California Courts Change Contractor Test for Employers

June 14, 2018 | Shannon Shoemaker


A growing number of companies are opting to hire and employ contract and project-based workers in lieu of permanent employees for a number of reasons including increased workforce flexibility and the lower costs including employee perks, training and benefits.

An Intuit report showed that contingent workers of all types (temporary employees, independent contractors, project-based gig workers and on-demand workers) make up 36 percent of the workforce, and are expected to reach 43 percent by 2020. Around 80 percent of large corporations plan to substantially increase their use of contract employees.

Relying on a contingent workforce invites some risk. Most notable is the government’s scrutiny of such relationships to ensure that these workers are truly contractors and not employees whose pay would be subject to various withholding taxes. Uber paid millions of dollars in settlements of class-action lawsuits from drivers who argued that they should be classified as employees and entitled to employee benefits.

The California Courts Legal Ruling

The most recent legal shakeup involves the state of California. In late April, In a ruling with potentially significant consequences for the gig economy, the California Supreme Court made it much more difficult for companies to classify workers as independent contractors rather than employees.

According to The New York Times, Dynamex Operations West, Inc. v. Superior Court could require companies like Uber, many of which are based in California, to follow minimum-wage and overtime laws and to pay workers’ compensation and unemployment insurance and payroll taxes, potentially upending their business models.

Industry executives have estimated that classifying drivers and other gig workers as employees tends to cost 20 to 30 percent more than classifying them as contractors. It also brings benefits that can offset these costs, though, like the ability to control schedules and the manner of work.

The primary change in California independent contractor law is the state requirement that adopts a modified “ABC” test for determining whether an individual is an employee under the Wage Orders. This new independent contractor test is modeled on Massachusetts’ independent contractor statute, which is considered the strictest in the country.

California courts and state agencies have long applied what is known as the “Borello test” for determining whether a worker was an independent contractor under the Industrial Welfare Commission Wage Orders. This flexible, multi-factor approach looked primarily at whether the hiring entity had a “right to control” the manner in which the worker performed the contracted service, along with eight other “secondary” factors, such as whether the worker was engaged in a distinct occupation or business, the skill required in the particular occupation, and whether the worker or the hiring entity supplied the tools used to perform the work and the place where the work was performed.

The New Three-Factor Test and Approach

Despite the Borello test being used for decades for Wage Order cases, the California Supreme Court rejected it in favor of a more rigid three-factor approach, called the “ABC” test.  Under this new test, a person will be considered an independent contractor only if the hiring entity can prove all three of the following:

(A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the 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.

It remains to be seen how California courts will apply this new independent contractor test, or if the standard or its application will be limited by federal law (like the Federal Aviation Administration Authorization Act, or FAAAA, has limited the standard in Massachusetts when applied to certain arrangements involving motor carriers of property). Regardless, companies should expect that it will be more difficult to prove that an individual was classified as an independent contractor under California wage and hour laws.

Although the California Dynamex court case only considered the relevant test for wage order claims, worker classification issues are relevant in many other contexts, such as tax, workers’ compensation, and wage-and-hour claims derived from a source other than the wage orders. This decision is a seismic shift for California wage and hour law and class litigation. The court now imposes a burden on businesses to defend their classification of workers as independent contractors. Misclassification of such workers can result in significant legal exposure with respect to wage and hour compliance.

For federal compliance, to properly classify a worker as an employee or independent contractor, carefully review the IRS’s guidance on contractor and employee designations prior to making a classification decision. Misclassifying a worker as an independent contractor can result in penalties as well as back pay for benefits and taxes. The IRS can help employers determine the status of their workers by using Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. IRS Publication 15-A, Employer’s Supplemental Tax Guide, is also an excellent resource.

Compliance Changes for California and Hiring Contract Workers

The new contractor test in California adds another layer to compliance. The new “ABC” standard is likely to place a heavy burden on companies with independent contractors in California. Companies that engage and hire contractors should involve their legal department or consult legal counsel to review the relationship with their contractors under the “ABC” test. Factor B, in particular, may be troublesome for any entity that uses independent contractors for its main service or product (such as delivery drivers hired by a delivery service company, cake decorators for a bakery, or at-home seamstresses for a clothing manufacturer).









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