Independent Contractor: A Costly Misclassification

Businesses beware: there are serious risks for the company that misclassifies its employees as independent contractors.  The temptation to classify workers as independent contractors is high because of the potential cost savings for the business, but companies should carefully assess the nature of their relationships with their workers because misclassification can be an extremely expensive error.

With the enactment of recent legislation in California, how businesses classify their workers has come under increased scrutiny.  The Employment Development Department estimates that roughly thirty percent of workers identified as “independent contractors” have been misclassified.  The recent legislation was enacted to thwart this practice by imposing increased penalties on businesses that misclassify, particularly where the investigating agency finds that the misclassification was “willful.”

Pros & Cons of Retaining Independent Contractors
There are certain business advantages to using independent contractors instead of employees that increase the temptation to classify workers as independent contractors.  These advantages include: 1) cost savings from mandated contributions such as state and federal unemployment taxes and social security, 2) cost savings from discretionary fringe benefits such as medical insurance, life insurance, retirement plans, sick and vacation time, and 3) inapplicability of most labor laws, medical leave laws, and state and federal discrimination statutes.
However, there are numerous potential disadvantages as well, including: 1) loss of control over how the worker performs the services, and 2) independent contractors are not “at-will,” so terminating the relationship could lead to breach of contract claims.  A business would be well-advised to give careful thought to the decision to have employees or independent contractors, especially since the business bears the risk of potential misclassification, and the penalties can be severe.

Determining Whether a Worker has Been Misclassified
There is no definitive test to determine whether a worker must be labeled as an employee or if he or she can be identified as an independent contractor.  With no straightforward way to categorize a worker’s status, courts and various agencies have focused on a multitude of factors to establish whether an employee/employer relationship exists.  These factors culminate in a totality of circumstances test that requires a case-by-case analysis.

Different agencies employ different tests to determine if a worker is an independent contractor or an employee, but they all generally come to a determination based on some combination of the following factors: the extent of control that the principal may exercise over the work, the nature of the work and whether it is usually done by an employee, the skill required for the work (the more highly skilled, the more likely the worker can be an independent contractor), whether the company supplied the tools and instrumentalities for the work, and the parties’ agreement.  While these tests encourage the courts to weigh the totality of the circumstances, the most significance is given to the amount of control the company retains over the individual’s work.

If an agency determines that an employee has been wrongfully misclassified, it will next investigate whether the misclassification was “willful” when assessing the penalties it seeks to impose.  The Legislature has defined “willful misclassification” as “avoiding employee status for an individual by voluntarily and knowingly misclassifying the individual as an independent contractor.”  The penalties associated with this finding can be significant, so it is in a business’ best interest to carefully analyze whether there could be any doubt about whether the independent contractor is really an employee.

Enforcement & Penalties for Misclassification
There are numerous potential penalties that can be imposed on a business for misclassification, varying in degree based on whether the misclassification was intentional or not.  In 2011, new provisions were added to the Labor Code that created additional penalties for employers that wrongfully and willfully classify workers as independent contractors.  Labor Code sections 226.8 and 2753 impose potential penalties between $5,000 and $10,000 for each violation, and penalties between $10,000 and $25,000 if there is evidence of a “pattern and practice” of misclassification.

California Labor Code section 226.8(d) also imposes a “Scarlet Letter” provision that requires the employer to post a notice on its website for one year informing the public that it has violated the law and has changed its practices.  This public shaming provision is supposed to act as an additional deterrent.  Also, not just the business, but the “responsible person” may also be subject to personal liability and criminal penalties under the new provisions.  This means that third-party advisors such as human resource personnel or financial advisors can be held jointly and severally liable for the misclassification.

Aside from statutory penalties, a business that misclassifies faces other associated costs as well.  For example, an employer may also be required to pay benefits to workers who were erroneously misclassified.  (Vizcaino v. Microsoft Corp., 120 F.3d 1006, (9th Cir. 1997), modified by 173 F.3d 713 and 184 F.3d 1070.)  The employee can also seek reimbursement for business expenses under Labor Code section 2802 that he or she incurred.  Perhaps most catastrophic are the costs of litigation associated with defending the employer’s decision against the jilted employee (or even worse, employees, in a class action suit.)

Misclassification can be a costly mistake for a business. Statutory penalties, litigation costs, and the added embarrassment of the public shaming provision can be disastrous to company morale and the bottom line.  No business should rest assured if it has independent contractors on its payroll.  Before getting mired down in penalties and litigation, businesses should carefully review their workforce to identify any potential exposure resulting from misclassification.

categories: business risk assessment; employee mobility; employment litigation; litigation; trade secret; unfair competition