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- Misclassification of an employee or a contractor can have severe tax and other consequences for the employer.
- Article “Classifying Workers: Contractors or Employees?”
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Article “Classifying Workers: Contractors or Employees?”
When hiring workers, employers sometimes choose to classify the worker as an independent contractor rather than an employee, either in the belief that it is less expensive or burdensome for the employer or at the potential worker prefers to be treated as independent contractors rather than as an employee for personal reasons or to potentially delay or avoid payment of taxes.
For employees, the employer must withhold and remit income and employment taxes from wages or salary paid to the employee to the taxing authority, including an additional employer contribution. Each year the employer is required to issue IRS Form W-2 to each employee specifying the amount earned and the taxes withheld during the prior year.
There is no requirement for withholding or remitting taxes for independent contractors and the employer is only required to issue IRS Form 1099 to the independent contractor if the amount paid during the year was $600 or more. Moreover the independent contractor is generally not entitled to any benefits available to employees.
However, the tax withholding and reporting obligations for employees or independent contractors are substantially different and wrongful misclassification of an employee or a contractor can have severe tax and other consequences for the employer. The employer could be liable for payment of the taxes that should have been withheld in addition to the employer’s share of the employment taxes, interest on those taxes and possibly penalties. In addition the employers could be subject to a class action lawsuit arising from the misclassification on behalf of all workers misclassified over several years. The resulting liability could be substantial and devastating.
The relevant factors necessary to determine whether a worker should be classified as an employee or an independent contractor include whether the worker was engaged in a separately established occupation or business; whether the worker could be discharged at any time without cause; the skill required to perform the services and accomplish the desired result; whether the worker or the service recipient supplied the tools, equipment, and place of work; whether the work was an isolated event or continuous in nature; whether the work was part of the hiring entity’s regular business; and the relationship the employee or independent contractor believed that they were creating. Almost every case is unique and turns on its specific facts, but the principal relevant fact has been whether the hiring entity had the ability to control the “manner and means” or the details as to how the worker completed the work.
The risk of a wrong classification has been simplified (and restricted) by the recent matter of Dynamex Operations West, Inc. v. The Superior Court of Los Angeles County decided in the California Supreme Court. Dynamex was not decided in the context of an income or employment tax dispute, but rather in the context of a California Industrial Welfare Commission wage order which is arguably not applicable in determining a worker’s status for tax purposes. However it is likely that the California Employment Development Department, which oversees worker classification issues for California income and employment tax purposes, will refer to Dynamex when making a determination as to the employment status of a worker.
Dynamex articulates an “ABC” test to determine whether a worker is an employee or an independent contractor. The “ABC” test provides that a worker is properly classified as an independent contractor if the hiring entity can establish that: (A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both as provided in the underlying contract and in fact; (B) the worker performs work that is outside the usual course of the hiring entity’s business; (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
Under these requirements almost all workers would likely be classified as an employee because of the requirements of the “B” test unless the worker is truly outside the scope of the hiring entity’s business. A contractor providing plumbing services to an apparel manufacturer would fit that provision. However a contract clothing designer may not. Likewise, a contract attorney providing legal services for a law firm would almost certainly be classified as an employee.
Employers would be well advised to closely examine the legal ramifications when determining the classification of workers and seek legal advice if there is any doubt. The consequences of an incorrect classification could be extremely problematic.
Bryan Friedman is a shareholder at Friedman Stroffe & Gerard, P.C. in Irvine, California. He is a shareholder of Friedman Stroffe & Gerard, P.C. and chairs the firm’s Corporate and Business Practice Group. Contact him at firstname.lastname@example.org or 949.265.1106.
The contents of this article are intended for general information purposes only and should not be construed as a professional opinion on any specific facts or circumstances. Professional advice should be consulted with regard to specific application of the information on a case by case basis.