For a very large proportion of businesses in California, both large and small, staffing costs are going up substantially. Hiring employees doesn’t just mean the cost of that individual’s salary, but also the payroll, taxes, insurance, and other costs associated with hiring on to the company.
Like many other business owners, cutting costs can sometimes affect hiring employees and growing your business. Historically, you may have found hiring an independent contractor as a more sustainable choice in California.
We would estimate that of the businesses that use 1099 contractors, more than 70% misclassify them as such. As a business owner, you may be reaping the benefits of not hiring an employee but still getting the work done as an employee would. Yet doing so puts you at a considerable financial risk. The risks vary from direct financial penalties through to extended litigation, but it is important that with this new Dynamex ruling on the independent contractor law, that you take a closer look at your California business.
Let’s do a deep dive into the independent contractor law in California.
If you are a small business owner in California, you cannot possibly have missed the recent changes in the law regarding retaining independent contractors on staff.
The State of California is hot on the topic of small business owners misclassifying workers as independent contractors rather than employees. How hot you ask?
In January 2012, a new California law for independent contractors was passed: California Labor Code Section 226.8 [text is included below]. This law imposed new penalties on employers who willfully misclassify their employees as independent contractors. Willful misclassification is defined as “voluntarily and knowingly misclassifying that individual as an independent contractor”.
In April 2018, the California Supreme Court revolutionized the analysis of the classification of independent contractors in the case Dynamex Operations West, Inc. versus Superior Court of Los Angeles County.
Misclassification of workers as independent contractors rather than employees can carry serious consequences for you. The classification of workers affects tax liability, as well as standards of employment.
Are you trying to navigate your way through the California Supreme Court’s Dynamex decision – namely the new A.B.C. legal test for 1099 Independent Contractor vs. W2 Employee status?
How do I determine whether a worker is an employee or an independent contractor? Or, put another way, what is the ABC test to determine if a worker is properly considered an independent contractor according to California law?
Under this test, a worker is properly considered an independent contractor only if the hiring entity establishes:
(A) that the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
(B) that the worker performs work that is outside the usual course of the hiring entity’s business; and
(C) that 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.
As you do this, you may be beginning to realize that your own contractors would not pass the A.B.C test.
Penalties: The Consequences of Breaking the Independent Contractor Law in California
This is one of the first questions that may have popped into your mind as an employer and business owner. Essentially, it is smart to assess the risk in this situation to understand what course of action you need to take. Below, we look at some of the consequences and risks you could be faced with if not properly following the independent contractor laws.
What are the statutory penalties for willfully misclassifying employees as independent contractors under Section 226.8?
The penalties for violating Section 226.8 include fines between $5,000 and $15,000 per violation of the law, in addition to any other fines allowed by law. If the employer is engaged in a pattern or practice of violating this law, the fines are increased to between $10,000 and $25,000 per violation.
In addition to fines, an employer that violates the law is required to post notice of its violation in a prominent location on its website for 1 year. If the employer does not have a website, it must post notice of the violation in each location where the violation occurred, in a prominent area accessible to all employees and the public.
Section 226.8 is enforced by the Labor Commissioner of the California Labor and Workforce Development Agency. The Labor Commissioner may investigate complaints by workers and, if necessary, initiate either a civil suit or a hearing before the Labor Commissioner pursuant to California Labor Code Section 98.
Section 226.8 may also be enforceable through California’s Private Attorneys General Act, which allows a private citizen to pursue civil penalties on behalf of the Labor and Workforce Development Agency, provided the citizen complies with the notice and waiting procedures of the Act. However, the availability of these actions for violations of Section 226.8 is unclear at this time.
What are the Federal tax-related penalties for misclassifying workers?
The IRS imposes strict penalties for misclassifying workers, whether intentional or unintentional. For unintentionally failing to withhold federal income tax, the penalty is 1.5% of the wages paid. The penalty is doubled to 3% if the employer did not file a Form 1099-MISC for the worker with the IRS.
The penalty for unintentionally failing to withhold the employee’s share of Social Security and Medicare taxes is 20% of the employee’s share of the tax. The penalty is doubled to 40% if the employer did not file a Form 1099-MISC for the worker with the IRS.
If the misclassification was intentional, or if statutory employees are misclassified, the employer is liable for the full amount of both the federal income tax that should have been withheld as well as the employee’s and employer’s share of Social Security and Medicare taxes.
What are the State tax-related penalties for misclassifying workers?
California state law also imposes tax penalties for misclassifying workers. These penalties include repayment of back payroll taxes, subject to interest, and a 10% penalty on the unpaid taxes. Failure to withhold and pay payroll taxes can also result in a misdemeanor charge, and the employer can be fined up to $1,000 or sentenced to jail for up to one year, or both.
Who would come after me Federally?
The 700lb gorillas of enforcement: the IRS and the U.S. Department of Labor.
Why those guys? According to the United States Government Accountability Office, up to 30% of audited firms had misclassified at least some employees. When a worker is misclassified and a lawsuit is decided in their favor, the employer will be ordered to pay back wages, back payroll taxes, fines, fees, and more. In addition, there’s a strong likelihood that the company will have auditors checking in more frequently. The exact ramifications for the employer will vary, depending on whether or not the agencies involved in the case determine if the misclassification was unintentional, intentional, or fraudulent.
Who would come after me in California?
In California, the state agencies that are most involved with the determination of independent contractor status are the Employment Development Department (EDD), which is concerned with employment-related taxes, and the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers’ compensation insurance laws apply.
Section 226.8 is enforced by the Labor Commissioner of the California Labor and Workforce Development Agency. The Labor Commissioner may investigate complaints by workers and, if necessary, initiate either a civil suit or a hearing before the Labor Commissioner pursuant to California Labor Code Section 98.
Section 226.8 may also be enforceable through California’s Private Attorneys General Act, which allows a private citizen to pursue civil penalties on behalf of the Labor and Workforce Development Agency, provided the citizen complies with the notice and waiting procedures of the Act. However, the availability of these actions for violations of Section 226.8 is unclear at this time.
Adding to the complexity, other agencies, such as the Franchise Tax Board, and the Contractors State Licensing Board also have regulations concerning independent contractors.
So Why Do They Do It? Why do small businesses hire workers as 1099 contractors rather than taking them on as full W2 employees?
In the short term, it’s a lot cheaper for a business to hire workers as 1099 contractors.
Classifying workers as independent contractors relieve an employer from responsibility for payroll taxes, social security, Medicare, workers’ compensation, Affordable Care Act (“ACA”) compliance requirements, and other withholdings that employees are entitled to. Utilizing independent contractors can also reduce OSHA obligations for some employers, as well as reduce the likeliness of discrimination cases, as only workers classified as employees are protected by Title VII.
According to a 2013 report from the Treasury Inspector General for Tax Administration, employers save an average of $3,710 per employee earning an annual income of $43,007 when they misclassify the employee as an independent contractor. That’s just the federal tax savings! Throw in the state tax savings, insurance savings, etc. It adds up.
It is also less complicated and provides greater flexibility. There is no requirement to provide a minimum wage, overtime, itemized wage statements, rest periods, meal breaks, time off, expenses, and the whole gambit of labor code requirements.
We were in a recent business meeting talking to over 20 other small business owners, all of which had 1099 contractors on staff. When we discussed what those businesses were using the contractors to do, it was very apparent they were, in fact, being treated as employees but paid as contractors. When we asked them if they were concerned about that, as one they responded, “oh, we don’t worry about that stuff”. Crazy but true.
Is there a way to solve the 1099 contractor vs. W2 employee status problem without all the legal risks?
So, now that you know the situation, are you stuck with just converting everyone to employees or letting these relationships die? We’re not ones to just identify a problem and leave it, so we want to share the options that you have in this scenario.
Below are four solutions:
- Comply with California’s desire to have all of your workers classified as employees by hiring them as such;
- Encourage your contractors to set themselves up as Independent Contractor S corporations;
- Hire off-shore virtual assistants in appropriate circumstances; or,
- Use a Professional Employer Organization (PEO).
Option One: Get in Line with the California Law and Turn Your Independent Contractors into Employees
Hire the worker as an employee: this is the safest way to deal with this situation. There will never be an argument from the state that you improperly misclassified a worker as an employee when in reality the worker was never anything more than a simple independent contractor.
Option Two: Encourage Your Independent Contractors to Register as an S-Corp in California
If a company signs an agreement with an Independent Contractor S corporation to perform contract work, the link between the company and the individual worker is broken.
By default, the way the Independent Contractor S corporation operates, there is no link between the company and the worker. The Independent Contractor S corporation is the employer of the worker. Even if that is an S corporation of one person. As the Independent Contractor S corporation employs the worker, it sets up its payroll which will deal with things like overtime compensation, itemized wage statements, compensation for business expenses, meal breaks, and so on.
Again, it is the responsibility of the S corporation that hires the worker to make certain it complies with all applicable wage and hour laws. Labor code violations go out the window because each Independent Contractor S corporation has its own employee(s). The S corporation has its own payroll from which the worker is paid. The S corporation has its own Worker’s Compensation Insurance Policy.
Clearly, there are some costs associated with contractors converting to S corporations. However, there is also a range of benefits. The savvy business owner currently working directly with 1099 contractors who looks at the A.B.C. test and realizes they are in violation, might incentivize their contractors to convert by sharing in the fees associated with forming an Independent Contractor S corporation.
While some contractors might be set up as LLCs, the majority of contractors start out as sole proprietorships. Simply converting LLCs taxed as proprietorships or partnerships to corporate taxation removes the barriers to employment for the contractor and removes the risk to the hiring company.
Need help in forming an Independent Contractor S corporation? Call the Incorporation Attorney at 714-634-1414.
Option Three: Hire Off-shore Virtual Assistants
When the staff you need do not need to be physically present, a virtual worker on staff can be the ultimate solution.
Current U.S. law assumes employees are domiciled in the U.S. As your virtual assistant is domiciled in the off-shore, they are not subject to U.S. law. Therefore any tax and labor law requirements are carried by them, not you. Tax is paid by them to the relevant off-shore taxing authority.
1099 contractor vs. W2 employee status problems simply does not apply. The A.B.C. contractor test is also not relevant. You can direct and performance manage your VA as much as you want.
There is, of course, another major benefit with hiring VAs. The cost of an off-shore worker is likely to be a fraction of the cost of a local U.S.-based contractor. See What Does A Virtual Assistant Cost?
Where to start? For Example, when you work with the Smart VA Staffing Agency, your virtual staff in the Philippines are employed by the Smart VA Staffing Agency. Although you set what work they do, give them performance feedback, and they report to you, you are simply contracting with Smart VA Staffing Agency for service.
Option Four: Utilize a Professional Employer Organization
For many employers – especially small business owners – the best way to minimize their chance of misclassification is to use a Professional Employer Organization (PEO). A PEO can provide payroll, benefits, HR services, and assist with compliance issues under state and federal law. This allows business owners to improve productivity and profitability, focus on their core mission, and grow their company, while the PEO maintains regulatory compliance.
Re-evaluate Your Relationship with 1099 Independent Contractors—and Avoid the Risk of Legal Litigation in California
As with any new interpretation of small business laws, we encourage you to seek legal advice and evaluate how your business is interacting with independent contractors. Violating the independent contractor law, especially in light of the new Dynamex ruling, could put your California small business at risk.
If you are a small business and are encouraging your independent contractors to form a corporation (or just need help to understand your options), talk with a legal business formation expert. We know how to navigate situations and help you prevent legal litigation before it starts. Contact us today!
DISCLAIMER: This legal alert is provided by the Law offices of Gale and Vallance, APC solely for informational purposes, without any representation that it is accurate or complete. It does not constitute legal advice and should not be construed as such. It does not create an attorney-client relationship between the recipient and any other person, or an offer to create such a relationship. Consult an attorney if you have questions regarding the contents of this communication.
References:
http://www.latimes.com/local/lanow/la-me-ln-independent-contract-20180430-story.html
https://www.worklawyers.com/1099-contractors-w2-employees/
https://www.incorporationattorney.com/sole-proprietorship-to-corporation-limited-liability-company
State Resources
The California Employment Development Department (EDD) has provided the following resources for classifying your workers:
- California Employer’s Guide 2012 – A comprehensive guide for employers in California, available at http://www.edd.ca.gov/pdf_pub_ctr/de44.pdf.
- Employment Determination Guide (DE 38) – A self-assessment that asks a series of “Yes” or “No” questions regarding your treatment of workers to help determine whether you are correctly classifying your workers. The guide is available at www.edd.ca.gov/pdf_pub_ctr/de38.pdf.
- Determination of Employment Work Status for Purposes of State of California Employment Taxes and Personal Income Tax Withholding (DE 1870) – After you complete and return this form, the EDD will send you a written determination stating whether your workers are employees or independent contractors based on the information that you have provided. This publication is available at www.edd.ca.gov/pdf_pub_ctr/de1870.pdf.
- Precedent Tax Decisions by the CUIAB – Available on the CUIAB’s Web site at
www.cuiab.ca.gov/precedent_decisions.shtm.
- Web-Based Seminars on employee and independent contractor issues, available at http://www.edd.ca.gov/Payroll_Taxes/Web_Based_Seminars.htm.
- Live Assistance on worker classification issues from the Taxpayer Assistance Center at (888) 745-3886.
Federal Resources
- Employer’s Tax Guide (IRS Publication 15) – Comprehensive tax guide for employers provided by the IRS, available at http://www.irs.gov/pub/irs-pdf/p15.pdf.
- Form SS-8 – If you would like the IRS to determine whether your worker is an employee or independent contractor, submit Form SS-8, available at http://www.irs.gov/pub/irs-pdf/fss8.pdf.
California Labor Code 226.8.
(a) It is unlawful for any person or employer to engage in any of the following activities:
(1) Willful misclassification of an individual as an independent contractor.
(2) Charging an individual who has been willfully misclassified as an independent contractor a fee, or making any deductions from compensation, for any purpose, including for goods, materials, space rental, services, government licenses, repairs, equipment maintenance, or fines arising from the individual’s employment where any of the acts described in this paragraph would have violated the law if the individual had not been misclassified.
(b) If the Labor and Workforce Development Agency or a court issues a determination that a person or employer has engaged in any of the enumerated violations of subdivision (a), the person or employer shall be subject to a civil penalty of not less than five thousand dollars ($5,000) and not more than fifteen thousand dollars ($15,000) for each violation, in addition to any other penalties or fines permitted by law.
(c) If the Labor and Workforce Development Agency or a court issues a determination that a person or employer has engaged in any of the enumerated violations of subdivision (a) and the person or employer has engaged in or is engaging in a pattern or practice of these violations, the person or employer shall be subject to a civil penalty of not less than ten thousand dollars ($10,000) and not more than twenty-five thousand dollars ($25,000) for each violation, in addition to any other penalties or fines permitted by law.
(d) (1) If the Labor and Workforce Development Agency or a court issues a determination that a person or employer that is a licensed contractor pursuant to the Contractors’ State License Law has violated subdivision (a), the agency, in addition to any other remedy that has been ordered, shall transmit a certified copy of the order to the Contractors’ State License Board.
(2) The registrar of the Contractors’ State License Board shall initiate disciplinary action against a licensee within 30 days of receiving a certified copy of an agency or court order that resulted in disbarment pursuant to paragraph (1).
(e) If the Labor and Workforce Development Agency or a court issues a determination that a person or employer has violated subdivision (a), the agency or court, in addition to any other remedy that has been ordered, shall order the person or employer to display prominently on its Internet Web site, in an area which is accessible to all employees and the general public, or, if the person or employer does not have an Internet Web site, to display prominently in an area that is accessible to all employees and the general public at each location where a violation of subdivision (a) occurred, a notice that sets forth all of the following:
(1) That the Labor and Workforce Development Agency or a court, as applicable, has found that the person or employer has committed a serious violation of the law by engaging in the willful misclassification of employees.
(2) That the person or employer has changed its business practices in order to avoid committing further violations of this section.
(3) That any employee who believes that he or she is being misclassified as an independent contractor may contact the Labor and Workforce Development Agency. The notice shall include the mailing address, email address, and telephone number of the agency.
(4) That the notice is being posted pursuant to a state order.
(f) In addition to including the information specified in subdivision (e), a person or employer also shall satisfy the following requirements in preparing the notice:
(1) An officer shall sign the notice.
(2) It shall post the notice for one year commencing with the date of the final decision and order.
(g) (1) In accordance with the procedures specified in Sections 98 to 98.2, inclusive, the Labor Commissioner may issue a determination that a person or employer has violated subdivision (a).
(2) If, upon inspection or investigation, the Labor Commissioner determines that a person or employer has violated subdivision (a), the Labor Commissioner may issue a citation to assess penalties set forth in subdivisions (b) and (c) in addition to any other penalties or damages that are otherwise available at law. The procedures for issuing, contesting, and enforcing judgments shall be the same as those set forth in Section 1197.1.
(3) The Labor Commissioner may enforce this section pursuant to Section 98 or in a civil suit.
(h) Any administrative or civil penalty pursuant to subdivision (b) or (c) or disciplinary action pursuant to subdivision (d) or (e) shall remain in effect against any successor corporation, owner, or business entity that satisfies both of the following:
(1) Has one or more of the same principals or officers as the person or employer subject to the penalty or action.
(2) Is engaged in the same or a similar business as the person or employer subject to the penalty or action.
(i) For purposes of this section, the following definitions apply:
(1) “Determination” means an order, decision, award, or citation issued by an agency or a court of competent jurisdiction for which the time to appeal has expired and for which no appeal is pending.
(2) “Labor and Workforce Development Agency” means the Labor and Workforce Development Agency or any of its departments, divisions, commissions, boards, or agencies.
(3) “Officer” means the chief executive officer, president, any vice president in charge of a principal business unit, division, or function, or any other officer of the corporation who performs a policymaking function. If the employer is a partnership, “officer” means a partner. If the employer is a sole proprietor, “officer” means the owner.
(4) “Willful misclassification” means avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.
(j) Nothing in this section is intended to limit any rights or remedies otherwise available at law.
(Amended by Stats. 2012, Ch. 162, Sec. 116. (SB 1171) Effective January 1, 2013.)
