Employee or Independent Contractor, That Is the Question Many Employers Are Asking

By Patty Chen, Esq.

Misclassifying employees and independent contractors can lead to steep penalties and consequences. Doing so has resulted in million-dollar settlements for some companies. As one example, on January 17, 2020, Power Design Inc. agreed to pay $2.75 million to settle a lawsuit alleging it misclassified 500 electrical workers as independent contractors instead of employees.

There have been significant changes to how employees and independent contractors are classified. This article will provide an overview of the different ways the federal and California state governments determine a worker’s status, and ways an employer can determine the correct classification for its workers. 

To begin, an employer controls (1) the work of the employee, (2) what an employee does and (3) how an employee does it. On the other hand, an independent contractor is in a trade or business offering services to the general public.

Federal Determination of Worker’s Status 

The Internal Revenue Services (“IRS”) determines a worker’s status for payroll taxes (income taxes and FICA taxes).  The Department of Labor (“DOL”) determines a worker’s status for pay and benefits status purposes. The Fair Labor Standards Act (“FLSA”) sets rules for minimum wages, overtime, child labor, OSHA, and other protections. 

1. DOL Rules for Determining Worker Status Under the Fair Labor Standards Act (for pay and benefits status) 

The Fair Labor Standards Act

The FLSA requires covered employers to (1) pay nonexempt employees at minimum the federal minimum wage for every hour worked, (2) pay overtime pay for every hour worked over 40 hours in one workweek, and (3) keep certain employee records.  Many states also have minimum wage laws. Some state laws provide greater employee protections; employers must comply with both.

Under the FLSA, the term “employee” means any individual employed by an employer, with exceptions. 29 U.S.C. 203(e). An independent contractor is not an employee under the FLSA. The FLSA does not define the term “independent contractor.”

The courts and the DOL have created several tests to determine a worker’s status. In California, there are several legal tests to determine whether a person is an employee or independent contractor. California uses the ABC test from Dynamex Operations West, Inc. v. Superior Court (2018) 4 Cal.5th 903 (Dynamex) for wage and hour issues. But, the manners and means test will be used in California courts if the ABC test does not apply. Federal courts use the economic realities test.

DOL Rules for Determining Worker Status 

Provisions of the FLSA are administered, enforced and interpreted by the Secretary of Labor, through the Wage and Hour Division of the DOL (the “Division”). The Division issues regulations and bulletins interpreting the provisions of the FLSA. While the Division’s regulations and interpretations are not binding on the courts, good-faith reliance on those regulations and interpretations may constitute a defense for a violation of the FLSA’s minimum wage and overtime requirements, even if the regulation or interpretation is later held to be invalid. 29 CFR § 775.1; 29 USCS § 259.

On January 6, 2021, the DOL set forth a new standard rule for distinguishing between employees and independent contractors, which is scheduled to take effect on March 8, 2021. The rule identifies multiple factors that are important to consider, but its first two factors are identified as the “core factors” that are most important to the analysis. Those two factors are:

  • The “nature and degree of control over the work”; and
  • The worker’s “opportunity for profit or loss” based on initiative and/or investment.

In addition to these two core factors, the rule also identifies three other “guideposts” that may help in the analysis if there is no clear conclusion after analyzing the two primary considerations. The additional factors are:

  • the amount of skill required for the work;
  • the degree of permanence of the working relationship between the worker and the potential employer; and
  • whether the work is part of an integrated unit of production.

The core factors carry greater weight in the analysis than the secondary guideposts. In evaluating the individual’s economic dependence on the potential employer, the actual practice of the parties involved is more relevant than what may be contractually or theoretically possible. For example, a business’s contractual authority to supervise or discipline an individual may be less relevant if in practice the business never exercises such authority. The rule also provides multiple fact-specific examples applying the factors and demonstrating how they should be analyzed in practice.

2. How the IRS Determines Worker Status (for payroll purposes)

To determine a worker’s status, the IRS looks primarily at whether the employer has the right to control the specifics and the means by which the worker performs the job. The IRS uses several factors to determine if an employer exercises enough control over an employee to create an employment relationship, including:

  1. Behavioral Control. A worker is an employee when the employer has a right to control the worker’s job, even if the employer does not exercise its right of control. The IRS looks at which party controls when, where and how the work is performed, and the degree of instruction and training the employer gives to the worker, and how the employer evaluates the completed work.
  2. Financial Control. When the employer has the right to control financial aspects of a worker’s job, it is more likely that the worker is an employee. The IRS looks at whether the employer pays for the worker’s equipment, how the worker’s pay is calculated, and whether the worker can experience profit or loss from the job.
  3. Relationship of the Parties. The way the worker and the employer view their relationship is a factor. Written contracts describing the relationship are considered, but are not necessarily determinative. Other evidence can be considered, like whether the business provides insurance or the permanency of the relationship.⁠

Behavioral control is the most important factor, but none of the factors are necessarily decisive.⁠ Instead, the IRS will look at the entirety of the employment relationship and weigh each factor in light of those circumstances.⁠ The IRS also may consider factors that are not listed above. 

It is sometimes difficult to determine a worker’s status. If you are unsure, assume the worker is an employee in the eyes of the IRS. But, if you want to find out a worker’s status, you can file a Form SS-8 to request a determination from the IRS. 

California’s Rules to Determine a Worker’s Status 

1. Dynamex Case and the ABC Test

California has its own rules for determining worker status. In the seminal case, Dynamex Operations West v. Superior Court, (2018) 4 Cal.5th 903, the California Supreme Court created the ABC Test. In Dynamex, the court held that a worker is an independent contractor if the worker:  

a. is free from the control and direction of the hiring entity (employer) in connection with performance of the work, both under the contract for the performance of the 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 that involved in the work performed. Id. at 916-917. 

Dynamex applies when applying the Labor Code, Wage Orders; and the Unemployment Insurance Code. It is also  retroactive and applies to all pending cases at the time of the decision. Vazquez v. Jan-Pro Franchising International, Inc. (Jan. 14, 2021, No. S258191) ___Cal.5th___ [2021 Cal. LEXIS 584, at *1].

California legislature codified the Dynamex decision in Assembly Bill No. 5 (AB-5), which added Labor Code sections and changed several statutory schemes so that Dynamex applied to many wage and hour contexts. See Labor Code sections 2750 et seq. and 2775 et seq. It also expressly lists which workers can be independent contractors. If this presumption applies, it can be rebutted with evidence that the worker is actually an employee.

2. Manners and Means Test (for pay and benefits status)

Before Dynamex, California courts used a multi-factored approach called the manner and means test, or the Borello test. California courts still use the manner and means test if the ABC test does not apply. 

Under the manner and means test, the key question is whether an “employment relationship” has been created. An employment relationship exists when an entity hires someone to do something for its benefit or the benefit of a third party.⁠ S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341, 350.  But, often, it is difficult for courts to determine if an employer has the right to control a worker’s manner and means in completing their duty.⁠ California courts will then consider secondary factors to determine a worker’s status if the manners and means test is not conclusive. A court will consider the following secondary factors:

  1. Does the employer supervise the worker?
  2. Can the employer fire the worker at any time?
  3. Is the worker’s work part of the employer’s normal business and/or trade?
  4. Does the worker operate their own separate business?
  5. Does the worker make their own⁠ business decisions?
  6. Does the employer provide equipment to the worker?
  7. How is the worker paid?
  8. Is the worker a skilled laborer?
  9. Did the employer train the worker?
  10. How does the employer and worker define the relationship?

If, after considering these secondary factors, a court remains unsure about a worker’s status, it will usually presume the person is an employee. See Labor Code, § 3357; see also Jones v. Workers’ Comp. Appeals Bd. (1971) 20 Cal.App.3d 124, 127.

3. EDD Worker Status Determination

If you are still confused about whether your relationship meets the legal definition of “employment” under California law, you can request a determination by California’s Employment Development Department (“EDD”). The request can be completed on Form DE 1870 and mailed to the EDD. The EDD usually provides a written determination within 60 days of receiving the request.

To discuss the above topic, please contact Patty Chen at patty@encorelaw.com or any other Encore Law attorney.