California Independent Contractor vs Employee

California independent contractor and employee rules affect taxes, overtime, wage claims, and business compliance. AB5, the ABC test, Borello, and misclassification penalties shape worker classification decisions.

By Brad Nakase, Attorney

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Table of Contents

1. Introduction

2. Federal Worker Classification Rule

3. IRS (federal) exemptions for statutory non-employees and employees

4. California Worker Classification Rule

5. Borello: When the ABC Test Is Inapplicable

6. EDD (California State) & the IRS (Federal): Employer responsibilities

7. Repercussions for companies that misclassify employees

8. Options for reducing obligations and voluntary compliance for workers who have been misclassified

9. FAQs

Introduction

For a variety of reasons, including staffing flexibility or lower office costs, both large and small firms nationwide use independent contractors or freelancers. Understanding the distinction between an independent contractor and a company employee is necessary for an organization’s tax needs, since these people drive today’s gig economy.

Government agencies are examining businesses to determine whether they are designating their workers as independent contractors rather than employees in order to avoid paying workers’ compensation, social security, unemployment taxes, and Medicare.

Federal Worker Classification Rule

A revision to the Fair Labor Standards Act’s classification of employees vs independent contractors has been recommended by the U.S. Department of Labor. By examining the following, these regulations made it simpler for companies to categorize employees as independent contractors:

The degree to which the services provided are essential to the employer’s operations.
The enduring nature of the employer-employee relationship.
The amount of funds employees spend on facilities, tools, and equipment.
The type and extent of the employer’s control over the employee.
The potential for earnings and losses for the worker.
The degree of initiative, discernment, or vision needed for a person to succeed in an open marketplace competition with other people.

The Department of Labor is suggesting that employers take exclusivity into account under the permanency element in the revised regulations. The new adjustments go back to considering the entire situation, with no element being more significant than any other. Employers may take into account the following economic reality elements under the revised regulations:

The level of expertise needed for the job
The extent to which the professional relationship is permanent
The worker’s expenditure on tools or supplies needed for the job
The degree to which the provided service is essential to the employer’s operations

Delivery services, ride-hailing businesses, and other industries will be most affected by the new regulations. These gig workers might be categorized as employees of the business rather than independent contractors. They carry out tasks that are essential, vital, or fundamental to the employer’s main business.

Businesses ought to consider these factors when classifying a person as an employee or an independent contractor in California. A worker’s status as an employee or independent contractor in California is determined by numerous variables. Some may favor one categorization while others may favor another. Furthermore, the type of business or offerings being provided may determine how these characteristics are evaluated.

For instance, since videography is typically not one of the legal firm’s primary services, a videographer engaged by the firm to film an interview is more likely to be regarded as an independent contractor in California. On the other hand, as videography is typically one of the primary services offered by a film production firm, a videographer engaged by the company to provide filming services is probably going to be seen as an employee.

IRS (federal) exemptions for statutory non-employees and employees

For some employment tax purposes, employees can be considered as statutory employees even if they would otherwise be regarded as independent contractors. These examples include: (1) drivers who pick up and transport dry cleaning or distribute food items; (2) permanent life insurance sales representatives; (3) people who work from home on supplies or products that are provided by someone and given back to them; and (4) permanent traveling salespeople.

On the other hand, direct sellers, registered real estate brokers, and some companion sitters are among the three types of statutory non-employees that the IRS recognizes. Direct sellers and authorized real estate agents are considered self-employed if: (1) an agreement in writing stating that they aren’t employees for tax purposes (federal) is in place; and (2) the majority of their regular payments are directly tied to sales performance instead of hours worked.

California Worker Classification Rule

1. AB5 in California

A few states, including California, Illinois, Massachusetts, Florida, and New York, have certain qualifying requirements in addition to the federal regulations to decide whether a person can be categorized as an employee or an independent contractor. The strictest description of an independent contractor is found in California’s AB5 statute.

AB5 is California’s gig worker statute. The law distinguishes between an employee and an independent contractor in California using the ABC test. It relies on the California Supreme Court’s Dynamex ruling. Employees are regarded as independent contractors if they satisfy each of the three requirements.

Regarding the execution of the work, the individual operates independently of the hiring company.
The individual works for the recruiting organization outside of regular business hours.
The individual regularly works in a profession, trade, or business that has been independently created.

For the purposes of state wage, hour, and unemployment benefits, workers who do not meet all three requirements must be considered employees.

2. Architects’ Particular Occupation Exception

Certain professions are expressly exempt from the ABC assessment of AB 5 under the law. Particularly, an individual is exempt if they are a practicing architect, lawyer, engineer, accountant, or private investigator with an active California license. An employer must use the earlier Borello criteria to decide whether to classify the licensed professional as an employee or an independent contractor in California because AB 5 does not apply.

Governor Gavin Newsom signed AB 2257 into law. It immediately altered the legislation controlling whether a company can establish an independent contractor arrangement with another business to clear up any doubt in AB5. AB 2257 establishes a business-to-business exception from the Dynamex test. The simpler Borello test is applicable.

This exemption only pertains to those who are licensed. It does not apply to people who are normally employed in the field.

3. Exception for Business-to-Business Service Providers

A solo professional with a limited liability company who works full-time for a corporation, just like one of its employees, will probably be considered an employee. The legislation views the notion that the two are independent and distinct enterprises as a ploy to get around employment regulations. Thankfully, the legislation permits legitimate, independent enterprises to continue operating as independent contractors.

A written contract is necessary for the business-to-business services provider exemption. The business service provider must:

Be an enterprise (corporation, LLP, partnership, etc.)
Be appropriately licensed (if licenses are required)
Be separate from the hiring organization
Function from a different place than the hiring organization
Keep a clientele apart from the employment company
Present itself to the public as being able to offer comparable services to others
Be independent of the hiring company’s guidance and supervision; establish its own prices
Supply its own instruments/tools
Offer its services to the hiring company directly rather than to its clients
Do not carry out tasks that call for a Contractors State License Board license

All things considered, the exception typically permits an architectural firm to employ a business to offer some of the more conventional independent contractor services, such as a sub-consultant engineering firm.

4. Exception for Professional Services

The “professional services” exception is the other significant exception to AB 5. For the objective of this law, “professional services” are described in Labor Code Section 2750.3 as marketing services that include graphic design, fine art, and conventional photography, marketing administration, and some other specific artistic and technical work.

Professional service providers are excluded from AB 5 when they carry out the legally required tasks and:

Keep a place of business apart from the recruiting organization.
Possess a business license in addition to any licenses or permits that are necessary for the person to conduct their profession.
Establish their own prices, manage their own schedules.
Appear to be capable of performing the same kind of labor for others.
Possess judgment and discretion when rendering the services.

The fact that the entity offering the professional service may be an individual distinguishes the professional services exemption from the business-to-business exemption. It is not necessary to use a company to deliver professional services. As the name implies, the service provider must be a business of some kind for the business-to-business exception to apply.

Borello: When the ABC Test Is Inapplicable

When AB 5 is not applicable, an employer determines whether a worker is an employee or an independent contractor in California using the outdated Borello test. Compared to the ABC test, the Borello assessment is more subjective because it considers the connection as a whole and evaluates the general “economic reality.”

The most important factor is whether the employer has authority (or the authority to control) over the employee’s employment, including the type of work they do and how they do it. In essence, is the employer solely concerned with the finished product, or does the employer have control over the worker’s means and methods? Depending on the problem at hand, it also takes into account other elements like:

Whether the employee’s occupation differs from the company’s.
Whether the task is a regular element of the company’s operations.
Whether the worker or the firm provides the tools, equipment, and workspace.
The worker’s capital investments in the tools or supplies needed to complete the task, and the expertise needed for the specific job.
The type of work, including whether it is typically carried out by an expert without monitoring or under the business’s direction in the area.
The employee’s potential for profit or loss is based on their managerial abilities (bonuses are not included in this potential).
The extent to which the working connection is permanent.
The mode of remuneration, such as time or work.
Whether the parties think they are establishing an employer-employee relationship.

A person is not automatically classified as an employee by the Borello test based on a single fact or factor. Rather, depending on the “economic reality” of their relationship, all elements are balanced & weighed against one another to establish whether a person is an employee or an independent contractor in California. This is not the same as the ABC test or the various AB 5 exceptions, which call for the employer to prove each of the test’s three components before classifying an employee as an independent contractor.

EDD (California State) & the IRS (Federal): Employer responsibilities

Form 1099-NEC or 1099-MISC ought to be filed with the IRS for an independent contractor. This needs to happen when the employer pays the worker $600 or more annually. Additionally, the company must submit a DE 542 (Report of Independent Contractor) to the EDD within 20 days. This is after paying $600 or more or signing a contract with an independent contractor for $600 or more within any given fiscal year. There is no need to withhold money from an independent contractor’s salary.

On the other hand, if the staff member is an employee, the employer is required to pay the company’s share of taxes on employment on those wages, withhold & deposit the individual’s share of employment-related taxes on those wages, and report the employee’s earnings to the IRS and EDD. These payments must be made electronically by the employer on a predetermined timetable (monthly or semi-weekly).

In most cases, the employer must submit quarterly and annual tax returns that show the payment amounts. Social Security, Medicare taxes (including supplementary Medicare tax on workers earning over a specific amount), & federal unemployment tax are examples of employment taxes paid to the IRS.

In addition to withholding & depositing State Disability Insurance & Personal Income Tax (“PIT”) owed from the employee on earnings paid (and deducted by the employer on the EDD’s behalf), employment taxes to EDD comprise Unemployment Insurance & Employment Training Tax computed on those wages.

Repercussions for companies that misclassify employees

A company may be responsible for paying employment taxes for a person who is classified as an independent contractor, which would be imposed at a higher rate if there is no justification for this classification. Furthermore, the relief measures listed below will not be applicable.

Employers who fail to submit their employment tax payments on time, in the right amount, & in the right manner may also be subject to a failure to make a deposit penalty from the IRS. Additionally, since the firm had initially filed Form 1099 for submitting payments as if it were for an independent contractor, the IRS may impose an information return fine for the business’s failure to file Form W-2 with the IRS and deliver such Form W-2 to the worker.

Underpayment, late payment, failure to transmit payment electronically, & wage noncompliance penalties are a few of the penalties that are imposed in California for wage infractions. Willful misclassification carries civil fines of as much as $25k per infraction.

Options for reducing obligations and voluntary compliance for workers who have been misclassified

An employer may be exempt from paying IRS employment taxes for a worker. There has to be a legitimate cause (not deliberate or careless) for failing to treat the worker as an employee. This is pursuant to Section 530 of the Revenue Act.

The company must have consistently filed all necessary federal information returns (Form 1099-MISC). Then only it may be eligible for Section 530 relief. The company must have done this without switching from employee (Form W-2) to an independent contractor status. They must not have treated any employee in a position that was substantially similar.

Additionally, the employer had to have a legitimate justification for not treating that person as an employee, like citing a federal court case, being consistent with an earlier IRS audit, adhering to industry standards, or having another legitimate reason (such as depending on an accountant or lawyer).

Another method that enables companies to reclassify their workers as employees with a partial remedy from federal employment taxes is the Voluntary Classification Settlement Program (“VCSP”). This is offered to qualified companies that commit to treating their employees (or a group or class of employees) as employees moving forward.

Businesses that have (1) consistently addressed the workers to be reconsidered as independent contractors or additional non-employees, (2) filed all necessary Form 1099s for the enrolled workers to be reconfigured for the preceding three years, and (3) are not presently the subject of an employment tax audit conducted by the IRS, Department of Labor, or EDD (or another state agency) are eligible for the VCSP.

Through VCSP, the participating company can agree to pay ten percent of the employment tax obligation that would have been owed on worker remuneration for the latest tax year and to classify the classes or class of workers as employees for subsequent tax periods. For those employees who were reclassified within the VCSP for earlier years, the company is exempt from interest and other penalties, as well as an IRS worker classification tax audit.

DE 938P, Refund of Personal Income Tax or Claim for Adjustment, is a crucial tool for possibly lowering the EDD tax due. The company may be able to use DE 938P to obtain relief from any or all of the PIT responsibility, as well as associated penalties and interest, even if the EDD finds that the business did not appropriately withhold PIT from the salaries paid to the employees.

A PIT assessment utilizing DE 938P may be modified in a number of ways. One is to request a certification from the employee attesting to the fact that the wages were recorded on the California income tax return. Another is for the company to certify that the employee received a Form 1099-MISC, Schedule K-1, or Form W-2 and that it was submitted to the IRS & FTB on time.

FAQs

1. An independent contractor or an employee: Which California agencies decide the status?

EDD is the most important state agency in assessing a worker’s status as an independent contractor. The state body is mostly focused on taxes associated with employment. Determining an employee’s status in California, particularly with relation to wage, hour, & worker’s compensation insurance, is another obligation of the DLSE. The FTB (Franchise Tax Board) and the CSLB (Contractors State Licensing Board) are two other organizations with comparable mandates.

2. Is it possible for me to be considered an employee under one statute and an independent contractor according to another?

A person may be considered both an employee & an independent contractor since different regulations apply to various situations, such as termination versus hourly salary. It is impossible to undervalue the significance of carrying out a thorough investigation & evaluation of various working relationships.

3. Correctly identifying oneself as an independent contractor or employee: Why is it essential?

Because it affects workers’ compensation claims, designation is critical. The ABC test may also be applicable to wage and work-hour regulations in your state. In certain states, the test may additionally identify a worker’s eligibility for unemployment benefits. The ABC test is applied to particular sectors in other states.

4. I am an independent contractor: Can my employer schedule my work?

No. An independent contractor has complete autonomy. An employee can’t decide when & how they work. Employers could be blamed for misclassifying independent contractors when they do that.

5. I am an independent contractor: Is a business license required for working?

Depending on the type of work, yes. Some independent contractors can operate lawfully without a company license, though. It is advisable to acquire one when providing any services to third parties.

6. Employee vs independent contractor: How to identify?

The term “independent contractors” has no precise definition. Court rulings and enforcement agencies’ interpretations of a particular case or circumstance play a major role in determining an employee’s status. According to Labor Code 3357, organizations like the DLSE first assume that each staff member is an employee when addressing employment status questions. But to make an actual decision, a number of criteria must be taken into account, none of which are dominating in and of themselves.

Determining whether the individual providing services has total control over their job is the most important issue in the majority of employment status cases that are brought to the DLSE. Among other things, how the work is done & the tools used are taken into account.

7. I signed a contract as an independent contractor. Does that mean I am?

No. If you don’t pass the ABC rule for independent contractors, you are an employee even if you were forced to sign a contract that states you are an independent contractor or if you are paid in a way that implies you are an independent contractor. Your employment status is not determined by the agreement you sign or how much you are paid. Employers are not permitted to alter a worker’s job status by unlawfully imposing tax obligations that are granted by labor law or by taking any other unfair acts that disadvantage the worker.

It doesn’t matter if there are written contracts claiming an independent contractor relationship. To decide cases based on specific circumstances, California courts & the Labor Commissioner investigate “behind” these agreements to see if they represent a real relationship.

8. If I am mistakenly identified as an independent contractor rather than an employee, why must I care?

According to California labor law, independent contractors & employees are very different. For example, employees have a right to overtime, minimum wage, lunch breaks, and rest periods. Laws against discrimination in the workplace also protect them. These advantages and safeguards are not available to independent contractors.

Additionally, workers can file claims and enforce the law on a wide range of workplace/employment-related issues with state agencies such as the DLSE. These organizations are inaccessible to independent contractors. Rather, individuals are limited to using the legal system to resolve conflicts and uphold the rights outlined in their contracts.

9. I was refused overtime & categorized as an independent contractor. How should I proceed?

There are two primary approaches to handling misclassification. One option is to submit a wage claim. A lawsuit is another option. Wage-related misclassification claims can be decided by the DLSE. Additionally, the court has the authority to order your employer to reimburse you for overtime that you lost due to misclassification. Prior to receiving overtime in any scenario, your position of employment must be ascertained.

In accordance with Labor Code 203, you may file a claim (a waiting time penalty) if you are deemed an employee via the aforementioned procedures and you are no longer employed by the company in question. The penalty’s eligibility is contingent upon one’s job status. The waiting time fine is not applicable to independent contractors.

10. I submitted a misclassification-related wage claim: What happens?

The deputy labor commissioner is tasked with determining the best course of action. It is based on the facts & circumstances in the claim after it has been filed with the DLSE. The claim may be rejected or sent to a hearing or conference.

Parties receive notification by mail of the meeting’s date, location, and time, whether the deputy labor commissioner chooses to hold one. The purpose of conferences is to evaluate the validity of assertions. They also decide whether an agreement without a hearing is necessary. A hearing is planned if the parties are unable to reach a consensus during the conference. The claim may potentially be rejected for reasons like insufficient proof.

You and any witnesses who may be present must provide testimony under oath if a hearing is convened. Additionally, proceedings are documented. An ODA (Order, Decision, or Award) is served to all parties at the conclusion of the hearing. An ODA may be appealed in a civil court, where the case will go to trial, and each side may submit new witnesses and proof.

11. The ODA has been disregarded by my employer. What am I able to do?

Your employer ought to act in accordance with the ODA. The court may be forced to enter a decision against the company by the DLSE. Like any other monetary judgment issued by a court, this one is enforceable. You can designate the DLSE to pick up an award on your behalf if you are encountering problems.

12. How can employers address misclassification?

Employers in California ought to stand back and use the AB 5 framework to analyze their contractual relationships with workers. Understanding the ABC test is essential for lowering the risks connected with misclassification claims made by employees, class action lawyers, and state authorities because all businesses are subject to this regulation regarding misclassification.

Most essential, with the goal to minimize legal risk when employing, businesses should continuously follow the California courts and their understanding of AB 5. In situations where there is no apparent demarcation, employers should also be aggressive in returning independent contractors to employee status.

A business may amend its current contracts and procedures to comply with AB 5 if reclassification is not an option. A careful choice of compliant labor contractors or independent employment agencies is necessary when using them. Since employers are typically found to be equally liable for wage & hour violations committed by third-party employment agencies and labor subcontractors when providing workers, employers additionally have to uphold responsibilities in agreements and compensate clients for violations.

13. Which legislation applies in situations involving workers or employees? Federal or state law?

Employers may not know which laws to abide by due to conflicts between state and federal laws. Employers are expected to abide by regulations that are more favorable to employees. This clarifies why workers are initially thought to have the standard classification of employees. Employers must demonstrate otherwise to support the status of independent contractors.

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1,467

California Independent Contractor vs Employee

Introduction

Federal Worker Classification Rule

IRS (federal) exemptions for statutory non-employees and employees

California Worker Classification Rule

Borello: When the ABC Test Is Inapplicable

EDD (California State) & the IRS (Federal): Employer responsibilities

Repercussions for companies that misclassify employees

Options for reducing obligations and voluntary compliance for workers who have been misclassified

FAQs

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