Posted by: Leanne Abraham

Understanding the IRS and state regulations, as well as the case law, to determine if a contractor should be classified as an employee may be confusing but do not avoid it or put it off. Make sure you have the right classification before a contractor starts work or it could cost you down the road.  The penalties, fines and legal costs could run into the six figures or more depending on how many workers are involved.

To help us better understand the risks of misclassifying workers, how to mitigate these risks, and how to ensure you properly determine a classification, we reached out to an HR law expert, Lou Storrow, Esq,. Lou also provided a list of helpful resource sites which are referenced at the end of this article.

First, what are the risks of a misclassification?

Both California State (EDD and DLSE) and the IRS have sets of guidelines to define when a contractor should be considered an employee. Their goal is to ensure that an employer is not misclassifying a worker to avoid payroll taxes, paying minimum wage or overtime, and complying with other wage and hour law requirements. They also want to ensure employers are not denying workers the protection of workers compensation, unemployment insurance, and other employment benefits.

If it is determined that a worker should have been an employee then all back payroll taxes and wages will be due. The IRS will also add some penalties and fines (1.5 to 3% of wages and 20% of the employee’s payroll taxes) but the big costs are the CA state fines (up to $25,000 per violation for repeat offenders) and possible lawsuits.

When state and federal law both apply, the courts will apply the rules that give more protection to employees.  Since California rules generally are more protective than federal rules, and California state fines can add up fast ($100-$200 per employee, per pay period, per multiple violations of the labor code), Lou advises that California rules are the most important ones to ensure you comply with.

The costs can increase even more if the claimant has engaged a lawyer. The lawyer can add their fees into the final ruling so a $10,000 judgment might have a $50,000 legal fee added on. This is why Lou advises most employers to consider settling a case to help reduce the potential legal costs.

Lou also informed me that, in recent years, more and more cases are being brought under PAGA, which is a California law that allows one worker to bring a class action lawsuit against an employer for labor code violations. The incentive to the worker to step up and do this is that they receive 25% of the fines that the state may impose.

Bottom line, it is very important that you classify a worker properly before the work starts. Even if your worker wants to be a 1099 and you are confident they would never bring a complaint against you, conflicts can occur and loyalties can change when money is involved. Also, employees cannot waive their rights to the labor code. Someone else could report the violation on their behalf or they could be included in a class action and you would be charged despite their wishes not to.

Potential oversights and mitigating risk

Lou provided some examples of how an employer could get caught without realizing they crossed a line. For example, a contractor starts to do a lot of work on site and they begin to feel like part of the team. If they can still be defined as a contractor protect yourself by collecting proof of their independence such as their business card, website, promotional pieces or advertising.

In this same example, if you do eventually convert this contractor to an employee, they may want benefits back to when they started working extensively with you. Lou cited a case where a large number of contract programmers at Microsoft were converted to employees and filed a lawsuit for back benefits and won.

Another thing to watch for is if you have a contractor that starts referring to themselves as an employee or asking questions like, “can I get medical coverage?”, “will you pay overtime?” or “does your workers' compensation cover me?”.  If your contractor is confused about their own status this is a factor that the EDD may use to classify the worker as an employee. If they are in fact a contractor, then you need to document the evidence to support this. In general, the EDD rules are that all workers are employees unless they can pass the guidelines for contractors.

Defining if a contractor is a contractor

In general, you are not at risk if your contractor has their own business with multiple clients, uses their own equipment and the work they do for you is ancillary to your business. For example, an accountant that you hire to close your books every month or a technical person who comes in to fix your network when needed are both probably contractors. 

The most significant criteria for a contractor is that you do not control how or when they do the work. A significant indication of control is if your contractor relies on you almost exclusively for their livelihood. In this situation, you exert a lot of control because you can terminate at will. One way to reduce this ‘control’ is to have a 30-day termination clause but this alone will not protect you.

A tactic that some employers have used is to ask the ‘contractor’ to set up a business and get their own laptop and business cards to look like a contractor.  These measures alone do not define a contractor, especially if you are their main livelihood and, if a case is brought against you, a judge will certainly see through your intent.

Lou provided three sites that can help you determine if your contractor(s) should be employees or not, including a checklist of questions.

·       The DLSE (Department of Industrial Relations, Division of Labor Standards Enforcement) has a FAQ page on independent contractor classification.

·       EDD Employment Determination Guide and Worksheet: http://www.edd.ca.gov/pdf_pub_ctr/de38.pdf

·       Who is a Statutory Employee? http://www.edd.ca.gov/pdf_pub_ctr/de231se.pdf

If you have an especially unique case you can get a ruling, but you will need one from each independent body (IRS, EDD, DLSE and your workers' comp carrier) since they each apply slightly different criteria. You could also contact Lou to help you out at This email address is being protected from spambots. You need JavaScript enabled to view it..

If you determine a contractor should be an employee but there are reasons you do not want to bring them onto your payroll (e.g. you want to try them out first, a part time or short term employee would be a benefits hassle, or there is a head count freeze) then you can payroll them through a staffing service like Premierehire until you are ready.

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Leanne Abraham, is the President of Premierehire, an executive search and staffing company that helps companies recruit and retain top talent in a variety of disciplines including engineering, IT, finance, marketing, operations, office support, customer service, and inside sales. Please call us for a free consultation on how we can solve your hiring challenges or email This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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