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Independent Contractors and Consultants in California

This article discusses the advantages and disadvantages of using independent contractors and also discusses the tests to determine the status of an independent contractor including the Common Law TestsBorello Test, and the economic realities test.

  1. Advantages of Using Independent Contractors

    1. a. The business does not pay the employer contributions for:

      1. State unemployment tax.

      2. Social Security.

      3. Federal unemployment tax.

    2. The business does not pay the benefits its employees are receiving.

    3. The business has an option as to whether to provide workers compensation coverage.

    4. Wage and hour laws (for example, overtime laws) do not apply.

    5. There is a greatly reduced chance of discrimination claims.

    6. The potential for wrongful termination claims and unemployment benefit claims are greatly reduced.

  2. Disadvantages of Using Independent Contractors

    1. The business cannot control HOW the contractor performs services.

    2. Unlike with employees, independent contractors can only be terminated for cause and in accordance with the agreement.

    3. Businesses are required to report all individuals who will be receiving a 1099 form at the end of the year by the earlier of:

      1. 20 days after making payments equal to or exceeding $600.

      2. 20 days after entering into a contract paying more than $600 a year.

        Businesses are required to report independent contractors on EDD Form DE 542, Report of Independent Contractors. However, if the independent contractor is a corporation, a DE 542 is not required.

    4. The penalties for misclassifying an employee as an independent contractor are tough, including payment of employer contributions, interest, and penalties that may average 50% of the amount of compensation paid to the worker. Failure to file a 1099 form for the worker increases the penalties. The worker may also be entitled to retroactive benefits.

  3. The Tests

    1. Unfortunately, different government agencies use different definitions of "employee" and different tests to determine if a worker is an independent contractor. There is a fair amount of overlap among the tests, though.

    2. California’s Common Law Test. California uses the "California common law" test for income tax withholding, unemployment insurance and disability insurance.

      1. With this test, "the most important factor is the right of the principal to control the manner and means of accomplishing a desired result". Basically, the more control the employer has, the more likely the worker is liable to be classified an employee.

      2. If there is any doubt, California looks at the following ten items that essentially match the test in Section 220 of the Restatement of Agency:

        1. Whether or not the one performing the services is engaged in a separately established occupation or business.

        2. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of a principal without supervision.

        3. The skill requiredin performing the services and accomplishing the desired result. (Lower-skill workers are more likely to be found to be employees.)

        4. Whether the principal or the person providing the services supplies the instrumentalities, tools, and the place of work for the person doing the work.

        5. Thelength of time for which the services are performed to determine whether the performance is an isolated event or continuous in nature.

        6. The method of payment, whether by the time, a piece rate, or by the job (with payment by piece rate or job being some evidence of independent contractor status).

        7. Whether the work is part of the regular business of the principal. (If it is, the worker is more likely to be an employee.)

        8. Whether or not the parties believethey are creating the relationship of employer and employee.

        9. The extent of actual controlexercised by the principal over the manner and means of performing the services.

        10. Whether the principal is or is not engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual.

    3. California’s "Borello" Test California uses the "Borello" test for workers compensation, wage and hour laws and the Fair Employment and Housing Act. This is essentially the same as the California common law test, except that the Court may also consider the factors in the federal "economic realities" test, which is discussed below.

    4. Federal Common Law Test. The federal government uses the "federal common law" test for federal income taxes, ERISA, immigration and copyright law.

      1. The IRS has a traditional 20-factor test (using many of the same factors as the California common-law test).

      2. Recently, though, the IRS has shuffled most of these 20 factors (although de-emphasizing some of them) into various portions of a new three-area test that examines behavioral control, financial control and type of relationship between the parties.

        Behavioral control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
        1. Instructions the business gives the worker. An employee is generally subject to the business' instructions about when, where, and how to work.

          The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

        2. Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.

          Financial control. Facts that show whether the business has a right to control the business aspects of the worker's job include:
        3. The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important.

        4. The extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.

        5. The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

        6. How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.

        7. The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.

          Type of relationship. Facts that show the parties' type of relationship include:

        8. Written contracts describing the relationship the parties intended to create.

        9. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.

        10. The permanency of the relationship. If you engage a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that your intent was to create an employer-employee relationship.

        11. The extent to which services performed by the worker are a key aspect of the regular business of the company.

    5. Federal Economic Realities Test. The federal government uses either the "federal common law test" (see above) or the "economic realities" test for discrimination law. The Ninth Circuit identified the following factors as distinguishing employees from independent contractors via the "economic realities" test:

      1. The degree to which the alleged employer has the right to control the manner in which the work is to be performed;

      2. The worker’s opportunity for profit or loss depending upon his or her managerial skill;

      3. The worker’s investment in equipment or materials required for the task, or the worker’s employment of helpers;

      4. Whether the service rendered requires a special skill;

      5. The degree of permanence of the working relationship; and

      6. Whether the service rendered is an integral part of the alleged employer’s business.

    6. Federal Safe Harbor.

      1. Under the "Safe Harbor" rule of Section 530 of the Revenue Act of 1978 an individual will not be reclassified as a common-law employee for employment tax purposes provided the taxpayer meets the following requirements:

        1. For purposes of employment taxes, the business did not treat the worker as an employee at any time.

        2. The business filed a 1099 form for the worker on time. (This is required if the business pays the contractor $600 or more during the year–or pays an attorney any amount.)

        3. The business has not treated workers in substantially similar situations as employees.

        4. The business has a "reasonable basis" for treating the worker as an independent contractor because it relied on:

          1. Case law, published rulings or a technical advice memorandum or private letter ruling pertaining to the particular business.

          2. A past IRS audit of the business resulting in no assessment of payroll taxes for workers holding positions substantially similar to the position held by the work in question.

          3. A long-standing recognized practice of a significant segment of the industry.

            The IRS concluded in IRS Letter Ruling 9801001 that a company’s reliance on the advice of legal counsel established a reasonable basis for the independent contractor treatment. To be effective, you need to have the advice in writing.

      2. Exceptions:

        1. The safe harbor applies only to federal employment taxes, not for other purposes.

        2. The safe harbor applies to the federal government only; California is not bound by this.

        3. The safe harbor does not apply to technical services performed after October 22, 1986, pursuant to an arrangement between the employer and another organization (for example, leased employees).

  4. Guidelines and Tips

    1. There are special rules for certain industries.

    2. Contractual language alone does not determine independent contractor status. On the other hand, it is a factor.

    3. California law state that "employee" includes anyone with a written agreement stating the work will be considered "work for hire". As a result, California businesses that hire independent contractors should not use the phrase "work for hire" in those agreements.

    4. It helps a lot if the independent contractor earns at least one- third of his/her income from sources other than your company.

    5. The one more-or-less "bulletproof" approach is for the independent contractor to be incorporated (or have an LLC). One downside for the worker is that California has a minimum corporate/LLC tax of $800 a year.

    6. Stating the following items in an agreement help with independent contractor status:

      1. The worker is responsible for his/her own taxes etc.

      2. The worker will not be receiving benefits.

      3. All you are interested in are the results, and you have no say in the method, manner or means of performance.

      4. The worker will submit invoices on his/her letterhead.

      5. The worker has provided a copy of his/her own business card.

      6. The worker will work at home or, alternatively, will pay rent for use of the business’s office and equipment.

      7. The worker is free to work on projects for others.

      8. The term of the agreement is for a fixed period (rather than being open-ended).

    7. Providing benefits to the worker is a strong indication of an employee relationship.

    8. It is very dangerous to change current or former employees to independent contractor status.

    9. With a full-time worker, the longer the relationship continues the more likely the government is to consider the worker to be an employee.

      1. Microsoft and some other companies use one year.

      2. Others use the 1,000 hours (six months) that is the maximum period ERISA allows before employees begin receiving benefits.

      3. It may be safe to re-engage the worker again as an independent contractor if six months have passed since the worker was terminated.

  5. Leased Workers.

    Business have increasingly used "leased workers" (leased from temporary agencies or other similar businesses) in an attempt to avoid workers being classified as employees.

    1. Often this is not sufficient. The Ninth Circuit has ruled that the federal common law test takes priority.

    2. The IRS has held that workers previously employed by the business are subject to federal withholding.

    3. Depending on the amount of control the contracting business exerts (or has the right to exert) over the leased employees, it may be held to be a joint employer with the leasing agency.

  6. Ownership.

    If a business does not have a written agreement with an independent contractor stating that the business owns the resulting work, the work developed will be owned by that contractor–and the business will have only a non-exclusive license to use it.

    1. Businesses also need to ensure that their agreements with independent contractors (such as programmers and Web designers) also include an assignment of ownership rights in the resulting product once it is finished. Clauses that transfer ownership up front may well not be sufficient.

  7. Non-Disclosure Agreements.

    Businesses often require non-disclosure agreements from their independent contractors. Independent contractors often need to insert language making exceptions for their prior knowledge.