With the inclusion of California Proposition 22 on the ballot this November, the question of what distinguishes an employee from an independent contractor is on the forefront of many employers’ minds. Understanding this distinction is vital to running a business, as it could impact taxes and other legal obligations. Misclassification could also result in significant tax penalties for small businesses.
Employees get paid a regular salary, have taxes withheld from those wages, work part- or full-time, and have their work and schedule dictated by the employer. Conversely, there is much less of a burden for employers whose workers are classified as independent contractors, as the responsibility of taxes and benefits falls to the contractors and not the employer.
Responsibilities of the employer come down to whether the employer needs to withhold payroll taxes such as income taxes, Medicare, and Social Security out of a paycheck, and is qualified for unemployment. While an employee and contractor might be paid the same, the responsibility for withholding taxes falls to the contractor.
This also means that there are different tax forms for independent contractors. At a minimum, this includes a W-9 and a Form 1099-MISC if the contractor is paid $600 or more a year. Furthermore, contractors are typically not covered by labor laws and operate independently of a hiring entity. Therefore, contractors are usually also responsible for their own benefits.
Now that we have outlined any employer’s responsibilities for both classifications, it’s important to understand how California law determines the difference between the two categories. Determining the differences between an employee and an independent contractor is often based on a common law test that has recently been given more weight in California after temporary “gig” workers using online hiring platforms such as Uber, Lyft, and Postmates sought to obtain clarification.
Effective January 1, 2020, California passed Assembly Bill 5 (AB 5), a codified method through which to determine the three-part test known as the “ABC test.” The ABC contractor test determines worker classification as an employee or contractor. AB 5 also established exceptions for certain employers/workers in specific industries. The ABC test is now the official way to help employers categorize their workers as independent contractors or employees.
However, California Proposition 22, which voters will be weighing in on come Election Day, proposes that app-based drivers be considered independent contractors, overriding AB 5. The proposition defines app-based drivers as “workers who (a) provide delivery services on an on-demand basis through a business’s online-enabled application or platform or (b) use a personal vehicle to provide prearranged transportation services for compensation via a business’s online-enabled application or platform.” Should the proposition not pass, Uber, Lyft, DoorDash and other businesses who hire app-based drivers will be required to use AB 5 as means for classifying their employees just as any other business does.
According to the IRS, one of the most important determining points for classifying employees is locus of control. For example, whether the employer is only able to control the results of the work or if the worker is allowed to have input on how work is performed as well.
According to AB 5, the key factors to be examined are:
While the ABC test enacted in AB 5 generally holds as the determination, there are some exceptions of which employers should be aware. Specific industry areas that may be exempt include:
According to AB 5, classifications in the above industries cannot be determined using the ABC test, but must be subject to the Borello test, the previous test used for employee classification.
Other categories in the “gray zone” include statutory employees. According to the IRS, statutory employees are independent contractors who can be “treated as employees by statute” and may necessitate withholding social security and Medicare taxes. Statutory employees may include (but are not limited to)
The EDD information sheet discusses the various categories of statutory employees.
When structuring a business and hiring talent for your team, it’s critical to find and file the correct employee classifications. While hiring contractors can result in lower employer taxes and overhead costs, if misclassified, your business could face tax liability or litigation.
The behemoth ridesharing services Lyft and Uber recently faced litigation for misclassifying their workers as independent contractors. On August 10, 2020, a federal judge granted a preliminary injunction against both Uber and Lfyt, requiring them to classify their drivers as employees.
As you structure your business or create an operating agreement, it’s critical that you do so with the awareness of employee classifications. With the expansion of the gig economy and the flexibility that technology allows, it may be more difficult to determine where your workers fit amidst the “gray zones.” For help discerning changing laws or structuring protections for your business, contact Steinberg Law.