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Employee Versus Independent Contractor: Get It Right, or Pay the Consequences

Part of the fallout of the economic downturn is the emergence of the “freelance economy.” This is largely fueled by the financial advantages of hiring independent contractors instead of employees. But employers beware: Getting your classifications wrong can be costly.

The economic benefits of hiring an independent contractor are set out in the tax code: An employer generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee but don’t generally have to withhold or pay any taxes on payments to independent contractors. And of course, most employers do not provide medical and other benefits to independent contractors, as they do for employees.

But people and positions don’t come with clear labels stating “employee” or “independent contractor.” Employers need to get it right when they classify those who work for them or risk civil penalties for getting it wrong. Penalties for misclassifying an employee an independent contractor include taxes, penalties, and interest.

And those penalties are going up on January 1, 2012 for employers who willfully misclassify employees as independent contractors. Under Senate Bill 459, employers who violate the law are subject to an additional civil penalty of between $5,000-$15,000 for each violation, in addition to any other penalties or
fines permitted by law. Lab C §226.8(b).

So, how do you determine whether someone working for you is an employee or an independent contractor? The most important factor is the employer’s right to control the manner and means of accomplishing a desired result. If that right of control exists, it’s an employer-employee relationship.

But sometimes it’s just not clear whether the employer has the  “right to control.” That’s when the employer should look to the following 10 factors (22 Cal Code Regs §4304-1(a)):

  1. Distinct occupation or business (i.e., is the service provider engaged in a separately established occupation or business?);
  2. Industry custom (i.e., is the type of work usually done under the direction of a principal without supervision?);
  3. Skill (i.e.,is there skill required in performing the services to accomplish the desired result?);
  4. Tools and place of work (i.e.,is the worker or the principal providing the tools and place of work for the person doing the work? Note, this factor may be less significant when the worker is providing intellectual services);
  5. Length of time of service (i.e., what is the length of time in which the services are performed and is the performance an isolated event or continuous?);
  6. Method of payment(i.e., is payment by time, piece rate, or completed job?);
  7. Regular business(i.e.,is the work part of the principal’s regular business?);
  8. Intent of the parties(i.e.,what is the parties’ belief on whether they are creating an employer-employee relationship? Recent California cases, however, do not give much weight to the parties’ intent or how they characterize their relationship);
  9. Principal’s actual exercise of control (i.e.,although the right to control may be determinative, what is the extent of the principal’s actual control over the manner and means of performing the services?); and
  10. Benefit to principal (i.e.,is the principal engaged in a business enterprise or are the services for the benefit or convenience of the principal as an individual?).

These 10 factors are merely indicia of the right to control and are superseded by independent evidence that directly establishes that right. 22 Cal Code Regs §4304-1(b). Also, there are specific applications of these factors with respect to certain industries, real estate, professional home health care, computer services, art, and newspaper distribution. 22 Cal Code Regs §§4304-2—4304-6.

The federal and state governments lose a lot of needed tax revenue from independent contractor misclassifications and are stepping up enforcement. And enforcement may be just the beginning of a nightmare for employers. As the Morrison & Foerster Monthly News explains, [i]f the IRS or a state agency brings an enforcement action, it’s a fair bet that private actions claiming wage and hour and other violations will follow close behind.”

For everything you need to know about classifying employees and independent contractors, and the advantages of each, turn to CEB’s Advising California Employers and Employees, chap 3. CEB covers this issue in its CLE program, Employee or Independent Contractor: Misclassification Can Be Costly, available On Demand.

© The Regents of the University of California, 2011. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited.

10 Responses

  1. FYI, chapter 4 of CEB’s new title, Drafting Employment Documents for California Employers, is also dedicated to independent contractors. It includes a multi-page questionnaire designed to enable employers to determine whether a prospective worker should be classified as an employee or an independent contractor. It also includes a helpful table outlining the factors most commonly used by federal and state agencies and the courts in making the distinction.

  2. Great post Julie. Thank you!

  3. This issue resonates with me because a few years ago I represented a small silicon valley comedy club that was being sued by its workers compensation insurer for “unpaid” premiums because the insurer claimed that the COMEDIANS were the club’s employees!

    The insurer (AIG — that’s right, I’m namin’ names) tried to claim that because the club provided the place of work and that the performance of comedy was the club’s regular business, the comics were the club’s employees. But of course, the “place of work” factor is inapplicable in the performing arts field (are the Rolling Stones considered employees of the Oakland Coliseum when they come to town?), and the “principal’s regular business” argument is similarly inapplicable. And every other factor cut in favor of independent contractor status. Indeed, the comedians (who traveled around the country and would perform for a couple nights and then move on to another city) had their own business cards, publicity photos, websites, etc. It was so obvious that the comedians were legitimate independent contractors, it was hard to believe AIG actually sued my client.

    But they did, and they refused to back down, even after I explained the above facts to them. But we didn’t back down, either, and two days before trial, they dismissed the case!

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  5. so what do you do if someone files you as 1099 and you know he/she should have filed you as employee?? IRS tried to help me when I called but told me It was a self help question and only website can help me!

  6. ah! file a SS8 to determine !

  7. […] Employee Versus Independent Contractor: Get It Right, or Pay the Consequences […]

  8. […] Employee Versus Independent Contractor: Get It Right, or Pay the Consequences […]

  9. […] Employee Versus Independent Contractor: Get It Right, or Pay the Consequences […]

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