Bill Seeks to Curb Misclassification of Independent Contractors

April 22, 2008

A Senate bill drafted and backed by big labor aims for more transparency and accountability among businesses that classify workers as "independent contractors." The Senate Appropriations Committee voted unanimously at yesterday's hearing to put SB 1490 in the suspense file, meaning its cost implications will be researched more thoroughly before a final committee vote.

Unlike most California labor bills backed by unions, SB 1490 has not exactly galvanized unanimous opposition from the state's employers. In fact, many small businesses are at least willing to consider the bill's provisions, in light of complaints that unscrupulous companies often misclassify workers in order to save a buck. Regardless, many employers both big and small say proper classification of workers is an often-confusing process and needs clarification.

The California Chamber of Commerce is the only formally identified opponent to the bill. Its stance is that the measure would do nothing to help businesses with the classification process, and instead pile more time and cost burdens onto the backs of employers.

"The only way we are going to solve the problem is to provide some clarity to the guidelines. Slapping on more responsibilities and fines will not solve the heart of the problem," says the chamber's policy advocate Marti Fisher, iterating her organization's belief that SB 1490 would only increase the likelihood that businesses working with independent contractors would get penalized for honest mistakes.

Legislating a Complex Issue

SB 1490, if passed and signed into law, would require businesses that hire independent contractors to provide a form - to be generated by the Employment Development Department (EDD) - that explains the factors used by the EDD to determine status; an explanation of what it means to be an independent contractor, including tax obligations and the absence of protections such as workers' compensation coverage; and a notice of the worker's right to contact the EDD for verification of status.

The bill also would require employers to maintain all records of ICs for two years, subject to audit, and would "expand the application of the existing civil penalty and misdemeanor provision to the compliance requirements," although the exact nature of this expansion is not detailed in the text of the bill.

The intent of the bill is to crack down on the intentional misclassification of workers as independent contractors, which allows employers to skirt costs associated with full-fledged employees, says Caitlin Vega, legislative advocate for the California Labor Federation, AFL-CIO, which drafted the legislation.

"The problem is that there is such an economic incentive to misclassify, especially when you consider the underground economy," Vega says. "I think our bill particularly addresses the concerns of small businesses by providing this form that clarifies classification for both parties."

But most employer-side labor attorneys, even those who agree with the intent and content of the bill, say it does very little to actually clarify the classification process.

"This bill in and of itself will not give more clarity or benchmarks for employers," says Veronica Gray, a partner in the Irvine office of Nossaman, Guthner, Knox & Elliott LLP and chair of the firm's employment practice group. "It doesn't tell you how to evaluate; it just says you have to be in compliance...that if you do it wrong, [the EDD is] going to penalize you."

While the statute would do nothing to simplify the process, Gray says, it could prompt more businesses to "sit down and go through the laundry list and document why they made this person an independent contractor" in the first place, perhaps preventing mistakes and future litigation in the process.

Although she represents businesses, Gray says she agrees with labor advocate Vega's point about the abuse of the independent contractor classification (mainly by larger entities) and that this bill could help level the playing field for smaller businesses.

The Chamber's Fisher, however, says the bill will do nothing for workers or employers. In a letter to members of the Senate Appropriations Committee, Fisher says the bill should be opposed because it is not binding on other agencies that may also assess fines and penalties independently, does not provide an appeals process, does not contain a safe harbor provision, lacks a funding mechanism and creates new demands on an already-stretched EDD.

The Department of Finance estimated that there will be a one-time cost to the EDD of $4.2 million to meet the requirements and a $1.9 million on-going cost, but penalties assessed against violators may enhance state revenues. It's not clear whether the revenues would offset the implementation costs.

High Stakes of Worker Classification

Businesses that hire independent contractors can save on workers' compensation insurance, unemployment insurance, overtime, meal and rest breaks and deductions such as Social Security taxes, says San Francisco attorney Robert Tollen, a partner with Seyfarth Shaw LLP. But employers who misclassify workers as independent contractors are subject to severe penalties, he says, especially when ICs bring a legal action that calls into question their employment status.

"A worker injured on the job who was incorrectly classified as an independent contractor is entitled to recover court damages, without showing the employer was at fault, and the damages are not limited by the workers' compensation schedule," Tollen says. "They may be whatever a jury decides to award, and they might include punitive damages."

According to bill author Sen. Alex Padilla (D-Van Nuys), of the 5,000 audits conducted by the EDD last year, 3,000 instances of misclassification were found, affecting 105,000 employees. The misclassified workers went without benefits or the protection of California's labor laws.

"Not only is this bad for workers but it gives those businesses that skirt the rules an unfair advantage over those that do play by the rules," Sen. Padilla told the Senate Appropriations Committee. "It also costs the state money when we don't collect the due payroll tax revenues and unemployment insurance taxes."

Staffers from the Padilla's office did not return calls by press time.

Mixed Response From Small Business Community

Scott Hauge, president of San Francisco-based advocacy group Small Business California (SBC), says he received an overwhelming response from members after sending them a request for input about SB 1490, which he testified on at yesterday's hearing. Although 35% to 40% of the respondents say they oppose the bill, he states, most respondents at least show interest.

"There is no shortage of small business owners who want to go after those who break the rules," says Hauge, referring to the abuse of worker classification mainly by large corporations with more robust legal counsel.

SBC member Mike Van Horn, president of San Rafael-based consultancy The Business Group, says the statute would only add to the paperwork burden of business owners and would only duplicate current law. But most of the positive responses have to do with a desire for more clarity, which attorneys say this law simply won't accomplish.

"Greater clarity in this area would be a good thing," says Robert Schilling, co-founder and partner of leadership coaching firm Schilling & Maure Inc., based in Long Beach.

Schilling, whose company hires independent contractors, says he's very careful about the terms of their working relationship. They set their own schedules, work in their own offices and are required to show proof of other clients. Schilling says that in his business additional payroll taxes don't make a big difference and that payroll increases have never affected his company's workers' compensation premiums.

Tax attorney and SBC member Steven Isler says he has one client who owes $166,000 in taxes for a misclassification problem. He supports the bill and says the burden should be placed on the employer because they "sometimes willingly and some unknowingly play Russian roulette with their financial futures and ruin their lives." This bill, he says, would make companies tread carefully before making a decision to classify a worker as an IC.

Part two of this series will provide hands-on advice for employers on how to properly and lawfully classify workers as either employees or independent contractors.

Proper Classification of Workers is Critical, But no Exact Science

April 24, 2008

Businesses can save significant payroll costs and avoid most labor-related liabilities by working with independent contractors instead of employees. But there's a catch. Willful, even accidental misclassification of workers is fraught with steep penalties and exposes companies to a laundry list of costly legal actions.

Any manager who wishes to classify workers as independent contractors, or "ICs," must understand the high stakes of such a decision and make sure the classification is absolutely airtight. But since different state and federal agencies use different criteria to classify ICs, attorneys, consultants and business owners say it's not often a black-and-white determination.

"There is a lot of confusion about it, and there are those who classify folks as ICs who really should be classified as employees," says small business consultant Mike Van Horn, president of The Business Group, based in San Rafael.

The two main government agencies that enforce worker classification are the Internal Revenue Service (IRS) and the state's Employment Development Department (EDD), each providing a list of factors for determining status. The U.S. Department of Labor (DOL), the Workers' Compensation Appeals Board (WCAB) and the California Labor Commissioner's office each have their own lists, but there is very little overlap among the five agencies.

Attorneys say that since most of the various agencies' listed factors leave room for argument either way, employers should do a gut check and play it conservatively if there is any doubt.

A Question of Control

Although different tests can be used to determine a worker's status as an independent contractor, attorneys say the rule of thumb is the issue of control.

"The main thing is this: 'I decide the means, the method and location of work. I am only responsible to you for the end product.' That's the real key about being an IC, that the employer does not control the means and methods of how they do it," explains San Francisco attorney Mark Schickman, a partner with Freeland Cooper & Foreman LLP.

The IRS, in addition to its list of 20 factors that determine employee status, provides the following three categories for assessing the degree of control an employer has over a given worker: Behavioral control, financial control and the relationship of the parties. Both lists are available for download from California Executive's "Employment Practices" resource section, as well as a factor-by-factor comparison of how various agencies classify employees versus ICs.

The EDD provides 11 factors for determining classification status, available on its Web site.

Long Beach-based business consultant Robert Schilling says his firm hires ICs but is very careful about classification. If a so-called IC worked in his firm's facilities, for example, he says that would raise a "yellow flag" of possible misclassification.

"They have to work in their own offices, set their own schedules, they almost always have to have some business entity through which we can pay them and they have to show evidence of other customers," Schilling says. "Otherwise we play it safe and take them on as temps."

But the "mechanical listing" of factors provided by the IRS and the EDD often fail to address the heart of the matter, says San Francisco attorney Robert Tollen.

"A much more practical test is for a company to ask itself whether, regardless of the EDD's [or the IRS's] list of factors, the company is assigning a worker to engage in work that is a normal part of the company's business," says Tollen, a partner with Seyfarth Shaw LLP. If the answer is yes, he says, red flags should go up.

Irvine attorney Veronica Gray says that if your existing staff can do the same task a so-called IC is asked to perform, the IC may actually be considered an employee. If it's something that needs to be outsourced, though, employers usually are safe by classifying that person as an IC. The EDD takes this question into serious consideration for classification purposes, says Gray, a partner with Nossaman, Guthner, Knox & Elliott LLP and chair of the firm's employment practice group.

Gray advises her clients to focus on the EDD's list of factors, particularly because they would be used in conjunction with proposed legislation (SB 1490) that would strengthen enforcement in California. Others say the IRS list provides better guidance. But everyone agrees that it's best to base classification on whichever list is the strictest for a given worker in a given situation.

Other considerations include the question of supervision by the company, the duration of the relationship, possession of his or her own tools and payment for specific tasks, to name a few. Attorneys say companies with workers whose classification falls into a gray area should either consult legal counsel or err on the side of caution and classify them as employees.

The High Cost of Non-Compliance

The very costs that businesses avoid by hiring ICs are the ones that can come back to haunt them if an IC is later determined to have been an employee, such as workers' compensation and unemployment insurance, overtime, meal and rest periods, mandatory deductions such as Social Security contributions and payroll taxes, Tollen says.

An employee incorrectly classified an IC who is injured on the job is entitled to damages but is not limited by the workers' compensation schedule and may include punitive damages, Tollen says. In addition to court damages, companies would be on the hook for back wages, back taxes, payment for missed meal breaks and other costs.

"Suits might not come for, say, three years after the worker started work. In the meantime, the employer has not reserved for such expenses," Tollen says. "Being required to pay them all in one lump sum at the end of a costly lawsuit can be crippling."

In addition to merely paying back unpaid wages, insurance premiums, taxes and other expenditures, the IRS can charge interest on late payment of taxes, a penalty of up to 20% of the underpayment total and criminal sanctions, according to its Web site. The EDD, similarly, can assess a penalty of up to 10% of unpaid contributions and seek criminal sanctions, according to its Web site.

For workers classified as ICs who are paid below the minimum wage, the Labor Commissioner can assess a penalty of $100 per employee per pay period for each incident, plus another $250 per employee per pay period for each additional violation, according to the state's Labor Code. Add legal fees and time spent in court and in meetings with attorneys, not to mention negative publicity, and one would think the deterrent would be strong enough to keep businesses in line.

The High Cost of Following the Rules

But there often exists an even stronger incentive to bend the rules, especially if lawful compliance results in the inability to compete, as San Jose salon owner Charles Welsch explains.

Welsch owns a Great Clips Inc. haircutting franchise in the San Jose area and recently sold another. He says many of the area's hair and nail salons convince their employees to become ICs and have them sign documents agreeing to the relationship. This allows them to cut costs while cutting hair at below market prices. And since the state provides specific "Barbering and Cosmetology" guidelines for what constitutes an employee (versus an IC), Welsch says confusion is not a valid excuse.

He says the person to whom he sold his other Great Clips franchise reclassified his employees as ICs and was able to run the business on $250 in daily gross receipts instead of the $500 Welsch says he needs to pull in daily. His existing franchise is doing well enough, he says, although competitors who improperly classify their workers are giving him a run for his money.

"Any reasonable person would say this is an employee-employer relationship. But this guy says he went to his attorney and [got the green light]. It's bad advice and detrimental to the state of California," says Welsch, who believes roughly two-thirds of the cosmetology industry operates "under the table," or otherwise non-compliant with classification guidelines. From his perspective, he says, proper worker classification is seriously under-enforced.

In addition to pending legislation mentioned earlier and discussed in greater detail in part 1 of this two-part series, Gray says new Labor Commissioner Angela Bradstreet has made it her mission to push for more personal liability among business owners who break labor laws, which would include worker classification. Neither Commissioner Bradstreet nor her staff attorneys responded to an interview request by press time.

Sometime laws intended to regulate businesses punish the lawful when they're not adequately or fairly enforced. But attorneys say failure to properly classify workers, regardless of intent, is like playing Russian roulette.

Steve Tanner
Editor
California Executive
(916) 741-9571
stanner@provpubs.com
http://www.cal-exec.com