strong evidence of the right of direction and control. Other factors that support a finding of the right to control (which are similar to those used by the DLSE) include:

  1. Whether or not the one performing the services is engaged in a separately established occupation or business.

  2. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of a principal without supervision.

  3. The skill required in performing the services and accomplishing the desired result.

  4. Whether the principal or the person providing the services supplies the instrumentalities, tools, and the place of work for the person doing the work.

  5. The length of time for which the services are performed to determine whether the performance is an isolated event or continuous in nature.

  6. The method of payment, whether by the time, a piece rate, or by the job.

  7. Whether or not the work is part of the regular business of the principal, or whether the work is not within the regular business of the principal.

  8. Whether or not the parties believe they are creating the relationship of employer and employee.

  9. The extent of actual control exercised by the principal over the manner and means of performing the services.

  10. Whether the principal is or is not engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual.

The IRS uses a new 11 Factor Test to Determine if a Worker is an Employee or Independent Contractor.

The IRS will weigh and balance 11 factors in three groups (behavioral control, financial control, and the parties' relationship) to determine if an independent contractor should be reclassified as an employee.

The Behavioral Control Test seeks to determine whether there is a right to direct or control how the worker does the work. If the IRS determines that there is extensive control, the worker will be classified as an employee. If a worker is told when, where, how and whether to work, the IRS will likely find extensive control and classify the worker as an employee. According to the IRS, the following are examples of types of instructions about how to do work:

  • What tools or equipment to use

  • What workers to hire or to assist with the work

  • Where to purchase supplies and services

  • What work must be performed by a specified individual, or a sequence to follow

The Financial Control Test. If the alleged employer has the ability to control the business aspects of the worker's job, the IRS is more likely to find an employer-employee relationship. Under the Financial Control Test, the IRS will look at the following 5 factors:

  • Does The Worker Have A Significant Investment In The Project? An employee typically does not have a monetary investment in the work to be performed, while an independent contractor often will have a significant investment in their business.

  • Does the Worker Have Significant Unreimbursed Expenses? If the worker is not reimbursed for some, or all, business expenses, then the worker may be an independent contractor, especially if the unreimbursed business expenses are substantial and fixed ongoing expenses.

  • Does the Worker Have The Opportunity for Profit or Loss From the Work? If the worker can realize a profit or loss, the worker is more likely to be an independent contractor. With employees there typically is no loss since the employer usually provides employees a workplace, tools, materials, equipment, and the supplies needed for the work.

  • To What Extent Is The Worker's Services Available In The Marketplace? If the worker is free to work elsewhere, advertises his or her services to others, maintains an office, etc. the worker is more likely to be deemed an independent contractor.

  • How Does The Business Pays The Worker? Employees are typically guaranteed a regular wage, while an independent contractor is typically paid a flat fee for a particular job.

The Type of Relationship Test. The IRS will then look at the type of relationship that existed between the owner and the worker, such as:

  • Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since the basis of the determination is based on the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, the written contract can make a difference.

  • Whether the business provides the worker with employee-type benefits, such as: insurance, pension plan, vacation pay, or sick pay. An independent contractor typically provides their own benefits.

  • The permanency of the relationship. If the business expects the worker to remain until terminated, that is evidence of an employer-employee relationship. Most independent contractors are engaged for a specific project, or period.

  • The extent to which the services performed by the worker are an integral part of the business. If a worker provides services that are a key aspect of the company's regular business activity, it is more likely that an employer-employee relationship exists. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

Although each of the test's balance and weigh different factors, it typically comes down to what we said in the introduction. In general, a worker is appropriately classified as an independent contractor if:

  1. the owner-employer neither controls, nor directs, the worker's work;

  2. the work performed by the alleged independent contractor is different from the employer's work, and is performed at another location; and

  3. the worker has an independently established business with regular clients.

California employers should err on the side of caution and if in doubt classify the worker as an employee.

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Our employment law practice consists of: (1) assisting employees with their contracts and wage claims and (2) counseling employers who seek to comply with new state and federal employment laws, providing human resource training, and providing essential contracts and employee policies to prevent employee lawsuits. To schedule a consultation call 818-849-5206 or Send Us An Email and California Employment Law Attorney Melissa C. Marsh will see if she can assist you.

California employment lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.

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Located in Los Angeles, California, the Law Office of Melissa C. Marsh handles business law and corporation law matters as a lawyer for clients throughout Los Angeles including Burbank, Sherman Oaks, Studio City, Valley Village, North Hollywood, Woodland Hills, Hollywood, West LA as well as Riverside County, San Fernando, Ventura County, and Santa Clarita. Attorney Melissa C. Marsh has considerable experience handling business matters both nationally and internationally. We routinely assist our clients with incorporation, forming a California corporation, forming a California llc, partnership, annual minutes, shareholder meetings, director meetings, getting a taxpayer ID number (EIN), buying a business, selling a business, commercial lease review, employee disputes, independent contractors, construction, and personal matters such as preparing a will, living trust, power of attorney, health care directive, and more.