It truly is a tightrope walk doing business in California, especially if you engage independent contractors. Still, you don’t panic. Let’s talk about what makes California high risk (hint: worker classification tops the list), what’s at stake, and how businesses can protect themselves.
Why is California Considered High Risk?
California is considered the riskiest of the risky states for doing business. The Golden State is often the first to legislate an issue surrounding employment and other states often follow suit with similar laws. Whether you do business in the state or not, what happens there will affect you in one way or another.
In addition to California’s worker classification rules (which are some of the most stringent in the country and where our focus will be today), California requires employers to walk a narrow path when it comes to sexual harassment training, privacy protections, meal wages, and more.
This is where California’s rules affect employers the most because it’s where it’s hardest for companies to classify workers as independent contractors. California’s approach to worker classification (among other topics) purportedly intend to protect workers and provide “the labor law protections to which they are entitled.” In addition to the federal legislation, states have free reign to make some of their own rules. True to form, California has some of the strictest requirements surrounding worker classification and it’s important for companies to pay attention because violators can expect to be subject to strict penalties such as fines, possible jail time, and damage to their reputations.
What Makes Worker Classification Extra Tricky in California?
When California replaced the long-standing Borello test with the ABC test, it eliminated some of the gray area in deciding whether a worker is an employee or not. Workers can only be considered an independent contractor if all of the following apply:
(A) that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
(B) that the worker performs work that is outside the usual course of the hiring entity’s business; and (C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
This is the narrowest definition of an independent contractor to date and puts more pressure on point “B” than ever before.
What’s at Stake For The Government?
Whenever a government agency legislates an issue, it’s reasonable to ask what the stakes are and how much attention they’ll give it. In this case, there is a ton of money on the line. To date, determining the differences and properly classifying workers have been highly complicated tasks, depending on factors such as the ability to hire or fire a worker, the kind of occupation, the method of payment, location and more. According to the court’s ruling in the Dynamex case, “the misclassification of workers as independent contractors rather than employees is a very serious problem, depriving federal and state governments of billions of dollars in tax revenue.”
The government’s concerns center around the fact that:
- Independent contractors write off business expenses and may underreport income
- Small businesses can avoid certain taxes with fewer W2 employees
- ICs are more difficult to track and tax accurately than W2 employees
What Does it Mean For Business?
Some employers like this way of structuring worker classification because in theory, it gives workers more ownership in the company’s success. Others say it makes their business model unsustainable.
It’s point “B” of the ABC test that can be most challenging to the way many businesses operate. It states that a worker must perform “work that is outside the usual course of the hiring entity’s business” to be classified as an independent contractor.
Some companies have restructured operations completely to avoid hiring more W2 employees (new laws have a way of precipitating new ways to get around said laws). Another way to avoid reclassifying is simply to operate business as usual and wait to be challenged. Smaller companies have been known to get away with this approach indefinitely.
What About The Workers?
Still, some independent contractors have been unhappy with the changes and expressed concern for their livelihood. Even if all the perks afforded an employee (healthcare, time off, etc.) bring them close to their original pay in practice, their paycheck may look a lot smaller on the surface. Many industries have been granted exemptions from the ruling, indicating that, as always, there is no simple cut and dry answer to an issue this complicated.
Independent contractors set their own schedule and manage their own businesses. While independent contractors are still responsible for paying taxes, they can also take advantage of many write-offs. Along with the perks, they do have the responsibilities that come with owning their own business. They run their own books, pay quarterly taxes, advertise, purchase their own equipment, and deal with the seasonal nature of the biz. Independent contractors also don’t get paid time off and are responsible for purchasing their own health insurance.
Some workers prefer the stability and possibility for advancement that come with having a greater presence at the office and familiarity with the ins and outs of the company.
How Can Companies Mitigate Risk?
Unless a company is made up 100% of full-time employees, this subject is relevant. Mistakes could result in fines, back taxes, and even jail time. The first step is to stay well on top of worker classification rules. There are exemptions to the ABC test and they continue to evolve. Independent contractors fall outside the wage order’s protections so even some “employees” could still potentially qualify as independent contractors for all other purposes. Stay on top of classification news and how these changes play out in practice will continue to shake out in the courts and in the market going forward. Stay ahead of the game to see how these changes affect your business. California is embarking on the real-time evolution of the economy.
What Are The Stakes for Mistakes?
Big companies like Uber make headlines for their missteps and pay equally big fines for their worker classification choices. Still, it can be a costly mistake to think it’s only the big companies that face consequences. By rescinding the Trump Administration’s “Worker Classification Rule,” the Biden administration made it easier for workers to argue for minimum wage and overtime protections/compensation. In addition to having to pay back 100% of the matching FICA taxes they would have paid had they classified the worker correctly up front, employers can end up subject to additional penalties such as the following:
- $50 fine for each W-2 form they failed to file
- A penalty equal to 1.5% of the employee’s wages
- $5,000 penalty for the first misclassified employee and up to $25,000 for each subsequent violation
Suffice to say, misclassifying workers does not save money in the long run. Perhaps scarier than the possibility of monetary damages, misclassification has landed some business leaders under house arrest.
In addition, class-action lawsuits, failed audits, and negative headlines can damage a company’s reputation to the point where both workers and consumers are hesitant to engage with the company. It’s just not worth it!
The most common mistakes when engaging contractors in California are misclassifying workers, (of course!), being lax about training requirements or privacy, and meal wage/overtime errors.
As the economic landscape shifts and independent contractors rise in prevalence, the financial stakes and potential for missed revenue rise, too. In response, government agencies have been ramping up their focus on the subject. The IRS and DOL are not alone. States are joining the fray, attempting to crack down on misclassification while tightening the reins on training requirements, and payroll guidelines.
Where the money goes, lawyers follow. There’s big money in class action lawsuits and new cases are always being filed. While fear is never productive, you should be very, very conscientious when engaging independent contractors in California. Companies must be very vigilant to protect your business, stay compliant, and reduce the risk for fines and unpleasant attention from the IRS.
When is Engaging a Partner a Good Idea?
Examine your options: Working with an Employer of Record (EOR) or Professional Employer Organization (PEO) is standard best practice in this evolving freelancer economy. While both provide payroll and insurance services, the differentiating factor is that an EOR relieves employers of much of the regulatory risk involved in working with independent contractors while a PEO operates as a co-employer and does not assume the employment risk.
If you don’t have the in-house team to do it yourself, it’s worth considering working with a partner. The bottom line is that doing business in California is complicated and the consequences of errors can be immense. While the onus is on employers to classify workers correctly and stay in line with the state’s changing requirements, it’s possible to navigate a rocky landscape with relative ease.
In our world, accurate worker classification and top-notch risk management when it comes to overtime, meal wage, and other laws are always the priority. We are the first to be aware when change is in the air. We track rules in every state as well as on a federal level and offer services to help clients stay compliant.
If you think a partner would help your business, contact us now.