Avoid the High Cost of Misclassifying Workers as Independent Contractors

Authored by Steve Holden. Published in the Sacramento Business Journal October 2012.

For many businesses, the costs associated with hiring and maintaining employees is one of the largest line items.  To reduce these costs, businesses may look to use contractors instead of employees.  While it makes financial sense to hire contractors, improper classification of these workers could end up as a very expensive nightmare.

With a new law and increased enforcement efforts, businesses that are careless or too aggressive with the use of independent contractors may end up paying dearly.  Labor Code section 226.8 creates hefty penalties for employers who “willfully” misclassify employees as independent contractors.  The penalties can be as high as $15,000 for a single violation and up to $25,000 per violation if the employer is deemed to have engaged in a pattern or practice of misclassification.  Willful violators also will be required to post notice of the misclassification for one year and invite employees to contact the Labor and Workforce Development Agency if they believe they may be misclassified.  In addition, employers who misclassify often are liable for unpaid income taxes, employment taxes, overtime wages, employee benefits and the penalties associated with each. Misclassification cases are frequently pursued as class actions with the add-on of attorneys’ fees liability.  In short, the cost of misclassification can be extremely high.

Unfortunately, proper classification of workers is not always easy.  Confusion can arise because the law requires employers to weigh various factors but without clear guidance on what weight to assign to each factor.  Moreover, the courts and various government agencies involved do not use the same set of factors.  The principle factor used to determine a worker’s classification is whether the employer has the “right to control” the worker.  While that factor may sound straightforward, it can be very tricky to apply in specific cases.  It is really a larger factor that is broken down into issues of behavioral control and financial control.

Behavioral control refers the right to direct how the worker does the job.  Employees typically receive training and instructions from their employer on how to do their job or a task.  An independent contractor does not.  An independent contractor is expected to bring expertise and knowledge about accomplishing the job that the employer does not possess.

Financial control refers to an employer’s right to direct the financial and business aspects of the worker’s job.  An employer provides and pays for the tools and resources employees need do their jobs. Independent contractors, on the other hand, are expected to provide their own tools and resources. Where this is tricky is that even the seemingly straight-forward test of “who provides the tools” can be tricky because California Wage Orders permit employers to require certain employees to provide their own hand tools and equipment as if they were independent contractors.

In addition to these complex control factors, the classification will depend upon the relationship between the worker and the employer and the nature of the work being done.  If the relationship is on-going and the employer provides incentives similar to benefits, it may be difficult to prove that a contractor classification is valid.  It will also be difficult to prove a valid contractor classification if the worker is performing production work that is an integral part of the employer’s business.

Employers could make the issue easy and avoid risking misclassification by classifying all workers as employees.  The government would certainly prefer this method.  Doing so, however, eliminates the potential cost savings associated with the legitimate use of independent contractors.

In seeking cost savings, it is common for employers to believe that a contractor classification is legal when the employee desires the classification and agrees with it.  Not the case.  It does not matter how strongly the employer and employee believe the classification is beneficial or proper.  The nature of the work performed and how it is performed dictates whether contractor classification is proper.

If agreement with the worker will not insulate the employer from liability, what will?  Short of classifying every worker as an employee, employers who use independent contractors will risk some misclassification exposure.  Employers can, however, dramatically reduce the risk by following a few guidelines.

1. Self-audit.  Conduct a comprehensive self-audit of worker classifications.  Do it before the government comes to audit or a worker files a claim.  The audit will include review of each position, workers classified as anything other than an employee, records for the various positions, tax records for both employers and contractors, written agreements, and carefully planned interviews with workers and supervisors.
2. Written agreement. Ensure both the employer and the contractor sign a carefully drafted agreement.
3. Work with counsel.  While internal staff could accomplish the audit, it is highly recommended that a qualified attorney is included in the process.  Not only can an attorney provide guidance on qualifications, they can also ensure the employer does not create evidence that could be used against the employer in a government audit or worker’s claim.  Counsel can also assist the employer in creating written agreements for contractors.
4. Establish procedures. These will include rules for bringing on new workers and creating new positions that may be classified as independent contractors.
5. Train and monitor.  After the audit is complete, supervisors and managers should be trained on the classifications and the expectations of workers in each classification.  Supervisors and managers should then be responsible for monitoring the work and ensuring that it is done in a manner consistent with the classifications.  It is important to note that it is not the job description or contractor work order that controls the legal classification, but rather what is actually occurring on the job.