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Independent Contractor Misclassification

After a 2018 ruling in California, the status of an independent contractor is even more narrow and difficult for West Coast companies to establish.

As the government cracks down on misclassifications, businesses in California now bear the burden of establishing that a worker is properly classified as an independent contractor by meeting a three factor test.

Burdens of Hiring Employees

As the California Supreme Court noted in a recent landmark case; the cost of hiring employees is expensive. To employ an individual a company must pay federal Social Security, payroll taxes, unemployment insurance taxes and state employment taxes, provide worker's compensation insurance, and comply with numerous state and federal statutes and regulations governing wages, hours, and working conditions.

There are at least 150 million independent contractors across North America and Western Europe. The rise in freelance workers reflects the emergence of startups focused on innovating traditional services. This is especially true in the gig economy where a startup may rely on hundreds, or even thousands, of workers across the country to fulfill its services. Think of all the people who drive for Uber, or deliver packages for Amazon or fresh food for Blue Apron.

Many early-stage startups simply lack the financial resources to pay employee benefits and would never be able to hire all the employees required for high-growth. It's not surprising then that many startups seek to avoid these fees by instead classifying workers as independent contractors.

In narrowing the scope of independent contractor classification, the California court focused on several important societal considerations, namely that: (i) the unfair economic advantage that business who misclassify workers gain over their competition who properly classify similar workers as employees and pay the associated costs; (ii) misclassification causes the federal and state governments to lose billions of dollars in tax revenue per year; and (iii) millions of workers are striped of the labor law protections to which they are entitled.

For all of these reasons the federal and state governments have begun cracking down on misclassifications in recent years.

On the civil side (lawsuits brought by worker-plaintiffs, not the government), FedEx settled a class-action lawsuit brought by 2,300 misclassified delivery drivers in California in 2015 for $228 million. Attorney for the drivers stated:

The $228 million settlement sends a powerful message to employers in California and elsewhere that the cost of independent contractor misclassification can be financially punishing, if not catastrophic, to a business.

FedEx settled another misclassification suit in 2016 brought by 12,000 drivers across 20 states for $240 million, and yet another one in 2017 brought by 12,627 drivers located in 19 different states for $227 million.

Ride-hailing companies, Uber and Lyft, were also hit with class-action law suits brought by drivers in 2016. Lyft settled for $27 million and agreed to reimburse the drivers, who would remain independent contractors, for work-related expenses such as gas and vehicle maintenance.

Uber was successful in two cases brought by its drivers. In one case the drivers were subject to an arbitration clause which ultimately prevented them from bringing a class-action lawsuit against the company. In the other case, a federal judge ruled that drivers for UberBLACK (Uber's limousine service), who were not subject to an arbitration clause, are independent contractors under federal law.

Each of these cases, however, were decided before April 2018 when California adopted the ABC Test in Dynamex v. Superior Court of L.A. County.

The ABC Test, which is new to the California analysis, makes it significantly more difficult to classify most workers as independent contractors.

Under the ABC Test

It is now assumed that a worker is an employee unless all of the following prongs are met:

The worker:

(a) is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;

(b) performs work that is outside the usual course of the hiring entity's business; AND

(c) is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

Breaking Down the New ABC Test

(a) free from control and direction

This requirement, which was already part of the common law standard for independent contractor classification, means that the hirer cannot control the worker in the typical ways in which an employer controls an employee. A hirer cannot dictate how, when, and/or where the services are performed. The lack of control over the worker must be written into the relevant independent contractor agreement and must also be upheld in practice.

Of course, to meet its business needs, the hirer can set terms such as the scope, requirements, and deadline of a projects. However, independent contractors generally cannot be compelled to follow company specific rules in completion of the services, such as wearing a uniform or using the hirer's equipment.

Basically, an engineer working as an independent contractor should be free to code from her apartment in her underwear at midnight, if she prefers. All that should matter is that the project she delivers is within the scope, timeframe, and quality that the hirer contracted her for.

Beware of the California court's caveat here:

Depending on the nature of the work and overall arrangement between the parties, a business need not control the precise manner or details of the work in order to be found to have maintained the necessary control that an employer ordinarily possesses over its employees.

(b) outside the usual course of business

To meet this prong, the worker cannot perform the same type of work as the hirer. Workers who would ordinarily be viewed by others as working in the hiring entity’s business are likely considered employees.

In the example of a website design company that develops custom websites directly for clients; the designers of such websites are probably employees because they perform the actual service the company provides to the consumer.

Alternatively, consider a company that offers a language learning mobile application; the coders who develop the app may be properly classified as independent contractors because the business doesn't offer mobile app development to consumers—it offers a product to facilitate learning languages.

However, if the coder becomes an integral part of the company's business, or the company fails to meet one of the other prongs, the coder could still be considered an employee.

A straightforward example of a legitimate independent contractor would be a plumber or electrician who merely performs a very specialized service that the company doesn't itself engage in and the worker would not reasonably be viewed by the public as an employee of the business.

(c) usually performs the service independently

Additionally, the worker can only be properly be classified as an independent contractor if the worker provides a traditionally independent service.

The court stated:

A business cannot unilaterally determine a worker's status simply by assigning the worker the label 'independent contractor' or by requiring the worker, as a condition of hiring, to enter into a contract that designates the worker an independent contractor.

A person who independently made the decision to classify herself as an independent contractor has usually registered a business and advertises its services to the public—the absence of which may be considered indication that the hiring business made the decision, and not the individual.

The independent contractor relationship should not be exclusive. As a free agent, the contractor should not be prohibited from contracting its services with other companies (the hiring business may still include non-disclosure clauses and keep any trade secrets properly safeguarded).

Keep in mind, however:

The fact that a company has not prohibited or prevented a worker from engaging in such a business is not sufficient to establish that the worker has independently made the decision to go into business for himself or herself.

Clearly, proper independent contractor status is currently a very gray area. Startups should have a lawyer review all independent contractor agreements, along with the business's actual practices, to ensure proper classifications.

Consequences for Misclassification

Regardless of whether a misclassification is intentional, the hiring company is at risk of owing back taxes and benefits and both civil and criminal penalties.

Both the IRS and the State of California have significantly increased compliance audits. A startup may experience an IRS audit if: one worker filed both a 1099 and W2 for the same company in the same year; a worker attempts to claim unemployment or disability; or a whistleblower files a SS-8 form.

Startups should consult an attorney to ensure that its independent contractor agreements comply with federal and state laws.

With the US Government continuing to clamp down on bad practices, the repercussions of misclassifying workers are increasingly outstripping the benefits.

(PGC. Sept. 2018).


Disclaimer: The information on this website is meant to be used for general educational purposes only. This information may not reflect the current law in your jurisdiction and should not be construed as legal or business advice or an advertisement for legal services. You should not act or refrain from acting on the basis of any information in this post or accessible through this website. If you have questions regarding your particular facts and circumstances, seek counsel from an experienced startup lawyer.



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