A Legal Guide to Employee Classification—Independent Contractors vs Employees

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. 

What Responsibilities Do Employers Have for Employees and Independent Contractors? 

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. 

California’s ABC Test to Determine Employee Classifications 

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: 

1. Behavior control: the degree to which the employer exercises control over the workers’ time, work life, and tools. If an employer trains a worker, directs their tasks, sets specific hours, and outlines how work should be completed, the IRS will likely consider them an employee. Conversely, if the worker sets their own hours and decides how and when the job is done, they will likely be considered an independent contractor. 

2. Financial control: If the worker is paid a salary or is guaranteed a regular company wage, they will likely be classified as an employee. If the worker is paid a flat fee for a specific product or job, they’re more likely to be considered an independent contractor. Additionally, independent contractors generally have a “significant investment” in their business whether that be tools, equipment, training, or licensing. It is not generally required to reimburse independent contractors for expenses like fuel or office supplies, as independent contractors may also use these tools to provide work for other businesses. 

3. Type of relationship: If a worker provides you with services directly related to your business’ core work and/or the employer provides benefits (such as sick days or healthcare), it is likely that the IRS will deem that worker as an employee. The IRS also considers the “permanency” of a relationship in determining classification. Independent contractors are generally hired for a set project for a set period of time. If someone is brought on board indefinitely, they will likely be considered an employee. 

Exceptions to AB 5: Employee Classifications Using the Borello Test

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:

• Doctors (licensed physicians and surgeons, dentists, podiatrists, psychologists, veterinarians)
• Licensed professionals (lawyers, architects, engineers, private investigators, accountants)
• Financial services (licensed insurance brokers, registered securities broker-dealers, investment advisors)
• Real estate agents
• Commercial fishermen
• Direct salespeople (provided the salesperson’s compensation is based on actual sales, rather than wholesale purchases or referrals) 
• Freelance writers and photographers (provided the employee contributes no more than 35 submissions to an outlet in a year)
• Hair stylists and barbers (provided that person sets their own rates and schedule)
• Others performing work under a contract for professional services with another business entity, or pursuant to a subcontractor in the construction industry

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)

• Corporate officers who are either residents of California or non-residents performing services in California
• An agent-driver or commission-driver engaged in distributing eat, vegetable, fruit, or bakery products, beverages (other than milk), or laundry or dry-cleaning service for his/her principal
• A homemaker performing domestic services at the direction of the individual he or she is serving
• Some entertainment industry artists
• Unlicensed construction workers
• Traveling or city salesperson

The EDD information sheet discusses the various categories of statutory employees. 

Why Employee Classifications Matter

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.