Independent contractor status scrutinized

Misclassifying employees, willful or not, could cost you. Business owners blame unclear definitions.

By Cyndia Zwahlen
Special to The Times

April 21, 2008

Independent contractor or employee?

Making the call can be confusing for small-business owners. Making the wrong decision, on purpose or by mistake, can be costly.

In California, the chances of getting busted are growing as the state cracks down on businesses that wrongly claim employees are independent contractors and, as a result, not subject to a slew of taxes and labor laws.

The number of state audits and investigations of businesses climbed to 5,706 in the fiscal year ended June 30, up 54% over three years, according to state data.

Each year, about half of those checks resulted in misclassification penalties, the data showed. Last year, the state collected back charges and fines of $163.6 million, up 30.4% from fiscal 2005.

Small-business owners blame unclear rules.

"There is massive confusion over what is an independent contractor," said Scott Hauge, president of Small Business California, an advocacy group, and owner of CAL Insurance & Associates Inc. in San Francisco.

Government officials and labor groups say some business owners knowingly tag employees as independent contractors to avoid paying payroll taxes, workers' compensation insurance premiums and overtime pay and skip out on other employee costs and labor laws.

In his latest attempt to fix the problem, which has grown along with the increasing designation of workers as independent contractors, state Sen. Alex Padilla (D-Pacoima) has introduced a bill that would require any person using an independent contractor to provide information from the state Employment Development Department at the time of a work agreement.

Senate Bill 1490 would direct the EDD to develop forms that would notify the person that he or she has been hired as an independent contractor. It would include the criteria the agency uses to classify independent contractors. And it would explain how the person could contact the EDD to determine whether the independent contractor status is correct.

"The problem is misclassification, willful in a lot of cases of employers classifying workers as independent contractors to save money, to cut corners," Padilla said. "Not only is it not fair to those employees, it's also not fair to the businesses that play by the rules."

Generally, if work done by a person is under the control of the employer, then that person is considered an employee. California employers reported 2.6 million independent contractors in 2005, the latest data available.

"The independent contractor criteria are spelled out pretty clearly in the code in California," Padilla said. "The biggest test boils down to the smell test: How much control is there about how work will get done? . . . There are several court rulings and precedents that are in place for reference."

The bill, which was approved this month by the labor committee of which Padilla is a member, is now in the appropriations committee. The proposed legislation also would require a business to keep a list of its independent contractors for at least two years or face a $500 civil penalty and the possibility of a misdemeanor charge.

Businesses already have to notify the state when they take on an independent contractor.

Sponsored by the California Labor Federation AFL-CIO, the bill follows Padilla's attempt last year to pass Senate Bill 622, which would have hiked penalties for misclassification. Gov. Arnold Schwarzenegger vetoed it.

Many small-business owners would welcome a clarification of the rules, advocate Hauge said.

"Is this going to conform to whatever the Franchise Tax Board says is an independent contractor? To what the IRS says?" he asked.

Hauge's small business was audited a number of years ago, he said, and had to convince the state auditor that the company's coffee service provider as well as its insurance vendor, the behemoth Hartford, were not employees.

The dividing line isn't always clear.

As the state's Industrial Relations Department website notes, there is no widely accepted definition of an independent contractor. There also are a number of state and federal agencies involved with determining who is an independent contractor, according to the website, including the EDD, which collects employer-related taxes; the Labor Standards Enforcement division; the Franchise Tax Board; the Workers' Compensation division; and the Contractors State Licensing Board.

Agencies might apply different tests or laws to the same situation so "it is possible that the same individual may be considered an employee for purposes of one law and an independent contractor under another law," the site stated.

At least one small-business advocate doesn't like the bill's paperwork requirement and the record-keeping penalty.

"It's ridiculous. It's requiring employers to hand out a piece of paper explaining what an independent contractor is, to independent contractors," said Tom Martin, executive director of the Los Angeles-based Small Manufacturers Assn. "We have a hard enough time keeping our doors open and now they want us to do another piece of worthless paper, to do the government's job."

Even with the proposed changes, independent contractors would require less paperwork than employees do, which is partly why they cost less for businesses to use, said Padilla, who believes contractors have a valid place in the workforce, as long as the designation is not misused to give a business an unfair cost advantage.

"A level playing field," Padilla said, "is in everybody's interest."

cyndia.zwahlen@latimes.com