INDEPENDENT CONTRACTOR OR EMPLOYEE: YOU DON’T MAKE THE CALL (PART 1)

In the increasingly complex landscape of employment law and regulation, determining whether a worker should be classified as an employee or an independent contractor seems like it should be a fairly straightforward assessment. The distinction, however, is not always obvious, and it cannot be made on paper alone. In this two-part article, we will explore the significance of this distinction, the factors to be considered, and some recent developments of which employers should be aware.

Employers have a variety of responsibilities relative to employees that do not exist for independent contractors in the areas of taxation, benefits, and wage and hour protections.  According to the Internal Revenue Service (IRS), an employer’s responsibilities for workers classified as employees include, but are not limited to, the following:

• Obtaining a completed Employee’s Withholding Allowance Certificate (Form W-4) from each employee upon hire
• Withholding and depositing federal income tax, Social Security and Medicare tax each pay period
• Reporting income and employment taxes withheld on an Employer's Quarterly Federal Tax Return (Form 941)
• Reporting and paying federal unemployment (FUTA) tax quarterly, as applicable (Form 940)
• Issuing a Wage and Tax Statement (Form W-2) annually 

Employee classifications may be examined by state or federal agencies in cases when the legitimacy is challenged, such as claims for unemployment insurance benefits, unpaid wages, workers' compensation, or allegations of employment discrimination.  In addition, these relationships may come under scrutiny during IRS or state agency investigations auditing wage payments, workers' compensation coverage, or Unemployment Insurance Fund contributions. It is against the law to willfully misclassify an employee as an independent contractor, and the cost of misclassification can be significant. An employer could find itself liable for back wages, unpaid overtime, benefit compensation, and monetary penalties for failure to comply with applicable labor laws, in addition to any liability for unpaid state and federal employment taxes, social security, and related penalties. Under California law, a “willful” misclassification could further expose an employer to civil monetary penalties and the requirement to post specified notices on its website and in an area accessible to all employees and the general public pertaining to the misclassification.[i]

Different tests are used by courts and government agencies to determine whether a worker is an employee or an independent contractor. Application of the same set of facts to each test may yield different results, so it is important to understand which enforcement agency governs the situation and which test that agency will apply.

Right to Control Test
In California and Nevada, courts generally apply the common law agency or “right to control” test.  However, as discussed further below, if the claim is based on a California wage order violation, then the more stringent ABC Test will apply. California Labor Code §3353 defines an independent contractor as “any person who renders service for a specified recompense for a specified result, under the control of his principal as to the result of his work only and not as to the means by which such result is accomplished." Similarly, Nevada Revised Statutes §284.173(2)defines an independent contractor as “a natural person, firm or corporation who agrees to perform services for a fixed price according to his or its own methods and without subjection to the supervision or control of the other contracting party, except as to the results of the work, and not as to the means by which the services are accomplished.” 
The IRS has identified Common-Law Rules[ii]for determining whether a worker is fairly classified.  These factors, which incorporate a “right of control” test, are broken down into three categories below.  No one factor is decisive, and the weight given to any one factor is determined on a case-by-case basis.

1. Behavioral Control. Facts showing whether the business has a right to direct and control include:

• Instructions - whether the employee is generally told:
• When, where, and how to work
• What tools or equipment to use 
• What workers to hire or to assist with the work 
• Where to purchase supplies and services 
• What work must be performed by a specified individual 
• What order or sequence to follow
• Training – whether the employee is trained to perform services in a particular manner.
  

2. Financial Control. Facts showing whether the business has a right to control the business aspects of the worker’s job include:

• Extent to which the worker has unreimbursed expenses 
• Extent of the worker’s investment 
• Extent to which the worker makes services available to the relevant market 
• How the business pays the worker 
• Extent to which the worker can realize a profit or loss
  

3.   Type of Relationship. Facts that show type of relationship include:

• Written contracts describing the relationship the parties intended to create 
• Whether worker is provided with employee-type benefits 
• Permanency of the relationship 
• How integral the services are to the principal activity 

Both the IRS (Form SS-8) and the California EDD (Form DE 1870, DE-38) offer forms that an employer may complete and submit in order to seek a determination as to a worker’s appropriate classification for tax purposes (IRS Form SS-8, EDD Form DE-1870 and DE-38).  However, credit unions are encouraged to use these forms for self-evaluation rather than formal determinations.
Note:  Many state courts do not adhere exclusively to the common law test when interpreting state employment laws. For example, the California Supreme Court has held that the common law test is merely "useful" to determine status under workers' compensation law, and that the federal "economic realities" test discussed in the next article is more useful for this and other employment statutes, such as state anti-discrimination law.[iii]

ABC Test
On April 30, 2018, the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court of Los Angeles[iv](“Dynamex”)adopted a more stringent test, known as the “ABC Test,” applicable to California wage order violations. Historically this test has been applied in other states such as Massachusetts, Vermont and New Jersey. At this time, it is unclear how this test will be interpreted and applied by California lower courts and state agencies to the various industries.  It is also too soon to tell how this test will impact other violations not involving a wage order, such as worker’s compensation or claims arising under the Labor Code.  However, to the extent the violation involves a wage order, the ABC Test will be used to determine independent contractor status.
The ABC Test presumes the worker is an employee and places the burden on the hiring entity to prove independent contractor status. In order to meet this burden, the employer must meet allof the following three “Parts”:
Part A: The worker is free from the hiring entity’s control and direction in connection with the performance of the work, both under the contract for performance of the work and in actual performance of the work;
Part B:  The worker performs work that is outside the usual course of the hiring entity's business; and
Part C:   The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

If a hiring entity fails to pass any one of these tests, then the worker will be considered an employee.  For this reason, the court explains that the factors may be analyzed in any order.  For example, it may be easier to determine whether Parts B or C are met; therefore, these parts may be analyzed first.  If the hiring entity fails to meet the burden in those parts analyzed first, then the no further analysis will be required and the employee will be considered an employee. 

Under Part A, the court will look at the contract for the performance of work, as well as the actual work performed and evaluate whether the worker is subject to the type and degree of control a business typically exercises over its employees. If the degree of control is comparable to what the hiring entity exerts over an employee, then then worker will be considered an employee, not an independent contractor.

For Part B, the court will look to see if the work being provided is truly unrelated to the hiring entity’s business.  This part is strictly applied and could be very difficult for a hiring entity to establish.  An example the court made of unrelated work was a plumber performing plumbing services for a company that sells clothes.  This was juxtaposed against a seamstress working from home for a clothing manufacturer making dresses with materials supplied by the hiring entity. In the latter example, the worker would be considered an employee.

Part C applies the plain language of the term “independent” in the independent contractor label and analyzes whether the worker has independently made the decision to operate his or her own business and is “customarily engaged in an independently established trade, occupation or business.”  This can be established by showing that the worker took the usual steps to establish and promote his or her business, such as incorporation, business licenses, advertisements or routine offerings.  The court emphasized that a hiring entity would not be able to meet its burden under this Part by simply showing that it did not prevent the worker from engaging in such a business.  

The practice of classifying a worker as an independent contractor is now much riskier in light of the application of the ABC test to wage order violations.  So, this type of relationship should be carefully reviewed with legal counsel and if it appears that any element of the three-part test can not be met, then consider reclassifying the worker as an employee.

[i]Calif. Labor Code §226.8.
[ii]IRS Publication 15-A (Rev. Feb. 21, 2018).
[iii]S.G. Borello & Sons v. Department of Industrial Relations, 48 Cal.3d 341 (1989).
[iv]Dynamex Operations West, Inc. v. Superior Court of Los Angeles, 4 Cal. 5th903 (2018).