Independent Contractor or Employee?
An independent contractor has different legal rights and obligations than an employee. The distinction between these arrangements can have dramatic consequences for workers and companies.
According to an article from the Los Angeles Times, the hiring of workers as independent contractors has recently “exploded.” The article cites a 2016 study by economists that estimates that twelve and a half million people, or 8.4% of the U.S. workforce, are now deemed independent contractors.
Generally speaking, the difference between independent contractors and employees is whether or not the entity paying for services has the right to control or direct the manner and means of work (tending to signify an employment relationship), or whether the person providing the services has independently made the decision to go into business for himself or herself (suggesting an independent contractor relationship).
The determination of each respective status can be particularly tricky because the definitions, criteria, and factors that courts and federal and state agencies apply to determine employee or independent contractor status can vary from one context to another.
For example, when an employer is determining what sort of IRS tax forms it must prepare, it must consider that the IRS looks to common law definitions of employee and independent contractor in making the determination. This method of classification is slightly different than the method used in federal cases, which applies what is usually referred to as the “economic reality” test in determining a worker’s status. However, when the question before a court is whether or not a worker is entitled to the protections of California’s non-discrimination laws, then state law, as well as another set of factors would apply in making the determination. In addition, California courts apply a different set of standards when determining whether or not a worker is an employee or an independent contractor for each case, depending on the purpose of the determination (for example, a different set of standards applies for cases under California’s workers’ compensation laws as opposed to wage and hour laws, and for purposes of determining unemployment insurance benefits, disability insurance, and state income tax withholding.)
Although the specific tests applied under federal and state laws differ, the factors in those tests are often confusingly similar to each other. They may even overlap or repeat. Furthermore, the application of the relevant factors in any of these tests to the circumstances of a particular case can be extremely fact specific. There may be some factors suggesting a worker is an employee and others suggesting he or she is an independent contractor. It is even possible that a worker can be considered an independent contractor for purposes of IRS tax filing, but they are considered an employee under California’s wage and hours laws.
The recent California Supreme Court decision in Dynamex v. Superior Court of Los Angeles helps decipher some of the confusion around what law and factors apply in the context of wage and hour laws, but it leaves other questions unanswered. We’ll further discuss the Dynamex case and how it applies in Chapter 3 below.
Why it matters
The question of whether a worker legally qualifies as an employee or an independent contractor can determine the outcome of many other legal issues. It is often, therefore, the single most important threshold question when it comes to employment cases.
Under both federal and California law, employers have fairly extensive obligations and duties to workers who are classified as employees. These include requirements for non-discrimination, non-retaliation, paying minimum wages, paying various taxes and insurance (such as social security, unemployment, and workers compensation), meeting certain minimum safety requirements and complying with other requirements such as minimum wage, overtime pay, meal periods and rest breaks.
Independent contractors are not generally entitled to all the same protections as employees. For instance, independent contractors must not only pay their own payroll taxes and self-employment taxes, but they are also responsible for all the other direct and indirect costs of conducting business themselves as well as for the risks and liabilities that attend their work.
Employers who want to avoid the costs and liabilities associated with being an employer may be motivated either to improperly classify employees as independent contractors or to take elaborate steps in an attempt to restructure their employee relationships as independent contractor arrangements.
As recognized by the court in Dynamex, “When a worker has not independently decided to engage in an independently established business but instead is simply designated an independent contractor by unilateral action of a hiring entity, there is a substantial risk that the hiring business is attempting to evade the demands of an applicable wage order through misclassification.” Dynamex, 74.
It is not just the employers and workers who are impacted by this. As noted by the L.A. Times, “the misclassification of workers as independent contractors costs the state roughly $7 billion in lost payroll taxes each year.” Furthermore, as the court in Dynamex noted, the wage and hour laws adopted by California are meant not only to ensure workers maintain a basic subsistence standard of living but also to shield the public from bearing the full financial responsibility for workers stuck in unhealthy or unsafe conditions or earning substandard wages.
IRS Form 1099 or W-2?
Under federal law, any business entity hiring a worker needs to determine the nature of the business relationship, whether an employee or independent contractor, at the outset in order to comply with the federal tax code.
As noted above, the IRS looks to common law tests to determine whether or not someone is an employee or an independent contractor. The common law test requires examination of all evidence of the degree of control and independence in the relationship. The facts would be examined as they relate to the following categories:
- Behavioral Control. To what extent does the business have a right to direct and control what work is accomplished and how the work is done, whether through instructions, training or other means? Someone who is required to complete assignments in a certain way at a certain place and time is more likely to be an employee than an independent contractor. If the entity receiving services provides training about required procedures and methods this indicates the business wants the work done in a certain way. Again, this kind of worker is more likely to be deemed an employee.
- Financial Control. To what extent does the business have a right to direct or control financial aspects of the worker’s job? In this area, the IRS would examine:
- Does the worker have unreimbursed business expenses? If the worker pays his or her own expenses, that is more to be expected of an independent contractor than an employee.
- Does the worker invest in his or her own tools or facilities used in performing the services? A significant investment by an individual into his or her own facilities, equipment, tools or supplies suggests the individual is in business for himself or herself rather than an employee.
- Does the worker make his or her services available to the public or relevant market generally? If so, that would suggest someone in business for themselves.
- How is the worker paid by the business? For example, someone in business for themselves may send out invoices to collect payment for services. An employee may receive a check at regular intervals.
- Can the worker realize a profit or incur a loss? The ability of an individual to realize a profit or incur a loss suggests the person is in business for themselves.
- Relationship of the Parties. How do the two parties perceive their relationship?
- Are there written contracts describing the relationship the parties intend to create? Note that this factor is more important in the context of IRS rules than it is under California wage and hour laws. Under California wage and hour laws, the existence of an agreement that labels the relationship as an independent contractor one is given zero weight. See Estrada v. FedEx, 154 Cal.App.4th 1 (2007). For the IRS, however, it can be a significant See IRS Publication 1779.
- Does the business provide the worker with benefits, such as health insurance, a pension plan, vacation leave or sick pay? Doing so suggests an employer-employee relationship.
- How permanent or temporary is the relationship? A relationship that is expected to be long-term and continuing is a characteristic of an employer-employee relationship.
- Are the services performed by the worker also a key aspect of the regular business of the hiring company? Consider, for example, an overnight or same-day delivery service. A driver performing delivery services in this context is performing a service that would be a key aspect of the regular business of the hiring company.
If you are not sure whether or not you or your worker should be classified as W-2 or 1099 for purposes of federal income tax withholding, you may request the IRS to make the determination for you. This is done by filing a request on IRS Form SS-8. The IRS will acknowledge receipt of your Form SS-8 and assign it to a technician to review, apply the law and decide. This may take up to six months.
The Dynamex Decision and the ABC Test under California Law
In April 2018, the California Supreme Court decided the case of Dynamex Operations West, Inc. v. Superior Court of Los Angeles County. Docket No. S222732. This decision marked an important change in how determinations of the employee-independent contractor question will be made by California courts for certain cases going forward. In fact, the decision adopted a standard that presumes that workers are employees unless the employer can establish otherwise when it comes to cases brought under the state’s wage orders.
The Dynamex Decision
Dynamex is a nationwide same-day courier and delivery service with several business centers in California. Prior to 2004, Dynamex classified its drivers in California as employees. In 2004, however, Dynamex restructured its relationship with drivers to save the company money. Dynamex’s policy after 2004 was that drivers would be treated as independent contractors required to provide their own vehicles and pay their own transportation expenses, including costs for fuel, maintenance, and liability insurance. Drivers were still expected to wear Dynamex shirts and badges and sometimes to affix Dynamex decals to their vehicles. At the same time, drivers were given the freedom to choose their own routes and delivery sequences as well as to hire other persons and make deliveries for other delivery companies.
In 2005, two of Dynamex’s drivers filed a class action lawsuit claiming that they and other drivers were improperly classified as independent contractors and that Dynamex was, therefore, violating various requirements of the California Labor Code and state wage orders.
The case went before the California Supreme Court with the question of whether the trial court’s decision to certify the lawsuit as a class action was proper. At issue was the question of whether, in certifying the class action status of the case, the trial court had identified the correct standard for classifying workers as either independent contractors or employees.
The California Supreme Court held that the trial court’s reliance on the fairly broad employment language of the wage orders was appropriate in classifying workers.
What is a wage order?
Wage orders are employment regulations that explain and describe the wage, hour and working condition requirements in specific industries. Wage orders are considered “constitutionally-authorized, quasi-legislative regulations that have the force of law.” Dynamex, 3 at fn3. Wage orders are published by the Department of Industrial Relations.
Under the wage orders, there is no actual definition of an independent contractor. Rather the orders generally specify that they “apply to all persons employed” in the relevant industry, with some exceptions. An employee is generally defined as “any person employed by the employer.” An earlier case, Martinez v. Combs, held that there were three alternative definitions of “employ” under the wage orders: (a) to exercise control over the wages, hours, or working conditions, or (b) to suffer or permit to work, or (c) to engage, thereby creating a common law employment relationship.” Dynamex, 4.
Clearly, these alternative definitions are very broad and the “suffer or permit to work” definition has the potential for swallowing any independent contractor distinction entirely. The court in Dynamex, therefore, found that the “suffer or permit to work” language should be viewed as a “term of art that cannot be interpreted literally” to include types of individual workers that have “traditionally been viewed as genuine independent contractors who are working only in their own business.” Dynamex, 7. This is one reason the wage order definitions cannot be seen as encompassing all workers within their sweep, and why the presumption that a worker is an employee may be rebutted by the employer in certain circumstances. The circumstances under which the employee presumption may be rebutted is generally referred to as the “ABC” test. Dynamex, 7.
The ABC Test
The ABC test provides that:
A worker is properly considered an independent contractor to whom a wage order does not apply only if the hiring entity establishes all of the following:
(A) that the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
(B) that the worker performs work that is outside the usual course of the hiring entity’s business; and
(C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
The presumption of an employment relationship and the ABC test thus applies in cases brought under California’s wage orders.
But what about cases brought under California’s Labor Code or its Fair Employment and Housing Act? The question of whether the same standard applies in those kinds of cases is not one that the court in Dynamex explicitly reached. As a result, it is not yet clear whether the presumption of an employment relationship and the ABC test might apply or should be applied in contexts beyond the wage orders.
However, the Dynamex Court did state that when it comes to the question of workers’ classification as employees or independent contractors, the proper analysis is not limited to the traditional common law test that was previously enunciated in S.G. Borello & Sons v. Dept. of Industrial Relations. Instead, the Court held that determining the appropriate classification standard calls for “application of a statutory purpose standard” to determine which factors “best effectuate… the underlying legislative intent and objective of the statutory scheme at issue.” Dynamex, 33.
This lays a strong foundation for future courts to find that the statutory purposes behind California’s Labor Code and/or Fair Employment and Housing Act require the application of the broader “suffer or permit to work” standard, together with its corresponding presumption of an employment relationship.
Classification as an Independent Contractor under the Fair Employment and Housing Act
California’s Fair Employment and Housing Act, or “FEHA,” is the statute that prohibits discrimination in employment practices on the basis of race, religious creed, national origin, ancestry, physical disability, mental disability, medical condition, genetic information, marital status, sex, gender, gender identity, gender expression, age, sexual orientation, or military and veteran status. Government Code §12940 – 12952. The distinction between employees and independent contractors is important under FEHA because the anti-discrimination protections provided by FEHA encompass employees but not independent contractors. “Persons providing services pursuant to a contract” are protected from unlawful harassment under FEHA, Government Code §12940(j)(1), but they are not protected from discrimination.
FEHA defines a “person providing services pursuant to a contract” as someone who meets all the following criteria:
- The person has the right to control the performance of the contract for services and discretion as to the manner of performance.
- The person is customarily engaged in an independently established business.
- The person has control over the time and places where the work is performed, supplies the tools and instruments used in the work, and performs work that requires a particular skill not ordinarily used in the course of the employer’s work.
In 2012, an African-American steel plant worker won a $25 million jury verdict against his employer ArcelorMittal for the company’s failure to address a hostile work environment that included racial epithets, vandalism, and graffiti directed toward the worker. One of the incidents described by the employee’s complaint was finding a stuffed monkey hanging from a noose in his car. Turley v. ISG Lackawanna Inc. et al., case number 1:06-cv-00794, in the U.S. District Court for the Western District of New York.
“Economic Realities” Test under the Fair Labor Standards Act
There are some cases where a California court might be required to apply federal law to determine a worker’s proper classification. Under the federal Fair Labor Standards Act, or “FLSA,” the test for whether a relationship is one of employer-employee or independent contractor is not determined by the same common law standards used by the IRS. U.S. Department of Labor, Wage and Hour Division Fact Sheet 13. The FLSA test is generally referred to as the “Economic Realities” test.
The factors considered significant under “Economic Realities” are:
- The extent to which the services are an integral part of the principal’s business. As used here, “principal” basically means the entity that is hiring the worker.
- The permanency of the relationship.
- The amount of the alleged contractor’s investment in facilities and equipment.
- The nature and degree of control by the principal.
- The alleged contractor’s opportunities for profit and loss.
- The alleged contractor’s opportunities for profit and loss.
- The degree of independent business organization and operation.
Under the economic realities test, there are some factors, however, that are not considered material. The factors to which the economic realities test gives no weight are:
- The place where the work is performed.
- The presence or absence of a written employment or contracting agreement.
- Time and mode of payment.
- Whether or not an alleged independent contractor is licensed by state or local government.
In California, the “Economic Realities” test is rarely applied because California’s Fair Employment and Housing Act, Labor Code and wage rules are generally much more advantageous to workers than FLSA. The Dynamex decision is likely to skew the equation even more to workers’ favor in California.
Misclassification, Penalties, and Remedies
Just as there are numerous contexts under which the classification of an employee or independent contractor becomes important, there are also a variety of penalties to which an employer might be subject for a misclassification and a number of ways a misclassified employee might be able to recover damages.
Under California Labor Code § 226.8, it is unlawful for any employer to willfully misclassify an individual as an independent contractor.
Engaging in willful misclassification can subject an employer to a civil penalty by the Labor and Workforce Development Agency of anywhere from $5,000 to $15,000 for each violation.
“Willful misclassification” means “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.” Labor Code §226.8(j).
If the Labor and Workforce Development Agency, or any court, finds that an employer has engaged in a “pattern or practice” of misclassification violations, the employer may be subject to civil penalties ranging from $10,000 to $25,000 per violation.
The penalties applied by the IRS can be even heavier. Any person who misclassifies an employee as an independent contractor for the purpose of willfully attempting to evade or defeat any tax under the Internal Revenue Code may be found guilty of a felony, fined up to $100,000 and sentenced up to five years in prison. 26 U.S.C. §7201. The IRS may even impose penalties for misclassifications that are unintentional. See 26 U.S.C. §3102(f), §3509.
Remedies for workers
Workers who have been misclassified as independent contractors and who should have been classified as employees are entitled to recover all the benefits to which they would have been entitled had they been properly classified. See Labor Code §2802(a). This can include payment for back pay, plus interest, on account of insufficient minimum wage, overtime, or missed meal breaks and/or rest periods. In some cases, employees may also recover attorney fees and court costs. Labor Code §2699(g).
An employee misclassified as an independent contractor who gets laid off may still file a claim for unemployment insurance with the Employment Development Department. If the EDD determines the employee has been misclassified, he or she may still receive unemployment benefits and the employer could be fined.
Similarly, misclassified workers who are hurt on the job may still file a claim for workers compensation with the Department of Industrial Relations Division of Workers’ Compensation. Uninsured employers may be punished with fines up to $10,000 and/or imprisonment up to one year.