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Effective January 1, 2012, a new California law creates large penalties for employers who “willfully” misclassify their workers as independent contractors. The new law comes amid a growing crackdown by the federal government and various states on employers who treat regular employees as independent contractors, thereby avoiding taxes and side-stepping various employment laws.
The bill, SB 459 (Corbett), was signed into law by Governor Jerry Brown on October 9, 2011, and adds Sections 226.8 and 2753 to the California Labor Code. The new law does not change the test for determining whether a worker qualifies as an independent contractor, but it greatly increases the financial risk for employers who misclassify workers. Under Section 226.8, it is unlawful for any person or employer to engage in the “willful misclassification” of an individual as an independent contractor. “Willful misclassification” is defined as “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.” Labor Code § 226.8(i)(4). In addition to the act of misclassification, each time a misclassified worker is charged a fee or has his/her pay reduced as a result of the misclassification, there is a new violation of Section 226.8.
An independent contractor provides a good or service to another individual or business, often under the terms of a contract that dictates the work outcome, but the contractor retains control over how they provide the good or service. The independent contractor is not subject to the employer’s control or guidance except as designated in a mutually binding agreement. The contract for a specific job usually describes its expected outcome. Essentially, independent contractors treat their employers more like customers or clients, often have multiple clients, and are self-employed.
For some professionals, the line between employee and self-employed independent contractor is often blurred, and employers can classify workers as either. There are several different standards used to determine if an individual is legally an independent contractor. While the intricacies of contracting are too numerous for a comprehensive treatment and the applicability of the test depends on the specific workplace situation, generally, the independent contractor tests employed by the IRS and the Department of Labor (DOL) offer useful guidelines as to who is and who is not an independent contractor.
The largest incentive for misclassifying workers is that employers are not required to pay Social Security and unemployment insurance (UI) taxes for independent contractors. These tax savings, as well as savings from income and Medicare taxes results in employers saving between 20 to 40 percent on labor costs. A report from the Treasury Inspector General for Tax Administration concluded that employers can save an approximate average of $3,710 per employee earning an annual income of $43,007 when they misclassify the employee as an independent contractor. There are a number of other advantages, beyond savings on state and federal tax costs, an employer may derive from misclassifying an employee, including:
Penalties range from $5,000 to $15,000 per violation for isolated violations. Where there is a pattern or practice of violations, the penalty range increases—$10,000 to $25,000 per violation. Under new Section 2753, paid advisors (excluding attorneys and employees of the company) who “knowingly advise” employers to misclassify workers are jointly and severally liable for any penalties imposed on the employer as a result of the misclassification. In addition to the new costly monetary penalties, employers who violate the new law are required to post a “prominent” notice on their public website stating, among other things, that they have “committed a serious violation of the law” by willfully misclassifying employees, and directing any other employees who feel they have been misclassified to contact the Labor and Workforce Development Agency.
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. For example, an independent contractor who works in California for a business based in Texas must be reported to California’s EDD.
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.
As with other California labor statutes, this one identifies the Labor Commissioner as the enforcement agency, but permits employees to enforce their rights through the courts. Employers must therefore be mindful of the risk of classifying groups of workers as independent contractors, especially given the prevalence of wage/hour class actions in California. At a minimum, employers who regularly use independent contractors should consider obtaining arbitration agreements with class action waivers to minimize their exposure in this area. Independent contractor classification is a nuanced legal question, and the new penalties underscore the importance of receiving sound advice in this area. Additionally, in light of the new advisor liability provision, consultants and accountants who might otherwise offer their advice on how to classify workers should put this question to an employment attorney.