California Supreme Court Announces New Test For Determining Employee Versus Independent Contractor Status

Rex Halverson

Using the “ABC Test” to Determine Employment Status

On April 30, 2018, the California Supreme Court’s decision in Dynamex Operations West v. Superior Court drastically overhauled the way the State determines whether a worker is properly classified as an employee or independent contractor. This is a major change from the old test which used a multitude of factors to determine if the worker was subject to the direction and control of the hiring entity. The new test, called the “ABC test” starts with the presumption that workers are employees and requires businesses that hire workers to prove three factors:

  1. 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; and
  2. The worker performs work that is outside the usual course of the hiring entity’s business; and
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work they performed for the hiring entity.

This new test shifts the burden to businesses to show that their workers are properly classified as independent contractors while simultaneously making it more difficult for them to do so. It expands what is considered an employee to include any worker that the business cannot prove all three of the factors for, instead of allowing for the flexibility of the old test, which was based on a comprehensive list of factors with no single factor determining the classification. The Court believes that the new test will be easier to apply and will cut down on confusion and litigation in the long term. In the short term, however, businesses will need to consider adjusting the classification of their workers in order to avoid facing serious penalties.

The California Supreme Court has provided some clarity on the three factors of the new test. For part (A) the Court made it clear that a business does not need to control the precise manner or details of the work in order to be found to have the necessary control that an employer ordinarily has over its employees. For part (B) the Court gave the example that an outside plumber hired to repair a leak in a bathroom in a retail store would be considered an independent contractor, but if a clothing manufacturing company hires a work-at-home seamstress to make dresses from cloth provided by the company they will be considered an employee. For part (C) the Court said that it has normally been understood that independent contractors are individuals who independently make the decision to go into business for themselves, accepting the risks and benefits that business entails.

What Does This Mean For Businesses Using Independent Contractors?

While the Dynamex case dealt only with California wage orders and the Labor Code, it is very likely that the new test will impact the way workers are classified for employment tax purposes as well. This requires that businesses reassess the categorization of their workers because businesses are responsible for withholding payroll taxes for an employee and paying employer payroll taxes, but independent contractors are responsible for their own taxes. The classification also determines what sort of benefits workers are owed and whether certain wage laws apply.

A large portion of the state’s budget is made up of money collected as state payroll taxes. It is the responsibility of the California Employment Development Department (EDD) to collect these payroll taxes, as well as enforce collection and conduct payroll tax audits of individual businesses. Even before the California Supreme Court announced the new test, the EDD had been aggressively reviewing and auditing businesses in an attempt to crack down on misclassified independent contractors and collect additional tax revenue.

Since the classification determines the amount of payroll taxes owed to the EDD, misclassification is a serious concern for the EDD auditors. Misclassification is often unintentional and occurs when a business owner has an erroneous understanding of what makes a worker an employee as opposed to an independent contractor, but a mistake can be very costly if the EDD decides to audit a business. Additionally, the EDD and IRS exchange information for the purpose of verifying proper classification, which means that if the EDD determines that there has been a misclassification, the IRS will likely look into the issue as well. The IRS uses a control and direction test organized into the three broad categories of (1) Behavioral Control, (2) Financial Control, and (3) Relationship of the Parties. Behavioral Control covers facts that show if the business has a right to direct and control the work performed by the worker, including training and instruction. Financial Control considers whether the business has a right to direct or control the financial and business aspects of the worker’s job. Relationship of the Parties includes facts that demonstrate how the worker and business perceive their interaction with one another.

The IRS has a Voluntary Classification Settlement Program (VCSP) which gives partial tax relief for businesses that willingly reclassify their workers from independent contractors to employees for future tax periods. To qualify for the VCSP, a business must show that they had a reasonable basis for not treating the workers as employees and that they treated the workers and any similar workers as independent contractors. Finally, the business must have filed all federal tax returns consistent with this classification, which means that if a worker was paid $600 or more and considered an independent contractor the business must have filed Form 1099-MISC for the worker. Under the VCSP, a taxpayer pays 10 percent of the employment tax liability that would have been due on compensation paid to the reclassified workers for the most recent tax year. The business is not liable for any interest or penalties and will not be audited for the worker classification of the affected workers for previous years.

This “safe haven” provided by the IRS has no similar counterpart at the EDD. So, for  purposes of California payroll taxes, a business will not receive any special protection from EDD auditor assessments for past years if it voluntarily reclassifies their workers as employees.

With the recent California Supreme Court developments on this issue, it is important to make sure that your business is keeping up in the changing legal landscape.

Experienced Payroll Tax Professionals Can Help

As a business owner, the best way to protect yourself from an IRS or EDD payroll or employment tax audit is by correctly classifying all of your workers. We have the requisite experience at Rex Halverson & Associates to assist you in this regard as some of our professionals have over 40 years of payroll tax experience. We can determine the proper classification for your workers under the ABC test and help you through the necessary next steps. For a free initial consultation, call us today at (916) 444-0015.