Independent contractors or employees? It’s not a new question. We’ve all been grappling with it for years, but why does the issue keep circling back around, and dare I say, keep getting more complicated?
People are divided on the subject. “Yes, I’m positive my design consultant is an independent contractor.” “No, that office manager of yours really needs to be on payroll as an employee.” We can’t seem to agree. Why is that?
Independent Contractor ABC Test
Well, it’s not that as intelligent business people, we can’t apply a set of rules to a situation and determine the right answer. If there were a standard, we’d all probably be able to figure it out and agree. But that’s the problem, there simply isn’t just one set of rules – until maybe now, with the recent decision in Dynamex Operations West, Inc. v. Superior Court.
Dynamex is a company that provides delivery services for retail businesses and originally treated all of their drivers as employees. Motivated by being able to save costs by converting these drivers to independent contractor status, Dynamex ended up with a class action lawsuit that made its way all the way up to our state’s highest court. On April 30, 2018, the California Supreme Court not only unanimously ruled in favor of the plaintiffs who argued that they had been misclassified as independent contractors but established a new test for determining employee status under the Industrial Welfare Commission’s wage orders.
While not necessarily good news for employers, the new “ABC” test will allow for a more straight forward process in determining how to properly classify employees vs. independent contractors.
History of Independent Contractor Laws
Let’s go back and see how we got here. As a reminder, it’s unfortunately not up to the worker and the hiring company to determine the best model for working together. There is a common misconception that you can just “1099” the worker and be safe treating him/her as an independent contractor. While filing a 1099 to report income paid to the person can help reduce your penalties with the IRS should it be determined that the person was misclassified, the act of submitting a 1099 does not in and of itself establish independent contractor status.
Almost everyone has heard of the IRS’s 20 factor test, which was boiled down in 2007 to an 11 factor test focusing on 3 main areas. The IRS examines the behavioral and financial arrangement between the worker and the hiring company as well as the nature of their relationship. This type of test, called a “common law test” walks you through a series of questions helping to identify if the worker in practice is functioning independently or not. Unfortunately, oftentimes even after applying the multiple questions, the answer is a little murky and could honestly swing either way.
Other agencies, like the federal DOL, use a different methodology called the “economic realities test.” Like the common law test, there are a series of questions that one poses about the worker and the hiring entity aimed at determining if the worker is truly independent from an economic perspective from the hiring entity. Is this person truly, from a financial perspective operating an independent business?
The challenge with both the common law test and the economic realities test, is that there is no true “pass/fail.” For example, with the IRS’s 11 factor test, you are not guaranteed independent status if you answer 6 out of the 11 questions correctly.
The different factors are given varying weights depending upon the exact terms and conditions of a particular worker’s relationship with the hiring company. And unfortunately, clarity is sometimes not reached until years after the relationship is established when there is a complaint or lawsuit and then a final ruling. Employers have been left guessing and hoping that their independent contractors are classified correctly.
Until now. California has recently followed suit with a number of other states in the country who have opted to utilize a more streamlined test called an “ABC test.” This 3-prong approach requires the hiring entity to establish that all 3 of the factors of the test are met. If either A, B, or C cannot be established, the analysis is over – your worker is an employee and not an independent contractor.
Prior to the decision in Dynamex, California’s courts relied on a test established in a 1989 court case. The previous “Borello” test, much like the IRS’s or the DOL’s tests, frequently left one in doubt.
The court in the Dynamex decision intentionally patterned its new ABC test after the one used in the state of Massachusetts, long considered the most stringent test in the country.
How the Independent Contractor ABC Test Works in California
A worker is legally presumed to be an employee, unless:
A. The worker is free from the control and direction of the hiring company in connection with the performance of the work, both under the contract and in fact;
AND
B. The worker performs work that is outside the usual course of the hiring entity’s business;
AND
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.
While factors A (the worker needs to be free from control of the hiring company) and C (the worker needs to truly be engaged in running his/her own business) have been part and parcel of all of the other tests we’ve had to apply over the years, factor B will probably have the biggest impact on current independent contractor relationships. Unless the worker is being utilized to provide some type of service that is not the hiring company’s core business, the person will be considered an employee.
Keep in mind that this new ABC test will now be the benchmark in California for determining employee status under the Industrial Welfare Commission’s wage orders which are the body of law that defines working hours and conditions, minimum wage, overtime, meal and rest periods, exempt and non-exempt status, etc.
The California EDD may continue to use its current methodology when making determinations regarding state taxes and benefits such as unemployment, disability, etc. And the IRS and federal DOL may also continue using their own criteria. However, it is entirely possible that other agencies will also adopt the ABC standard. Soon after the Dynamex decision, Senator Bernie Sanders introduced a bill that would incorporate California’s new ABC test into the federal rules for determining independent contractor status under the National Labor Relations Act (NLRA). We are clearly experiencing a trend.
But for now as we are left with different tests being used by different agencies, the challenge for a California (or any) employer is that it’s not possible to treat someone as an independent contractor for some purposes while an employee for others. When deciding if someone is going to be on payroll or not, we have no choice but to apply the most stringent test that could come into play. And we’re back to the California ABC test.
None of this was an accident. The court in Dynamex made it clear that they didn’t want workers to be deprived of benefits to which they would be entitled if classified as employees. They also made it crystal clear that they don’t want companies attempting to save money and thus unfairly competing in the marketplace if they treat workers as independent contractors and save on the cost of the employers’ responsibilities such as payroll taxes, workers’ compensation, and other mandated benefits and protections.
What the decision seems to have failed to address head on is the evolution we’re experiencing that people refer to as the “gig” economy. More and more individuals are getting involved with companies such as Uber, Grub Hub, and a host of other online, on-demand service entities that allow people to pretty much decide how much they want to work and when. If this new ABC test is going to be applied – and applied retroactively as the recent California superior court decision (Johnson v. Imperial Showgirls) has indicated – gig companies are going to have a very hard time continuing to employ workers as independent contractors.
The Dynamex decision acknowledged that there is often greater freedom for workers to be treated as independent contractors but drove home the point that “if a business concludes that it improves the morale and/or productivity of a category of workers to afford them the freedom to set their own hours or to accept or decline a particular assignment, the business may do so while still treating the workers as employees for purposes of the wage order.” Point well taken.
Impact of the Independent Contractor ABC Test on Employers
So where does this leave California employers? While the ABC test is quite new, we urge employers to take it seriously and to proceed conservatively. While we expect further litigation and ensuing clarification about nuances in the interpretation of the alphabet, this California Supreme Court decision is not going away.
Our Checklist for Employers:
- Examine all current independent contractor relationships to ensure that they would meet the ABC test.
- Consider a formal independent contractor audit by an outside third party who will provide an un-biased assessment.
- If any independent contractors would not pass the ABC test, re-classify those workers.
- Review all existing written independent contractor agreements.
- Encourage any existing independent contractors who may otherwise meet the ABC test to truly and actively promote their own business. Employers could even assist these individuals with advice and resources regarding incorporation, licensure, insurance, marketing, etc.
- For any companies who currently rely heavily or exclusively on independent contractors to provide their core services, give thoughtful consideration to the potential cost of an audit, complaint, or lawsuit. Weigh this risk against the cost of converting your business model to one that relies on true employees.
- Finally, pay careful attention to the communication surrounding any decisions to make changes. The Dynamex folks created a great deal of liability for themselves by having drafted an internal memo in 2004, enumerating the potential cost savings of converting all of their employees to independent contractor status. Learn from their mistake and consider hiring outside employment counsel to advise and protect audit findings and decisions under attorney-client privilege.
- Be careful about developing a communication plan for any worker reclassifications. How workers will react to the news will be directly tied to what and how it is delivered. Get some good HR and even PR help in this area.
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