Legal Updates on Independent Contractor Classification

Employment Law  

October 2011

Legal Updates on Independent Contractor Classification

Dealing with employees can be overwhelming. Payroll, litigation concerns and the like can lead a company to look for alternatives to save money and eliminate the hassle involved in managing employees. One way in which companies have attempted to address this issue in the past is to classify workers as independent contractors rather than as employees. Such a decision should not be made lightly, however. If fact, in many cases an independent contractor classification will not meet legal standards and can subject a company to increased penalties and litigation, in addition to repaying the amount initially saved by classifying the workers as independent contractors.

Law Governing Independent Contractor Classifications

Independent contractors tend to work in an entrepreneurial fashion, independent from the multiple companies with which they contract, whereas employees work at the direction of a single employer. Challenges to independent contractor classifications typically come in the form of a California Employment Development Department (“EDD”) or federal Internal Revenue Services (“IRS”) audit. These entities seek recovery of unpaid taxes, statutory benefit contributions, interest and penalties.  However, potential liability is not limited to EDD and IRS audits. Individual workers, as well as the federal Department of Labor (“DOL”) and the California Labor Commissioner, can challenge independent contractor classification in either a civil or administrative action in order to recover unpaid wages (including overtime), meal and rest period violations, and other violations of federal or state laws.

Depending on who is challenging the classification and in which forum, the test to determine independent contractor versus employee status will vary. In most cases, however, the focus is on whether the person who hires an individual to perform services has the right to exercise direction and control over the manner and means by which the individual performs his or her services even if that right is not exercised.

IRS Creates Voluntary Classification Settlement Program

Recently, the IRS announced a new initiative called the Voluntary Classification Settlement Program (“VCSP”). Under the VCSP, companies will be able to resolve past misclassification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying workers as employees. Under the program, eligible companies can obtain substantial relief from past federal payroll taxes if they prospectively treat workers as employees. The VCSP is available to many businesses, tax-exempt organizations and government entities that currently erroneously treat their workers or a class or group of workers as nonemployees or independent contractors, and now want to properly classify them as employees.

To be eligible, a business must: (1) consistently have treated workers in the past as independent nonemployees; (2) have filed all required 1099 forms for all workers for the previous three years; (3) not currently be under audit by the IRS; and (4) not currently be under audit by the DOL or a state agency concerning the classification of workers.  Employers accepted into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating companies will, however, have to classify the workers as employees going forward. In addition, for the first three years under the program, the companies will be subject to a special six-year statute of limitations rather than the usual three year limitation that generally applies to payroll taxes.

Significantly, however, states are not bound by the VCSP program. As a result, in California the EDD can still conduct its audit and individual employees, as well as the Labor Commissioner, can seek recovery for unpaid taxes, wages, etc.

New California Legislation Increases Liability for Companies Who Intentionally Misclassify

At the same time as the IRS is announcing its VCSP amnesty program, California has enacted legislation that will increase penalties for companies that intentionally misclassify workers. The Legislature first introduced SB 459 in February 2011, and Governor Jerry Brown signed the bill into law this month.  SB 459, which will add Sections 226.8 and 2753 to the California Labor Code, focuses primarily on companies who willfully misclassify employees as independent contractors. The legislation defines “willful misclassification” as “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.”

Among other things, the bill will: (1) prohibit willful misclassification of employees as independent contractors; (2) prohibit charging individuals who have been mischaracterized as independent contractors a fee or making deductions from compensation, where those acts would have violated the law if the individuals had not been mischaracterized; (3) authorize the Labor and Workforce Development Agency (“LWDA”) to assess civil penalties and take other disciplinary actions against persons or employers who violate these provisions; (4) require the LWDA to notify the Contractors’ State License Board of a violator that is a licensed contractor and require the board to initiate an action against the licensee; (5) authorize an individual to file a complaint with the Labor Commissioner to issue a determination that a person or employer has violated these prohibitions with regard to the individual filing the complaint; and (6) authorize the Labor Commissioner to assess civil and liquidated damages against a person or employer based on a determination that the person or employer has violated these prohibitions. Penalties against the companies subject to this law range from $5,000 to $25,000 for each violation, in addition to any other penalties or fines permitted by law.

Finally, the bill also requires companies who violate the law’s provisions to post on their websites and in public areas that they willfully misclassified independent contractors and imposes personal liability on non-lawyer consultants who advise employers to misclassify employees as independent contractors.

What Should Employers Do?

  • Consult with legal counsel to determine whether workers are properly classified as independent contractors.
  • Effectively assess the risks of misclassification, including simultaneous administrative and civil proceedings and increased liability in the form of unpaid wages and benefits, penalties and interest as well as other disciplinary action.

Please note that the information contained in this newsletter is not intended to provide specific legal advice. You should consult with an attorney and not rely on any information contained herein regarding your specific situation.