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 many factors the different 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, since the law does not specify criteria for such determinations.

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.

However, in April of 2018, the California Supreme Court adopted a new, three-part "ABC" test for independent contractor status for claims brought under the state’s wage orders. Under the ABC test announced by the court in Dynamex Operations West, Inc. v. Superior Court of Los Angeles, you must now prove each of the following elements in order to establish that a worker is an independent contractor and not an employee:

  • 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;
  • That the worker performs work that is outside the usual course of the hiring entity's business; and
  • That the worker 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 for purposes of the requirements of California wage orders.

Workers' Compensation

In an earlier case, S. G. Borello & Sons, Inc. v. Department of Industrial Relations, the California Supreme Court discarded the common law test as the sole means of determining independent contractor status in relation to workers' compensation coverage. The court applied six additional factors federal authorities use as well as the right-to-control factor.

This decision affected independent contractor status not only for workers' compensation purposes but for other employment-related claims as well. As a result, there has been a decrease in the number of independent contractor relationships upheld by the courts and administrative agencies.

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 right to control as well as other factors in making determinations of employee or independent contractor status.

It is still unclear whether the ABC test will be adopted by the Labor Commissioner or other agencies. 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.