Independent Contractor vs. Employee

Independent Contractors - California & Federal Law

There are important differences between hiring an individual as an independent contractor or as an employee. Mislabeling a worker as an independent contractor creates potential liability for employment taxes and penalties, and liability for failure to fulfill the many legal obligations owed to an employee, such as wage and hour requirements. Using a true independent contractor can relieve you of the many burdens placed upon you by California and federal employment laws, but simply calling someone an independent contractor does not make him or her one in the legal sense.

General Issues with Independent Contractors

Before classifying an individual as an independent contractor, familiarize yourself with the different tests that courts and governmental agencies use to determine independent contractor status.

Common Misconceptions

Many employers operate under the misconception that an individual can be classified as an independent contractor by signing an agreement to be one, or by working somewhere other than the employer’s normal place of business. This simply is not the case.

A Common Mistake is classifying an individual as an independent contractor vs. employee.

California Common Law Test and the ABC Test

California courts and administrative agencies have generally applied common law principles to determine independent contractor status. Recently, however, there have been major developments in independent contractor law.

Beginning January 1, 2020, a new law, commonly referred to as Assembly Bill 5 (AB 5), significantly altered the way California law distinguishes between employees and independent contractors. The new law follows the 2018 California Supreme Court’s decision in Dynamex Operations West, Inc v. Superior Court of Los Angeles that set aside the longstanding common law classification standard focused on an entity’s control over the worker and adopted a rigid “ABC test” to distinguish an employee from an independent contractor, though the decision was limited to application of the Industrial Welfare Commission (IWC) Wage Orders. AB 5 codified and expanded the ABC test, making it the general test for purposes of applying the Wage Orders and the Labor and Unemployment Insurance codes.

The most important factor in the common law determination involves the independent contractor's right to control the manner and means of accomplishing the desired result, even if the contractor does not exercise that right with respect to all details.

Under the ABC test, an individual is presumed to be an employee, unless the hiring company can prove that the worker:

  • Is free from control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  • Performs work that is outside the usual course of the hiring entity's business; and
  • Is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.

Failure to satisfy each of the three elements will result in an individual being classified as an employee.

California’s new law creates numerous exceptions to the ABC test for various industries and professions. If an exception applies, then courts and agencies will apply the test specified in the statutory exception, usually the control test, sometimes called the “Borello test” after the California Supreme Court case it is drawn from, S. G. Borello & Sons, Inc. v. Department of Industrial Relations. The Borello test is a more flexible factor-based test that focuses primarily on the hiring entity’s right to control the manner and means of performing the work but also requires consideration of several other factors.

Because different tests are applied depending on the legal issue and the specific circumstances of the business, employers should always consult with legal counsel to make sure workers classified as independent contractors can meet all applicable legal requirements.

Workers' Compensation

The Borello test, as described in S. G. Borello & Sons, Inc. v. Department of Industrial Relations, which focuses on the hiring entity’s control over the manner and means of performing the work, along with additional factors, has been the applicable test for determining independent contractor status in the context of workers’ compensation. However, under AB 5, beginning July 1, 2020, the ABC test will be the applicable test for the purposes of workers’ compensation.

Federal Taxes and Independent Contractors

The IRS is the federal taxing authority that determines whether an employment relationship exists between a worker and employer that requires payment of federal employment taxes, including Social Security taxes, payment under the Federal Unemployment Tax Act and withholding of worker-owed employment taxes.

Misclassification of bona fide employees as independent contractors may result in the federal government collecting significant financial penalties from employers and the IRS aggressively auditing companies to expose abuses. It is estimated that as much as $1.5 billion in income, Social Security withholdings and unemployment tax revenue is lost annually due to misclassification of as many as 3.5 million workers as independent contractors. Companies judged by the IRS to have misclassified employees as independent contractors face not only large government fines but also payment of employment taxes.

Wages and Hours

The true nature of the relationship between a wage claimant and a purported employer is addressed by the California Labor Commissioner when the issue of independent contractor status is raised in a wage claim or audit proceeding. Labor Commissioner's hearing officers and auditors use the ABC test in making determinations of employee or independent contractor status, unless a statutory exception applies, in which case they apply the test specified in the statutory exception, usually the Borello test.

Employers with questions about whether their independent contractors are properly classified should consult with legal counsel.

Independent Contractor Reporting Obligations

All businesses and government entities that hire independent contractors must file reports with the state Employment Development Department.

The independent contractor reporting program is designed to locate parents who are delinquent in their child support obligations. Businesses operating outside California are subject to this law as well. For example, an independent contractor who works in California for a business based in Texas must be reported to California's EDD.

Penalties

There is a penalty for each instance of late filing or failure to file the Report of Independent Contractors, unless there is good cause. The penalty increases if there is a conspiracy between the hiring entity and the independent contractor not to supply the required report or to supply a false or incomplete report.

Related Resources

HRCalifornia members have access to several tools and services that help those who manage human resources to work through independent contractor-related issues, including:

  • Independent Contractors Report - DE542 »
    Any business or government entity that is required to file a Federal Form 1099-MISC for service performed by an independent contractor must report using this form.