Employment Relationship - Misclassification

Misclassification of your independent contractors is one of the largest areas of liability and the easiest to get wrong for California employers. Failure to properly classify an employee results in a failure to comply with numerous employment laws, tax laws, employee benefit plan obligations and other legal requirements.

Legal Consequences of Misclassification:

Mistakenly classifying an employee as an independent contractor runs the risk of failing to comply with several laws including the following California specific laws:

• The California Labor Code, which governs employee wages (i.e. overtime and minimum wages rules), hours of work, and working conditions (i.e. meal and rest period requirements);

• California workers’ compensation laws;

• California state disability insurance (SDI) benefits;

• California state unemployment insurance benefits (UDI);

• California payroll tax laws governing withholding, deductions and contributions; and

• The California Fair Employment and Housing Act (FEHA), which prohibits discrimination in the workplace;

• California Family Rights Act (CFRA), which provides covered employees with up to 12-weeks of unpaid leave for certain family and medical care;

• A broad range of other employment and tax laws, both state and federal.

A contractor that is misclassified may be entitled to recover employment benefits made available to employees, such as retirement plans, sick leave, vacation or paid time off policies, …etc.

Financial Consequences of Misclassification:

When a business misclassifies an employee and fails to comply with the above employment and tax laws and the financial penalites can be significant in both civil and criminal areas. Misclassification of a contractor can result in the business being required to pay all back taxes, including the employee portion, in addition to the civil penalties, interest and in cases involving fraud, criminal sanctions such as fines and imprisonment.

Sanctions can include the following:

• Civil penalties of not less than $5,000 or more than $15,000 for the willful misclassification;

• Civil penalties of not less than $10,000 or more than $25,000 dollars for engaging in a pattern or practice of willful misclassification;

• Civil penalties in the above amounts for charging an individual who had been willfully misclassified a fee, or making deductions from compensation, for any purpose including for goods, materials, space rental, services, repairs, equipment service, or other reasons;

• In the event a court or agency makes a finding of willful misclassification, the posting on the employer’s website for one year, in an area accessible to employees and the general public, a statement of the findings, with information for employees to contact the California Labor Workforces Development Agency (LWDA) in an employee believes he or she has been misclassified;

• Payment of California personal income tax based on the employee’s wages;

• Payment of California unemployment insurance (UI) contributions;

• Payment of state disability insurance (SDI);

• Payment of state employment training tax (ETT);

• A penalty for failure to pay taxes of 10 percent of unpaid contributions;

• A penalty of 10 percent of estimated employer and worker contribution for failure to file a state tax return (a penalty of 50 percent of the amount if due to fraud or intent to evade);

• A penalty of up to $1000 for failure to file a return or for filing a false return or statement;

• Criminal penalties of up to one year in jail or $1000 for failure to file a return or for filing a false return (or up to one year in jail or state prison and/or $20,000 for willfully failing to file a return or supplying false information); and

• Interest on contributions required of the employer and the affected workers.

The California Employment Development Department (EDD) can assess liability without regard to statute of limitation if a business files fraudulent returns with the intent to evade employment taxes. These California fines and penalties are in addition the federal Internal Revenue e Services (IRS) sanctions.

Under federal taxes laws, employers who misclassify will generally be liable for the social security and Medicare taxes and income taxes that would have been withheld if properly classified. If a proper federal IRS form 1099 was issued to the worker there are special tax rated used for the payment of back taxes. The employer must pay both the employee’s share and the employer’s share of required taxes and cannot recover the employee’s share of social security tax, Medicare tax or income tax withheld from the employee if the special tax rate was paid.

If the employer did not issue a federal IRS Form 1099 to workers a different set of rates are used.

Best Practices:

Employers seeking to make reactive tax payments to correct misclassification mistakes will be required to use the applicable taxes rates for the year(s) in question. Employers seeking additional information regarding federal and California tax rates are advised to consult the federal IRS’s publication, Employer’s Tax Guide, and the California Employment Development Department (EDD) publication, California Employer’s Guide. In addition, the federal Internal Revenue Service (IRS) has developed an “amnesty” program for employers seeking to correct potential misclassification errors.

Common Misclassification Mistakes:

A signed, written independent contractor agreement with a worker confers independent contractor status.

A written contract or agreement does not, alone, define the relationship. Although it can be evidence of the kind of relationship the parties intended to create. The actual conduct of the parties will be determinative of the employee or independent contract relationship.

Workers obtained from staffing firms are independent contractors.

Workers obtained from staffing firms are usually a joint employee of the staffing firm and the employer. Both the on-site employer and the staffing firm supervise and control the work of the employee and therefore are both jointly and severally liable for violations of employment and tax laws.

Workers issues an IRS Form 1099-Misc are independent contractors.

The 1099 form is simply a method used by the IRS to track and report certain types of income. It does not confer independent contractor status.

Workers paid less than $600 a year are not subject to California payroll tax.

The amount paid to a worker is not by itself a factor determining independent contractor status. The amount paid may be relevant to whether to issue a Form 1099-Misc.

Part-time, temporary, probationary, and substitute workers are "casual: laborers, not employees.

There is no exclusion from employment, or requirement of independent contractor status, for part-time, temporary, probationary, substitute or outdoor labor. The employee status is almost like a default status if a person does work for another. Only when certain factors exist should someone be changed from the employee status to an independent contractor.

Family members are not employees.

Some family members may be subject to exemptions from California Wage Orders, but they are nevertheless considered employees and subject to payroll taxes unless certain conditions are met.

An industry wide practice of treating certain workers an independent contractors means workers in that job category are independent contractors.

Special test for employment status, not the practices in any particular industry or among competitors, determines whether a worker is an independent contractor. Because others are doing it will not save you from penalties.

Workers who perform similar work for businesses are independent contracts.

Performing work for other businesses is not, by itself, a determining factor. The contractors working relationship with each business must be looked at separately.

Workers with a city business license or a business car are independent contractors.

A city business license or business care, by themselves, do not make a worker an independent contractor. The worker must satisfy certain test for independent contract status in order to establish an independent contractor relationship.

Payment of workers solely by commission means they are independent contractors.

The method of payment is not, by itself, a determining factor for independent contractor status.

Some links to look at:

EDD FAQ for Payroll Taxes http://www.edd.ca.gov/Payroll_Taxes/FAQ_-_Payroll_Taxes_General_Information.htm#CommonLaw

EDD Employment Work Status Determination (includes info on requesting a ruling): http://www.edd.ca.gov/pdf_pub_ctr/de231es.pdf

Independent Contractor Misconceptions: http://www.edd.ca.gov/pdf_pub_ctr/de573m.pdf

Employment Determination Guide: http://www.edd.ca.gov/pdf_pub_ctr/de38.pdf

EDD payroll tax seminar done in conjunction with IRS – do take this class http://www.edd.ca.gov/Payroll_Tax_Seminars/

• They also have an independent contractor seminar that would be good to take

EDD Payroll Tax Online Tutorials http://www.edd.ca.gov/Payroll_Taxes/Web_Based_Seminars.htm

EDD Fraud and Penalties Page: http://www.edd.ca.gov/unemployment/fraud_and_penalties_what_you_need_to_know.htm

IRS Independent Contractor vs Employee: https://www.irs.gov/taxtopics/tc762

IRS Publication 15-A Employer’s Supplemental Tax Guide https://www.irs.gov/pub/irs-pdf/p15a.pdf

IRS Independent Contractor or Employee: https://www.irs.gov/pub/irs-pdf/p1779.pdf