BUSINESS LAW & PLANNING STRATEGIES
INDEPENDENT CONTRACTORS AND AGREEMENTS

In recent years, it has become increasingly popular for businesses to use the services of independent contractors for both short- and long-term projects rather than to hire new career employees or maintain former staffing levels.

Businesses can retain the services of independent contractors directly, or through a temporary employment agency or leasing service. The use of independent contractors initially appears attractive because the business may enjoy substantially lower personnel costs.

However, if an employer misclassifies a service provider as an independent contractor, and a government agency determines that the service provider is an employee, the employer may be responsible for fines, penalties, and unpaid taxes, and the “responsible person” for the employer may be subject to personal liability and criminal penalties.

Finally, the rules for who is an independent contractor under Federal law differ from those under California law. A worker may be classified as an independent contractor under Federal law but an employee under California law.

Different governmental agencies and jurisdictions apply different tests to determine whether a worker’s relationship to the hiring party is that of an employee or an independent contractor.  Although the tests are generally similar, there are differences businesses must take into account when defending an audit, investigation, or lawsuit.

TERMINOLOGY

Courts and administrative agencies use specific terminology when analyzing independent contractor status, and this terminology will be used throughout this menu item. Practitioners should be familiar with the following terms:

  • “Company” and “business” are neutral terms describing an entity for whom someone is performing services. These terms do not indicate whether the entity is an employer or a recipient of contracted services.
  • “Contract for” and “retain” describe the establishment of an independent contractor relationship, and should be used instead of “hire.”
  • “Customer” and “client” describe the user of the services the independent contractor performs.
  • “Employee” describes a worker in an acknowledged employment relationship. The term “employee” should never be used to refer to an independent contractor.
  • “Employee leasing agency” and “job shop” describe a business that contracts with its customers to provide the services of a third party worker.
  • “Employer” describes a person or entity in an employment relationship. “Employer” should not be used to describe an entity in an independent contractor relationship.
  • “Hire” describes the establishment of an employer-employee relationship.
  • “Independent contractor,” “contractor,” and “consultant” describe an individual who has contracted to perform services for a principal.
  • “Outsourcing” occurs when services previously or typically performed by employees are provided by an outside source. Services that are commonly outsourced include payroll, benefits administration, personnel management, human resources, and product support.
  • “Worker” and “service provider” are neutral terms describing an individual performing services; generally, an independent contractor, not an employee.

Preliminary Considerations

Before taking steps to classify a worker as a independent contractors and classifying them as such, one should investigate the following matters:

  • Which test will be applied to determine the legal classification of the proposed workers
  • Does the safe harbor of Revenue Act §530  apply to your situation?
  • Do statutory or regulatory exceptions override the common-law or other tests?
  • Do rulings and guidelines exist for your industry ? A national trade association may be a good source of information.Effective January 1, 2012, an employer engaging in “willful misclassification” of an individual as an independent contractor is subject to civil penalties of up to $25,000. Lab C §226.8. “Willful misclassification” is defined as “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.” Lab C §226.8(h)(4). An employer found liable for willful misclassification is required to post prominently on its website that it has “committed a serious violation of the law by engaging in the willful misclassification of employees.” Lab C §226.8(e). Contractors found liable for misclassification may be subject to disciplinary action by the Contractors’ State License Board. Lab C §226.8(d).

Anyone who, for compensation of any kind, knowingly advises an employer to misclassify an individual as an independent contractor may be held jointly and severally liable with the employer if the individual is found to be misclassified as an independent contractor. Lab C §2753(a). This provision does not apply to (1) a person who provides advice to his or her employer nor to (2) an attorney authorized to practice law in California or another United States jurisdiction who provides legal advice in the course of the practice of law. Lab C §2753(b)(1)–(2).

Potential Advantages in Using Independent Contractors

The potential advantages of using independent contractors include

(1) Cost savings from mandated contributions. The client does not pay the usual employer contributions for

  • State unemployment tax;
  • Social Security; Federal unemployment tax.

(2)Cost savings from discretionary fringe benefits. The client need not provide the independent contractor employee benefits such as

  • Medical or life insurance;
  • Vacation leave;
  • Sick time and pregnancy leave; or
  • Retirement plan participation

(3) The client can choose whether to provide workers’ compensation coverage.

NOTE: The California Supreme Court has held that unlike “a mere employee, an independent contractor, by virtue of the contract, has authority to determine the manner in which inherently dangerous construction work is to be performed, and thus assumes legal responsibility for carrying out the contracted work, including the taking of workplace safety precautions. Having assumed responsibility for workplace safety, an independent contractor may not hold a hiring party vicariously liable for injuries resulting from the contractor’s own failure to effectively guard against risks inherent in the contracted work.” Tverberg v Fillner Constr., Inc. (2010) 49 C4th 518, 522.

(4) Inapplicability of labor laws. By using an independent contractor, the client can avoid labor laws and wage and hour laws. The National Labor Relations Act (29 USC §§151–169) and the Fair Labor Standards Act (29 USC §§201–219) do not apply to independent contractors.

(5) Reduced risk of discrimination claims. The client will reduce the risks of discrimination claims because most antidiscrimination statutes protect employees only. For example, California law prohibits discrimination in employment based on race, religious creed, color, national origin, ancestry, physical disability, mental disability, age, medical condition, genetic information, marital status, sex, gender, gender identity, gender expression, or sexual orientation. Govt C §12940(a).

(6) Minimized potential for wrongful termination actions and unemployment benefit claims. The client may use an independent contractor for individual projects without incurring liability for unlawful employment termination suits or unemployment claims. See, e.g., Sistare-Meyer v YMCA (1997) 58 CA4th 10 (independent contractor cannot state cause of action for wrongful termination in violation of public policy based on assertion that termination of her contract was racially motivated).

(7) Greater flexibility to enter new lines of business. The client can expand into new lines of business without having the necessary knowledge and talent in-house.

(8) Highly specialized personnel available on contract basis. The client can use workers with highly specialized skills who are willing to work only as independent contractors, e.g., specialists in high-tech industries.

(9) Administrative savings. Clients save administrative time and costs by paying on a gross basis and not setting up a payroll system. Recordkeeping and reporting obligations are reduced.

NOTE: Employers are required to report all individuals who provide services for which they will receive a Form 1099 at the end of the year; the employer must report such persons within 20 days after making payments that in the aggregate equal or exceed $600 in a year or within 20 days after entering into a contract that will render more than $600 in a year. Un Ins C §1088.8.

(10) Minimize potential liability in workplace. Businesses are generally not liable for injuries incurred by the employees of independent contractors (Privette v Superior Court (1993) 5 C4th 689; Alvarez v Seaside Transp. Servs. LLC (2017) 13 CA5th 635) or by independent contractors (subcontractors) of independent contractors. Tverberg v Fillner Constr., Inc. (2010) 49 C4th 518. See also SeaBright Ins. Co. v US Airways, Inc. (2011) 52 C4th 590 (principal delegated duty to comply with workplace safety regulations to contractor, precluding liability for injury to contractor’s employee). But see Vargas v FMI, Inc. (2015) 233 CA4th 638 (presumption that hirer delegates tort duties to independent contractor may be overcome if relevant statutes and regulations demonstrate intent to limit application of Privette or preclude delegation of duty). Under the “peculiar risk” doctrine, the employee of an independent contractor may not recover from the party who hired the independent contractor, even if the hiring party failed to provide that special precautions be taken to avert the peculiar risk of the work, or failed to ensure that such precautions were taken. Toland v Sunland Hous. Group, Inc. (1998) 18 C4th 253. But see Hooker v Department of Transp. (2002) 27 C4th 198 (hirer of independent contractor is liable to contractor’s employees if hirer retained control over safety conditions at worksite and exercise of such control affirmatively contributed to employee’s injuries). See also Barclay v Jesse M. Lange Distrib., Inc. (2005) 129 CA4th 281 (business owner may be liable for injuries incurred by employees of independent contractors if business owner’s breach of its regulatory duties affirmatively contributed to such injuries). See also Vargas v FMI, Inc. (2015) 233 CA4th 638 (motor carrier acting through independent contractor driving leased vehicle is responsible for vehicle’s safe operation and is liable for accident resulting from negligent operation, maintenance, or use of vehicle).

Disadvantages in Using Independent Contractors

The following factors may be disadvantages in using independent contractors:

(1) Loss of control. The client will not be able to control how the contractor performs the services.

(2) Cannot terminate without cause. The client cannot unilaterally terminate the working relationship with the independent contractor without risking liability for breach of contract.

(3) Need to monitor legality of relationship. The client must monitor the relationship with the independent contractor to make sure its classification is defensible; i.e., the client must regularly review the amount of time the contractor spends on the client’s projects and the number of completed projects.

(4) Loss of continuity and ongoing relationship. The client may have no ongoing relationship with the contractor. The most defensible independent contractor relationships are intermittent and subject to the contractor’s availability.

(5) Client bears risks of misclassification. The penalties for misclassifying an employee as an independent contractor are onerous.

POTENTIAL PENALTIES FOR MISCLASSIFICATION

Penalties for misclassifying a service provider as an independent contractor include taxes, penalties, and interest.

Additionally, the “responsible person” of an employer may be subject to personal liability and criminal penalties.

1. Failure to Withhold/Contribute Payroll Taxes

IRS Sanctions

If the Internal Revenue Service determines that a worker should have been classified as an employee, rather than an independent contractor, it may assess the following penalties:

  • Payment of federal income tax that should have been withheld by the employer, estimated at 1.5 percent of the employee’s compensation. IRC §§3401(a), 3402, 3403, 3509(a)(1). This amount increases to 3 percent if the failure to classify the worker as an employee was due to willful neglect. IRC §3509(b)(1)(A).
  • Payment of Social Security contributions that should have been withheld by the employer, estimated at 20 percent of the employee’s compensation up to $127,200 per year for 2017. IRC §§3101(a), 3509(a)(2). This amount increases to 40 percent if the failure to classify the worker as an employee was due to willful neglect. IRC §3509(b)(1)(B). See, e.g., Employer’s Tax Guide, Publication 15 (Circular E), available at https://www.irs.gov/pub/irs-pdf/p15.pdf.
  • Payment of Medicare contributions that should have been made by the employer, estimated at 2.9 percent of the employee’s compensation. IRC §§3102, 3111(a). See, e.g., Employer’s Tax Guide, Publication 15 (Circular E).
  • Interest on income taxes and FICA and FUTA contributions that the employer should have withheld. IRC §6601.
  • A penalty for failure to file an employment tax return of up to 25 percent of the tax the IRS determines is owed. IRC §6651(a)(1).
  • A penalty for failure to pay of 0.5 percent of unpaid taxes per month, up to 25 percent in the aggregate. IRC §6651(a)(2).
  • A penalty for failure to deposit the tax amounts with the IRS of up to 15 percent of the amount the IRS determines is owed. IRC §6656.
  • A penalty for negligently or intentionally disregarding IRS rules and regulations of up to 20 percent of the underpayment that is attributable to the negligent or intentional behavior. IRC §6662. See Pub L 111–147, 124 Stat 71; Pub L 111–152, 124 Stat 1029 (any portion of any underpayment attributable to undisclosed foreign financial asset understatement subject to penalty of up to 40 percent).
    If the IRS determines the underpayment was due to fraud, a penalty of up to 75 percent of any underpayment. IRC §6663. NOTE: The 3-year statute of limitations on assessment of employment taxes may not be set aside because of an alleged fraud if there was no clear and convincing evidence that fraud was committed. U.R. Neely (2001) 116 TC 79.
  • A penalty of up to $250 for each information return the employer wrongfully failed to file. The total penalty may not exceed $3 million during any calendar year. IRC §6721(a). The penalty may be increased to $500 or greater if the failure was intentional. IRC §6721(e)(2).
  • A penalty of up to $250 for each payee statement the employer wrongfully failed to furnish. The total penalty may not exceed $3 million during any calendar year. IRC §6722(a). The penalty may be increased to $500 or greater if the failure was intentional. IRC §6722(e)(2).
  • Criminal sanctions, including imprisonment for up to 1 year and fines of up to $25,000 ($100,000 for corporations). IRC §7203
  • Personal liability for corporate officers, up to 100 percent of the amounts the employer should have withheld from the employee’s compensation. IRC §6672.

2. EDD Penalties

If the Employment Development Department determines that a worker should have been classified as an employee rather than an independent contractor, the EDD may impose the following liabilities and penalty assessments:

  • Payment of California income tax the employer should have withheld, estimated at 6.6 percent of the employee’s compensation. Un Ins C §13020; Rev & T C §18663(b)(1)(B).
  • Payment of state unemployment insurance contributions at a rate of up to 3.4 percent of the employee’s compensation. Un Ins C §982.
  • Payment of state disability insurance contributions the employer should have withheld, estimated at 1.5 percent of the employee’s compensation. Un Ins C §984.
  • Interest on contributions required of the employer and the employer’s workers. Un Ins C §1113; Rev & T C §19521.
  • A penalty for failure to pay of 15 percent of unpaid contributions. Un Ins C §1112.
  • A penalty of 10 percent of estimated employer and worker contributions for failure to file a return. Un Ins C §1126. If the failure to file a return was due to fraud or an intent to evade the EDD or its regulations, the EDD may assess an additional penalty of 50 percent of the amount of contributions assessed. This penalty is in addition to the penalties set forth in Un Ins C §1126. Un Ins C §1128.
  • An additional penalty under Un Ins C §13052.5(b) and Rev & T C §17041.
  • A penalty of up to $1000 for failure to file a return or for filing a false return or statement. Un Ins C §2117.
  • Criminal penalties of up to one year in jail or $1000 for failure to file a return or for filing a false return. Un Ins C §2117. If the employer willfully failed to file the return or supplied false information, the criminal penalties increase to up to 1 year in jail or state prison, a fine of up to $20,000, or both. Un Ins C §2118.5.
    NOTE: The EDD may make an assessment without regard to statutory time limits if the taxpayer filed fraudulent returns with the intention to evade employment taxes. California Mkt./MS Rhee (2001) Cal. Unemployment Ins. Appeals Bd. Precedent Tax Decision P-T-489.

3. Severity of Combined State and Federal Penalties; IRS Authority to Compromise Assessments

In efforts to reclassify workers as employees, the Internal Revenue Service and the Employment Development Department agreed to share information and resources. Thus, an audit by one agency is likely to result in an audit by the other. The combined penalties can be extremely costly, even if the misclassification was not fraudulent. Small businesses, in particular, may find that the assessments are so large that they can never be paid off. Unlike income taxes, employment taxes must be paid before the validity of the assessment can be contested. However, the IRS has the authority to compromise assessments that are doubtful as to collectibility. See IRC §7122; Treas Reg §301.7122–1. The IRS will not compromise if, among other things, the taxpayer’s equity in assets exceeds the total tax liability or the taxpayer is not current in filing with respect to other taxes due. If the IRS compromises a tax collection, the settlement amount must reflect the taxpayer’s maximum ability to pay, taking into account current and prospective income and net equity in assets. Some relief for the taxpayer also may be offered through the IRS’s Classification Settlement Procedure . The EDD lacks the IRS’s authority to compromise state tax assessments.

Bankruptcy will not solve the misclassifying employer’s problems. Federal and state obligations for employment taxes and penalties (incurred up to 3 years before the filing of the bankruptcy petition) are not dischargeable in bankruptcy. See 11 USC §§523(a)(1)–(7), 507(a)(8)(C)–(D). See also In re Pierce (5th Cir 1991) 935 F2d 709; In re Roberts (10th Cir 1990) 906 F2d 1440.

4. Potential Penalties Imposed by Workers’ Compensation Appeals Board

If the Workers’ Compensation Appeals Board (WCAB) reclassifies a worker as an employee, the employer who erroneously classified that worker as an independent contractor may be subject to

  • An action at law for damages brought by the injured employee or his or her dependents (Lab C §§3706–3708);
  • A stop order prohibiting the employer from using employee labor until the employer secures workers’ compensation coverage (Lab C §3710.1; see Bradshaw v Park (1994) 29 CA4th 1267);
  • Civil penalties of up to $10,000 per employee for the employer’s failure to be insured (Lab C §§3702.9, 3722);
  • Liens on the employer’s property (Lab C §3720);
  • Liens on any property owned by the employer’s shareholders or the shareholders of the employer’s parent company (Lab C §3720(b)); and
  • Criminal misdemeanor penalties, including imprisonment (Lab C §§3700.5, 3710.2, 3751).

5. Penalties Under National Labor Relations Act

If an employer refused to bargain with workers whom the National Labor Relations Board later classifies as employees, the employer may be liable for unfair labor practices within the meaning of §8 of the National Labor Relations Act (29 USC §§151–169). California Oilfield Maintenance, Inc. (1993) 311 NLRB 1079.

6. Liability for Minimum Wages and Overtime

a. Potential Penalties

An employer that erroneously classifies a worker as an independent contractor whom the California Labor Commissioner, the U.S. Department of Labor, or a court subsequently reclassifies as a nonexempt employee may be liable for

  • Minimum wage and overtime amounts the employer should have paid the employee (Lab C §1197; 29 USC §216(b));
  • The sum of any tip credit taken by the employer and all tips unlawfully kept by the employer, plus an additional equal amount as liquidated damages (29 USC §216(b));
  • Interest on unpaid minimum wage and overtime amounts (Lab C §§98.1, 1193.6);
  • A penalty for failure to pay the minimum wage ($100 for each underpaid employee for each pay period for which the employee is underpaid; and for any subsequent violation, $250 for each underpaid employee for each pay period for which the employee is underpaid, regardless of whether the initial violation is intentionally committed) (Lab C §1197.1(a));
  • A penalty of 25 percent of unpaid minimum wage and overtime amounts for failure to pay on time (Lab C §§204, 210);
  • An additional penalty equal to the amount of the unpaid minimum wage and overtime amounts (Lab C §§1197.1, 1194.2; 29 USC §§216(b), 260); and
  • Attorney fees and costs relating to the action (29 USC §216(b); Lab C §1193).The California Labor Commissioner may issue citations for violations, which may be served personally, by certified mail with return receipt requested, or by registered mail. Each citation must be in writing and must describe the nature of the violation, including reference to the statutory provision alleged to have been violated. The Labor Commissioner must take all appropriate action to enforce the citation and to recover the civil penalty assessed, wages, liquidated damages, and any applicable penalties imposed in connection with the citation. If, on inspection or investigation, the Labor Commissioner determines that an employer has paid or caused to be paid a wage less than the wage set by contract in excess of the applicable minimum wage, the Commissioner may issue a citation to the employer in violation to recover restitution of those amounts owed. Lab C §1197.1(b).

An employee may enforce Lab C §1197.1 through a representative action under the Labor Code Private Attorneys General Act of 2004 (PAGA) (Lab C §§2698–2699.5), if, before initiating a civil lawsuit, the employee complied with the various PAGA notice and administrative requirements. Ridgeway v Wal-Mart Stores Inc. (ND Cal, Jan. 25, 2017, No. 08-cv-05221-SI) 2017 US Dist Lexis 10510, *30 (the panel rejected Wal-Mart’s claims that plaintiffs should not have been awarded damages for layovers, rest breaks, and inspections; under California law, time drivers spent on layovers was compensable if Wal-Mart exercised control over the drivers during those breaks), aff’d in Ridgeway v Walmart Inc. (9th Cir 2020) 946 F3d 1066.

Businesses must file a report with the EDD when using the services of an independent contractor who is paid $600 or more in a calendar year, or whose contract calls for payment of $600 or more in a calendar year. The report must be filed within 20 days after the earlier of the date the $600 threshold has been reached or the date of entering into such a contract. Unless the failure is due to good cause, the EDD may assess a penalty of $24, or $490 if the failure is the result of conspiracy between the service recipient and service provider not to supply the required report or to supply a false or incomplete report. Un Ins C §1088.8(e).

      b. Statutes of Limitations

Actions under the Fair Labor Standards Act of 1938 (FLSA) (29 USC §§201–219) may be brought within 2 years after the cause of action accrued. 29 USC §255. The California Division of Labor Standards Enforcement may apply minimum wage and overtime laws retroactively for 3 years.

6. Employee Benefits

An employer may be required to pay benefits under its employee benefit plans to workers who were erroneously misclassified as independent contractors. Vizcaino v Microsoft Corp. (9th Cir 1997) 120 F3d 1006.

Statutes of Limitations

IRS

The Internal Revenue Service may assess payroll taxes for 3 years after the date the employer files its tax return (Form 941) for the year in question. IRC §6501(a). If the employer failed to file a return, or in instances of fraud, the IRS is not subject to a statute of limitations. IRC §6501(c)(1)–(3).

EDD

The Employment Development Department may assess payroll taxes for 4 years after the date the employer files its tax return (EDD Form DE-3) for the year in question. If the employer failed to file a return, or in instances of fraud, the EDD may assess payroll taxes for 8 years after the date the employer filed (or should have filed) the tax return for the year in question. Un Ins C §1132.