Independent Contractor Misclassification Penalties Now Severe

Last Updated: October 27, 2011


SB 459 goes into effect
on January 1, 2012 and is probably the most significant piece of new
employment-related legislation for California employers this year. The
“willful” misclassification of independent contractors will become in
and of itself an unlawful act that will subject an employer to fines of $5,000
to $25,000 for each violation as well as other significant disciplinary action.
These new penalties are in addition to any back taxes or other liabilities
resulting from the misclassification.

Background

There has always been risks for an employer who misclassifies a worker as an independent contractor which include back taxes, penalties, interest, unpaid personal incomes taxes of the misclassified worker, overtime, benefits, leave entitlement, and other rights and protections due to employees. The process of determining independent contractor status has never been an easy one. Different federal and state agencies use their own tests and criteria for making these determinations. While how much control the employer exercises over the work performed is a determining factor in all situations, the real-life situations in which employers find themselves are often “muddy” at best. Back taxes, penalties and interest alone can amount to as much as 70% of what was paid to the misclassified worker and an audit can go back 3, sometimes 4 years. For additional information about the criteria used by several federal and state agencies, click here: Vantaggio HR Info Bulletin – Independent Contractors vs. Employees-CA.

New California Rules

Effective January 1, 2012, employers are prohibited from the “willful misclassification” of independent contractors which the law defines as “avoiding employee status for an individual by voluntarily and knowingly misclassifying” the person. Given the complexity of the analysis required to make an accurate determination, and given how case-specific these determinations must be, we find this new definition to be disappointingly unclear. Our concern is that an employer who makes a good faith determination of independent contractor status might still be found to have engaged in a willful misclassification if they get it wrong. Employers are further prohibited from making any deductions from the compensation of independent contractors that would have violated the law if the worker had been correctly classified as an employee. Such illegal deductions would include the costs of goods, materials, space rental, services, licenses, repairs, equipment maintenance, fines, etc.

The civil penalties that will be assessed range from no less than $5,000 to $25,000 per violation, depending upon whether the employer is found to have engaged in a “pattern or practice” of such violations.

In addition to the new, severe penalties for employers, companies and individuals (other than the employer’s own internal staff or legal counsel) who help advise clients on such misclassifications can now be found jointly and severally liable under the law.

Employers who are licensed contractors who commit willful misclassification will now also be reported to the Contractors’ License Board which will in turn be required to take action against the licensee.

And perhaps the most surprising disciplinary action imposed by this law is that employers found to have engaged in a willful misclassification will be required to post on their internet site (or in another area accessible to all employees and the general public) for a period of 1 year a notice that includes the following: (1) that the person or employer has committed a serious violation of the law by engaging in the willful misclassification of employees; (2) that the person or employer has changed its business practices in order to avoid committing further violations; (3) that any employee who believes to have been misclassified may contact the Labor and Workforce Development Agency (along with the LWD’s complete contact information); (4) that the notice is being posted pursuant to a state order; and finally (5) the signature of an officer of the company.

For a full review of the new law, see California SB 459.

At the Federal Government Level

The concern over misclassified independent contractors is not specific to California. The U.S. Department of Labor announced that in their 2011 budget, an additional $25 million was being set aside for an initiative to target misclassification of independent contractors. Part of that money was to be used for hiring approximately 100 additional enforcement personnel and “competitive grants” to boost states’ incentives and capacity to address this problem. The Obama administration announced that they expect this initiative to generate over $7 billion in federal tax revenue over the next 10 years.

Ironically, at the same time that California is implementing increased punishment for employers who misclassify independent contractors, the federal government has introduced an amnesty program to help employers resolve past misclassification issues and reduce the past federal payroll taxes due.

The Voluntary Classification Settlement Program (VCSP) was launched by the IRS on September 21, 2011. To be eligible for the program, the employer must: (1) have consistently treated the workers in question as independent contractors in the past; (2) have filed all 1099 forms for the workers for the past 3 years; (3) not currently be under audit by the IRS; and (4) not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers.

The IRS has stated that employers who are “accepted” into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or other penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. However, it’s very important to note that participating employers will, for the first 3 years under the program, be subject to a “special” six-year statute of limitations, rather than the usual 3 year statute. Additionally, employers need to remember that federal payroll taxes are only one of the many liabilities for misclassification. A clear concern is that reclassifying a worker from independent status to employee status (especially if done mid-year) may alert other agencies and/or the worker to other areas of potential recovery for things such as unpaid overtime, missed meal and rest periods, other employee benefits, workers’ compensation benefits, state payroll taxes, unemployment benefits, etc. We would advise exercising extreme caution and due diligence before enrolling in this partial amnesty program.

What should employers do?

  • Make sure you are aware of the independent contractors that your company is using.
  • Perform a review of each independent contractor to make sure the person would meet the legal criteria.
  • Do not assume that someone is an independent contractor just because you are told that he/she has their own business, has a website, has their own corporation, etc. While these are factors that can help show true independent contractor status, the totality of the situation and what the person is actually doing for your company must be taken into consideration.
  • If any current contractors do not meet the requirements or are questionable, convert them to employee status. Consider fixing the problem retroactively to reduce your total liability.
  • For independent contractors who would legitimately pass the tests, make sure you have a well-drafted written agreement in place as well as documentation that would help you prove that your classification was legitimate (a copy of the contractor’s business license, proof of business insurance, copies of all 1099 forms filed, etc.)

In summary, the risks for misclassifying an independent contractor are significant! There is no substitute for competent, case-specific advice. Please contact us if you require assistance and consider seeking legal counsel from an attorney experienced in this particular area of employment law, and/or a formal, written determination from the EDD and/or the IRS.

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