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Employee or Independent Contractor?

In these tough economic times, employers are seeking to save money wherever they can. Employers sometimes seek to save money by classifying a worker as an independent contractor rather than an employee to save on employment taxes and worker’s compensation insurance. However, an incorrect determination as to classification can severely damage or even destroy a business.

Both the Internal Revenue Service (IRS) and California Employment Development Department (EDD) collect employment taxes from businesses. Both the IRS and EDD have created publications to assist employers in classifying
workers. The IRS Publication is Publication 1779 entitled “Independent Contractor or Employee. . .” The EDD Publication is Publication DE 38, “Employment Determination Guide.”

Both the IRS and EDD base their determination of whether a worker is an employee or independent contractor on the application of common law factors of employment, and the State of California takes an extra step with various statutory
provisions contained in the Unemployment Insurance Code. The IRS publication references three basic factors, which include (i) behavioral control; (ii) financial control; and (iii) the relationship of the parties.

In analyzing behavior control, the main issue is whether the business has to provide instructions to the worker on how to complete a task. Instructions can include how, when, and where to do a task, what tools to use to complete the task,
whether to hire assistants to complete the task, and where to purchase supplies to complete the task. The more instruction that is provided is an indication of a classification as an employee.

The other issue in the behavioral control factor is whether the business has to provide training to the worker. The more training required the more it is an indication of employee status.

The financial control analysis looks at whether the worker has a significant investment in their work, whether they are reimbursed for their expenses, and whether they have an opportunity to earn or profit or incur a loss on a task. A large
investment in their work is an indication of independent contractor status. Reimbursement of expenses is an indication of employee status. Earning a profit or incurring a loss is an indication of an independent contractor.

The relationship of the parties looks at whether a worker is provided any benefits and whether there is a written agreement between the parties that addresses the issue. The granting of benefits is an indication of employee status
and a written agreement can provide confirmation of either status reflecting an understanding between the parties. Although a written agreement is not determinative of the issue, it can be extremely helpful in close cases.
EDD’s publication DE 38 also looks to go through the common law factors. However, its publication goes through thirteen (13) questions to assist in making a determination. The questions are: (1) do you instruct or supervise the person while
he is working; (2) can the worker quit or be discharged at any time; (3) is the work being performed part of your regular business; (4) does the worker have a separately established business; (5) is the worker free to make business decisions
which affect his ability to profit from the work; (6) does the worker have a substantial investment which would subject him to a financial risk of loss; (7) does the business have employees that do the same type of work; (8) does the business
furnish the tools, equipment, or supplies used to perform the work; (9) is the work considered unskilled or semi-skilled labor; (10) does the business provide training to the worker; (11) is the worker paid a fixed salary, an hourly wage, or based on a piece rate basis; (12) did the worker previously perform the same or similar services for the business as an employee; and (13) does the worker believe that he is an employee.

If the answers to questions 1-3 are “no” and all of the answers to questions 4-6 are “yes”, there is an indication of independence. If all of the answers to questions 1-3 are “yes” and all the answers to questions 4-6 are “no”, it is a very
strong indication the worker in question is an employee. If the answers to questions 1 or 2 is “yes” or the answer to any one of questions 4-6 is “no”, there is an indication of employment. In this situation, the questions 7-13 will be mixed
and a business is advised to complete a Form DE 1870, giving all of the facts and circumstances of the working relationship and request a ruling from EDD. Often times businesses are audited on these issues when a worker goes to
EDD to collect unemployment benefits and EDD has no record of the person being an employee. In that situation, EDD will conduct an audit and make a determination. If that determination is one of employment, EDD will then share
that determination with the IRS. If the IRS starts the audit, they will share the results with EDD.

Additionally, businesses are picked up on audit based on their entries on their tax return. A large deduction for contract labor and little expenses for wages or taxes would be an indication that a business is using mostly independent
contractors and there would be a strong presumption that the business is classifying their workers improperly.

Business owners are well advised to have written agreements with workers they wish to classify as independent contractors. As part of the written agreement the business owners should require that the worker provide a copy of their
Business License that was issued to them. Although the written agreement may not be determinative of the issue, it can be very helpful.

An improper classification can cause the business to be subjected to back taxes, interest and penalties by both the IRS and EDD. If the period is a couple of years and involves many workers, this can signal disaster for the business.
Accordingly, before making a determination that a worker is an independent contractor rather than an employee, a business owner should be very careful and review the various taxing agency publications and consult with their tax attorney to
prepare the necessary Independent Contractor Agreement.