California employers already have plenty on their plates without also worrying about possible developments in employment law, but in this election season "change" is in the air.  Potential shifts in the political winds blowing in both Washington and Sacramento may soon affect California employers' classification of workers as independent contractors.  Independent contractors are an important part of many California employers' workforces and assuming a sound basis for classification exists, companies who engage a worker as an independent contractor rather than hiring him or her as an employee can potentially benefit from a broad range of features unique to the independent contractor relationship, including:

However, something that looks too good to be true often is exactly that, and even under existing law, many employers find themselves having to defend their decision to classify a worker, or group of workers, as independent contractors.

 

The issue of a worker's proper status can be raised in many ways, including unemployment claims, workers' compensation claims, wage/hour claims, tax issues and state or federal agency audits.  The legal test governing independent contractor classification is notoriously tricky, and the penalties for getting the wrong answer can be very substantial.  A threshold matter many businesses miss is that the parties' own characterization of their relationship does not control—instead, courts and government agencies look to the specific facts of the relationship to decide whether a worker is an independent contractor or an employee.  The mere fact that a company and a worker may have a written "independent contractor agreement" will not save the company from liability for misclassification if the facts of the working relationship do not support independent contractor status.

 

Part of the complexity of independent contractor classification is that each of the several government agencies with a "stake" in the issue has its own legal test.  What all have in common is that they are "multi-factor" tests which weigh a number of different elements in each specific worker's situation.  Think of them as "pebbles on a scale" tests—a company has to go through the list of factors, or "pebbles" and decide which side of the scale—contractor or employee—to place each pebble on.  Whichever way the scale tips at the end of the test is the best prediction of how a court or government agency might view the classification decision.  According to the California Employment Development Department (EDD), the agency most commonly involved in independent contractor determinations, the "basic test" for determining whether a worker is an independent contractor or an employee "is whether the principal has the right to direct and control the manner and means by which the work is performed."  Think of this as the "biggest pebble" on the scale—but not by any means the only one.  Other significant "pebbles" include:

Sometimes the "scale" will tip very clearly in one direction or another after all the "pebbles" are placed, but more often it teeters near the middle, leaving the company with a judgment call weighing the admittedly attractive benefits of independent contractor status against the potential risks—and the risks can be very significant. 

The potential penalties for misclassifying a worker as an independent contractor often operate like a row of dominoes—when one falls, others may fall in successive order.  A company found to have been misclassified a worker as an independent contractor can expect to pay back employer contributions for unemployment taxes and SDI premiums, plus penalties.  The unlucky employer may also be liable for state and federal income tax withholding and Social Security contributions, again, plus interest and penalties.  Should the situation arise as a result of a work-related injury where the worker was not covered by workers' compensation insurance, significant penalties can be assessed by the California Workers' Compensation Appeals Board.  Many of these back tax obligations are not dischargeable in bankruptcy, and depending on the number of independent contractors utilized and the scope of the enforcement action, the dollar amount of potential liability can spread far beyond the individual worker at issue.

Many California employers are also unaware of the requirement to report the initial engagement of most independent contractors to the EDD by filing form DE 542 (or entering the information on line).  While the stated purpose for requiring reporting of independent contractors is to locate parents working as independent contractors who are delinquent in their child support obligations, it bears notice that the EDD is also the principal state agency auditing compliance with independent contractor classification.  According to a recent Los Angeles Times article, the chances of "getting busted" by the state "are growing as the state cracks down on businesses that wrongly claim employees are independent contractors and, as a result, are not subject to a slew of taxes and labor laws."

Getting "busted" does not happen only in the context of a state or federal agency audit.  Recently, FedEx Ground Package System has been in the news in connection with that company's classification of truck drivers as independent contractors.  In late December, 2007, the IRS announced that, for the tax year 2002, it would impose a fine of $319 million for misclassifying some 13,000 FedEx Ground drivers as independent contractors.  On top of the IRS action, lawsuits were filed against FedEx Ground in many states by the affected drivers.  In the California case, Estrada v. FedEx Ground, 154 Cal. App. 4th 1 (2007), the California Court of Appeal found that drivers who worked full time, were paid weekly, had regular schedules and routes, received some employer benefits, wore company uniforms, used company equipment, and were required to work exclusively for the company, were employees, whose business expenses had to be reimbursed by Fedex.

Because of a perception that misclassification of workers as independent contractors is widespread in the U.S. economy, the issue has quietly attracted recent legislative attention in Washington.  In September 2007, Senator Obama introduced the "Independent Contractor Classification Act of 2007" (S. 2044).  Co-sponsored by a number of other notable U.S. Senators, including Barbara Boxer, Hillary Clinton and Edward Kennedy, this proposed federal legislation would allow the IRS to issue regulations on independent contractor classification and eliminate the defense of "industry practice" as a justification for misclassifying workers as independent contractors.  It would also require the Department of Labor to create a procedure for workers to petition for a determination of their status as employees or independent contractors and require employers to include notice of this process in a workplace poster.  Employers would further have to provide a notice to independent contractors of their federal tax obligations, the legal protections inapplicable to independent contractors, and their right to seek a determination of their status.  This bill was referred to the Senate Finance Committee and has not yet been acted on, but, given its primary sponsor, could easily become a legislative priority after the November election.

The U.S. House of Representatives also has two bills pending on independent contractor classification which were introduced following March 2007 hearings held in the House Committee on Education and Labor, Subcommittee on Workforce Protections, chaired by Rep. Lynn Woolsey (D-CA), focusing on the costs of employees misclassified as independent contractors.  Rep. Woolsey has been quoted as stating that "Employers who misclassify their employees as independent contractors rob workers of needed pay and benefits and cost government at all levels substantial uncollected revenues." 

On May 21, 2008 Rep. Robert Andrews (D-NJ) introduced the "Employee Misclassification Prevention Act" (H.R. 6111), which would require notice by an employer to every employee and independent contractor of their classification status, directing each worker to a Department of Labor website providing information about employee rights.  This bill would make misclassification of a worker as an independent contractor a violation of the federal Fair Labor Standards Act, and double the amount of liquidated damages under that law for wage and hour violations resulting from misclassification.  In support of H.R. 6111, the bill's sponsors have cited a Coopers & Lybrand study estimating that the federal government lost $34.7 billion in taxes between 1996 and 2004 because of misclassification of workers.  Also cited by the bill's sponsors is an estimate by the Government Accounting Office that more than 10 million workers in the U.S. are classified as independent contractors, and that "many of those are misclassified, deliberately or otherwise, when they are really employees."  Separately, on April 15, 2008, Rep. James McDermott (D-WA) introduced the "Taxpayer Responsibility, Accountability and Consistency Act of 2008" (H.R. 5804), which would allow for a determination of workers' employment status for employment tax purposes, and prohibit retaliation against workers for seeking such a determination. 

These developments have not gone unnoticed in the California Legislature.  Though vetoed by Governor Schwarzenegger in late 2007, SB 622 would have made unlawful the "willful classification of an employee as an independent contractor" and assessed specific civil penalties of up to $25,000 on top of any other penalties or fines resulting from misclassification.  Two other bills addressing independent contractor classification are currently pending in Sacramento.  Passed in both the Senate and Assembly, SB 1583 would make it unlawful for non-attorney third-party consultants to "knowingly advise an employer to treat an individual as an independent contractor to avoid employee status" and holds such advisors jointly and severally liable with the employer for any adverse determination regarding the individual's classification.  A broader bill, SB 1490, is still in committee, but like Senator Obama's proposed federal legislation, would require an employer to provide an independent contractor with a written notice explaining eligibility for labor and employment law protections, the impact of their tax status, and a right to request a written determination from the EDD as to whether the individual is properly classified as an independent contractor. 

As these developments continue to simmer, this may be a good time for businesses who use, or plan to use independent contractors as part of their workforce to take a close look at the standards for classification and see which way the "scale" tips.  As the potential penalties increase, and with the prospect that new legislation may subject independent contractor classification to even closer scrutiny, employers may want to determine well in advance of any new legislation whether they are on solid ground.