Don’t Make the Mistake of Classifying Your Employees as Independent Contractors in California
In a fast-paced startup environment, it is easy to overlook or put off figuring out how to classify your workers. It is usually simpler and less expensive to classify your workers as independent contractors than to understand and comply with all of the rules and requirements that apply to employees. But do not give into this temptation! Misclassification of employees as independent contractors can put you at risk of an audit or lawsuit and be expensive, time-consuming, and limit or delay your ability to raise capital. You’ll save yourself a lot of time, money, and headache if you classify your workers correctly from the get-go.
What does the law say?
Recent changes in California law have made the risk of misclassification a real threat. In January 2020 Assembly Bill 5 (AB 5) became effective in California. AB 5 creates a presumption that all California workers are employees unless they meet certain criteria. Startups are particularly affected by the new law because of their tendency to classify workers as independent contractors to save costs while raising funds. AB 5 is also particularly disruptive to businesses in the gig economy that rely heavily on independent contractors in their business model.
How do I determine if my workers are employees or independent contractors?
The key point to remember is that workers are presumed to be employees unless they meet all of the following requirements of the “ABC Test.”
Only if the worker meets all three of these elements are they properly classified as an independent contractors.
What does the ABC Test mean as practical matter?
(A) means that if you are going to classify your worker as an independent contractor you cannot have control over the precise details of their work or direct their work. If your contractor is subject to the same type and degree of control that is typical of employees, either through contract or in practice, then they should be classified as an employee.
(B) means that if you are going to classify your worker as an independent contractor, they cannot be performing work that is part of the usual course of your business. Examples provided by courts include a retail business hiring an electrician (independent contractor), a clothing manufacturer hiring a seamstress (employee), and a bakery hiring a cake decorator (employee). The latter two workers are performing work that is part of the usual course of the company’s business while the former is not. This element can become harder to determine depending on the type of business, especially for companies in the gig economy. The question is whether the business is providing the same service that the gig worker provides or is simply connecting the gig worker to the customer. That issue continues to be the source of much debate and litigation.
(C) means that if you are going to classify your worker as an independent contractor, they must be actually engaged in an independently established trade, occupation, or business and work for more than one entity. Indications of this include a separately incorporated business, a business license, and public promotion and advertising of the business. If the individual’s work relies on only one client (you), then this portion of the test is not met.
Why is this so important?
California law guarantees employees a variety of workplace protections that are often inapplicable to independent contractors. This includes entitlement to unemployment insurance, minimum wage, overtime pay, meal and rest breaks, workers’ compensation, paid sick leave, paid family leave, payroll withholdings, etc. By misclassifying a worker, your startup may be inadvertently withholding benefits that should be given to employees and withholding tax income from the state and federal government.
What can happen if I get this wrong?
Misclassification of an employee as an independent contractor puts you at risk of wage violation penalties and tax. AB 5 allows for the assessment of civil penalties between $5,000 and $25,000 per violation if you willfully misclassify an employee. A misclassified worker has the right to file a claim with the Labor Commissioner’s Office or sue their employer if they are being misclassified.
Are there any workers exempt from this test?
Yes. There are certain types of workers that are exempt from the ABC Test, including some that are likely to be employed by startups. For instance, graphic designers, marketing contractors, human resource administrators, and fine artists are not generally evaluated under the ABC Test if they maintain a separate business location, set their own rates and hours, are engaged or available to engage in similar types of work with other businesses, and regularly exercise discretion and independent judgment in their work. Individuals who are licensed lawyers, architects, engineers, private investigators, or accountants also are not included. This is the same for healthcare professionals performing services provided to or by a health care entity. And direct sales salespersons are not included if they meet the requirements under Section 650 of the Unemployment Insurance Code.
In addition, Proposition 22 was recently passed by California voters. Prop 22, or the App-Based Drivers as Contractors and Labor Policies Initiative, exempts drivers for app-based transportation and delivery companies from AB 5 by classifying them as independent contractors except in certain limited circumstances.
What test is used for exempt workers?
Except for drivers that fall under Prop 22, who are automatically classified as independent contractors, workers exempt from AB 5 can still be considered employees; they are just evaluated under the less-stringent standard set forth by the California Supreme Court in S.G. Borello & Sons Inc. v. Dept. of Indus. Relations, 48 Cal.3d 341 (1989). The Borello test does not impose the presumption of employment and uses a variety of factors to determine if a worker is an employee or independent contractor. It focuses primarily on the (A) element of the ABC Test--whether the business has the right to control the individual’s work. The other factors that may be considered under Borello include, but are not limited to: (1) whether the employer can discharge the worker; (2) whether the worker has a distinct occupation or business; (3) the kind of occupation with reference to whether in the locality the work was usually done under direction or by a specialist without supervision; (4) the skill required; (5) whether the employer supplies the workers’ tools, instrumentalities, or place of work; (6) the length of time services were performed; (7) whether the worker was paid by time or job; (8) whether the work was part of the company’s regular business; and (9) whether the employees believed they were creating an employer-employee relationship.
Your startup’s workers may be classified according to the ABC Test or could fall under an exception covered by the Borello standard. Either way, it is important to consult counsel and evaluate your classification of workers to guarantee they are being classified appropriately. If you are a startup in the gig economy, it is also important to stay abreast of developments in the law and shifts throughout the industry as a result of AB 5 and Prop 22.
What does the law say?
Recent changes in California law have made the risk of misclassification a real threat. In January 2020 Assembly Bill 5 (AB 5) became effective in California. AB 5 creates a presumption that all California workers are employees unless they meet certain criteria. Startups are particularly affected by the new law because of their tendency to classify workers as independent contractors to save costs while raising funds. AB 5 is also particularly disruptive to businesses in the gig economy that rely heavily on independent contractors in their business model.
How do I determine if my workers are employees or independent contractors?
The key point to remember is that workers are presumed to be employees unless they meet all of the following requirements of the “ABC Test.”
- The person 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.
- The person performs work that is outside the usual course of the hiring entity’s business.
- The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Only if the worker meets all three of these elements are they properly classified as an independent contractors.
What does the ABC Test mean as practical matter?
(A) means that if you are going to classify your worker as an independent contractor you cannot have control over the precise details of their work or direct their work. If your contractor is subject to the same type and degree of control that is typical of employees, either through contract or in practice, then they should be classified as an employee.
(B) means that if you are going to classify your worker as an independent contractor, they cannot be performing work that is part of the usual course of your business. Examples provided by courts include a retail business hiring an electrician (independent contractor), a clothing manufacturer hiring a seamstress (employee), and a bakery hiring a cake decorator (employee). The latter two workers are performing work that is part of the usual course of the company’s business while the former is not. This element can become harder to determine depending on the type of business, especially for companies in the gig economy. The question is whether the business is providing the same service that the gig worker provides or is simply connecting the gig worker to the customer. That issue continues to be the source of much debate and litigation.
(C) means that if you are going to classify your worker as an independent contractor, they must be actually engaged in an independently established trade, occupation, or business and work for more than one entity. Indications of this include a separately incorporated business, a business license, and public promotion and advertising of the business. If the individual’s work relies on only one client (you), then this portion of the test is not met.
Why is this so important?
California law guarantees employees a variety of workplace protections that are often inapplicable to independent contractors. This includes entitlement to unemployment insurance, minimum wage, overtime pay, meal and rest breaks, workers’ compensation, paid sick leave, paid family leave, payroll withholdings, etc. By misclassifying a worker, your startup may be inadvertently withholding benefits that should be given to employees and withholding tax income from the state and federal government.
What can happen if I get this wrong?
Misclassification of an employee as an independent contractor puts you at risk of wage violation penalties and tax. AB 5 allows for the assessment of civil penalties between $5,000 and $25,000 per violation if you willfully misclassify an employee. A misclassified worker has the right to file a claim with the Labor Commissioner’s Office or sue their employer if they are being misclassified.
Are there any workers exempt from this test?
Yes. There are certain types of workers that are exempt from the ABC Test, including some that are likely to be employed by startups. For instance, graphic designers, marketing contractors, human resource administrators, and fine artists are not generally evaluated under the ABC Test if they maintain a separate business location, set their own rates and hours, are engaged or available to engage in similar types of work with other businesses, and regularly exercise discretion and independent judgment in their work. Individuals who are licensed lawyers, architects, engineers, private investigators, or accountants also are not included. This is the same for healthcare professionals performing services provided to or by a health care entity. And direct sales salespersons are not included if they meet the requirements under Section 650 of the Unemployment Insurance Code.
In addition, Proposition 22 was recently passed by California voters. Prop 22, or the App-Based Drivers as Contractors and Labor Policies Initiative, exempts drivers for app-based transportation and delivery companies from AB 5 by classifying them as independent contractors except in certain limited circumstances.
What test is used for exempt workers?
Except for drivers that fall under Prop 22, who are automatically classified as independent contractors, workers exempt from AB 5 can still be considered employees; they are just evaluated under the less-stringent standard set forth by the California Supreme Court in S.G. Borello & Sons Inc. v. Dept. of Indus. Relations, 48 Cal.3d 341 (1989). The Borello test does not impose the presumption of employment and uses a variety of factors to determine if a worker is an employee or independent contractor. It focuses primarily on the (A) element of the ABC Test--whether the business has the right to control the individual’s work. The other factors that may be considered under Borello include, but are not limited to: (1) whether the employer can discharge the worker; (2) whether the worker has a distinct occupation or business; (3) the kind of occupation with reference to whether in the locality the work was usually done under direction or by a specialist without supervision; (4) the skill required; (5) whether the employer supplies the workers’ tools, instrumentalities, or place of work; (6) the length of time services were performed; (7) whether the worker was paid by time or job; (8) whether the work was part of the company’s regular business; and (9) whether the employees believed they were creating an employer-employee relationship.
Your startup’s workers may be classified according to the ABC Test or could fall under an exception covered by the Borello standard. Either way, it is important to consult counsel and evaluate your classification of workers to guarantee they are being classified appropriately. If you are a startup in the gig economy, it is also important to stay abreast of developments in the law and shifts throughout the industry as a result of AB 5 and Prop 22.