Classification of Employees as Independent Contractors

April 1, 2010
By: FitzGerald & Mulé LLP

Are you thinking about classifying some of your employees as "independent contractors" and issuing a 1099, in order to save worker's compensation premiums, payroll taxes or other employer contributions? If the employee agrees, then it is voluntary and lawful, right?

Wrong!

Employers should be aware that various branches of the State of California are scrutinizing businesses that identify persons as independent contractors for tax purposes, in payroll records, in response to governmental audits, etc. The State's various labor and employment arms are also coordinating efforts unlike any time prior to now, in order to investigate potential violators and ensure compliance with laws governing employees' rights.

Many years ago, the "independent" contractor was retained by a business under a simple contract, usually prepared by the business owner, in which the contractor agreed to pay their own self-employment taxes, use their own equipment, provide their own supervision and training, and provide their own employment-related benefits or, at least, acknowledge that the business owner would provide none.

In the last twenty years, when presented with this issue, the Division of Labor Standards Enforcement (DLSE) applied the California Supreme Court's test in S.G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341, i.e., essentially whether the person to whom the service is rendered (for example, the employer or business owner) had the control over the worker as to the work performed and the manner and means in which it was performed. The Borello case also held that the written agreement between the owner and contractor was not determinative. Id. at 349.

Other cases dispelled the assumption that the use of a 1099 form rather than a W-2 would prove the existence of an independent contractor relationship. Toyota Motor Sales v. Superior Court (1990) 220 Cal. App. 3d 864, 877.

In recent years, an independent contractor under worker's compensation guidelines may or may not have been be considered an independent contractor under Employment Development Department rules and regulations, or under the decisions of the Labor Commissioner. Instead, such persons could be considered "employees" with rights to claim past due wages or benefits, or to file litigation against the business owner for employer misconduct. Therefore, an employer's success depended largely on which governmental entity raised the issue.

However, decisions in California over the last four years have dramatically changed, and clarified, the scope of duties a person can perform within or for a business that determines their status as employee or independent contractor. The landmark decision was JKH Enterprises v. department of Industrial Relations (2006) 142 Cal. App. 4th 1046, which arose out of a Labor Commissioner investigation. JKH was a small business that ran a delivery service. After hiring persons initially as employee couriers, the Labor Commissioner investigated JKH and issued a "stop order" because JKH had failed to provide worker's compensation coverage for its employees pursuant to California Labor Code Section 3700, et seq. With an attorney's advice, JKH reclassified its workers as independent contractors. However, the Labor Commissioner returned, conducted another investigation, and issued fines and penalties against JKH for misclassifying its employees. The Hearings Officer focused on one issue - that the JKH couriers' work was "integral" to JKH's package delivery business and, therefore, they could not be independent contractors.

The Labor Commissioner's Hearings Offer issued a decision against JKH, which JKH challenged unsuccessfully in the Superior Court, and then the District Court of Appeal. The California Supreme Court denied review of the matter. Therefore, the Court of Appeals decision governs employers. Citing Borello, supra, that Court found that the employer had control over the workers because it used independent contractors regularly to perform work that is integral to the business of the company. Id. at 1064.

Before you retain or classify your workers as independent contractors for any purpose, be sure to obtain legal counsel as to whether the classification is correct and about how to draft a lawful independent contractor agreement.

For more information, contact FitzGerald & Mulé LLP.

This article is intended for informational purposes only. Nothing herein should be construed to constitute legal advice. It is recommended that you seek legal counsel before making decisions regarding labor and employment matters.

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