Independent Contractor or Employee? How to Choose Properly

One of the most common ways an employer gets into hot water is to improperly classify an employee as an independent contractor (“IC”). This is an important issue for businesses for a few reasons. There is no single, simple rule you can use to determine the proper employment status of an individual you hire to work for you. Several state and federal agencies pay close attention to this facet of operating a business. The cost of “getting it wrong” can be steep.

Who Cares About Classification as Independent Contractor or Employee?

Multiple state and federal agencies maintain regulations concerned with whether or not your business properly classifies the persons that you employ or hire. In California, the agencies that are most involved are:

• Employment Development Department (EDD) – ensures that your business is properly paying employment related taxes
• Division of Labor Standards Enforcement (DLSE) – enforces wage, hour and workers’ compensation insurance regulations
• Franchise Tax Board (FTB), Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB) also maintain regulations that touch upon how workers are classified
• The IRS and other Federal authorities have a hand in this too

These agencies are strict about enforcing their rules because the incentives for businesses to misclassify a person are significant (and therefore attractive) and the harm that can be done to workers is real. By classifying individuals as ICs, the employer gets to:

• Shift responsibility for payroll taxes to the worker
• Avoid workers’ compensation insurance
  • Bypass minimum wage, overtime pay, or other wage and hour requirements
• Simplify their accounting and administration

Because each agency has its own regulations, it is quite possible for an individual to be considered an employee by one agency and a contractor by another. Like I said, there is no single, simple rule to follow.

The Penalties for Misclassifying Workers

Accidentally misclassifying workers as ICs will most certainly result in penalties imposed by the IRS and the state as well as the need to properly classify workers going forward. If it is determined that the misclassification was intentional, then the penalties would be higher AND the employer would be responsible for the taxes that should have been withheld. If wage and hour rules, or other employee protections, were violated then the consequences become even more severe.

How to Determine a Worker’s Classification

The legal obstacle course of multiple agencies, each with their own definition of proper classification, may seem like it leaves business executives with no clear path. Luckily, as the law has developed in California, it has led to the development of a now commonly used “economic realities” test to help employers understand when an IC relationship is appropriate. Each circumstance should be evaluated as a whole and in context, but the factors that matter are the following:

• The degree of the employer’s right to control the manner in which the work is to be performed. An IC would have significant control over their day-to-day work.
• The worker’s opportunity for profit or loss depending upon his managerial skill. An IC is less likely to be paid by the hour and would therefore be able to earn more by being more highly skilled.
• The worker’s investment in equipment or materials required for her task, or in the employment of helpers. If the worker provides these, they are more likely to be considered ICs.
• Whether the service rendered requires a special skill. The more highly skilled, the more likely the IC classification is appropriate.
• The degree of permanence of the working relationship. Short-term, discrete jobs are often performed by ICs.
• Whether the service rendered is an integral part of the employer’s business. If it’s integral to the employer, then the relationship is more likely employer-employee.

If your business currently has relationships with workers that are treated as ICs, take a moment to review the above factors. Merely establishing an agreement that documents the relationship as IC, and providing a 1099 instead of W2 is not sufficient. If your relationship is truly one of a customer and IC, then it is important for the purposes of protecting your business to keep it that way. Just as employment rules are intended to protect the workers, arm’s-length agreements with outside contractors protect your company from liabilities that could stem from their actions.

What to Do Now

This post is not an exhaustive discussion of this issue. If you’re unsure about how to properly classify an individual who works for you, the California Employer’s Guide provided by the EDD is a valuable resource. EDD also offers an Employment Determination Guide complete with a series of “yes or no” questions to help you make the right choice. Each circumstance needs to be reviewed carefully and in context. Consulting an attorney versed in California and Federal employment laws will help you properly evaluate your company’s particular situation.