Law penalizes employers

By Tim Binder

A new California law penalizes employers who willfully misclassify employees as independent contractors. Penalties can be as high as $25,000 per violation for employers who commit a pattern and practice of willfully misclassifying such employees. The new law is Labor Code Section 226.8 that becomes effective January 1, 2012.

In addition to the monetary penalties, contractors licensed under the California Contractors License Law will be subject to disciplinary action by the Contractors State License Board. A paid consultant who knowingly advises an employer to treat an individual as an independent contractor to avoid employee status will be held jointly liable with the employer if the individual is found not to be an independent contractor.

According to some commentators, the law will discourage companies from using California service providers who are doing business as sole proprietorships. Larger companies, who are likely targets of the law, will be unwilling to risk the harsh penalties. Rather than engage the service provider as employees, with all the additional tax and regulatory burdens applicable to employees, companies will look to out-of-state service providers. Consultants and other service providers may find that they have to incorporate, with all the additional tax and regulatory burdens applicable to corporations, if they want to provide services to other businesses in California.

Willful violators will also have to post a “Scarlet Letter” on their website informing the world that the employer has committed a serious violation of the law by engaging in the willful misclassification of employees, that the employer has changed its business practices, and that any employee who believes he is being misclassified may contact the Labor and Workforce Development Agency.

So how does a company know whether a person is an independent contractor or an employee? You would think that if the state were going to impose penalties for willfully misclassifying employees, the state would provide clear, “bright-line” guidelines. If you thought that, you would be wrong.

Here is what the California Department of Labor Standards Enforcement says on its website: “There is no set definition of the term “independent contractor” and as such, one must look to the interpretations of the courts and enforcement agencies to decide if in a particular situation a worker is an employee or independent contractor.”

So there you have it. Clear as mud, right? To make matters worse, there are numerous “enforcement agencies,” each with its own set of rules. The Internal Revenue Service applies a 20 factor test. The California Employment Development Department uses a 10 factor test, and the Labor Commissioner relies primarily upon an “economic realities” test.

Then there is the Franchise Tax Board, the Division of Worker’s Compensation, and the Unemployment Insurance Board each with their own interpretations of who is an employee and who is an independent contractor. And don’t forget Labor Code Section 2750.5 that provides that if you hire an unlicensed contractor, that person is automatically your employee. So you may be responsible for withholding taxes and providing worker’s compensation insurance, among other things.

With this new law, California establishes potentially harsh penalties while failing to establish clear standards for employers to distinguish between who is an employee and who is legitimately an independent contractor. Businesses may be required to defend themselves under all the various tests, and the Labor Commissioner may use its own test to the exclusion of others. So companies may find themselves in the position of having properly classified a service provider as an independent contractor for federal and state income tax purposes, but having the Labor Commissioner or other state agency classifying that provider as an employee!

Companies that engage independent contractors should exercise caution in continuing to use such persons. To defend against a claim under the new law, companies should consider obtaining a legal opinion that supports the classification of the service provider as an independent contractor. Such an opinion will likely negate the “willful” misclassification and avoid the monetary penalties under the new law.

Tim Binder is the former general counsel for the Hotel del Coronado. He resides in Del Mar Heights.