Stiff New Penalties for Misclassification of Independent Contractors

There has been a trend in recent years for companies to treat workers as independent contractors in order to avoid the administrative responsibilities and extra costs applicable to employees (payroll taxes, workers’ compensation insurance, unemployment insurance, overtime pay, and various employee benefits). In response, both the Internal Revenue Service and state agencies have stepped up compliance audits to check whether businesses are properly classifying their workers. An employer who has made incorrect classifications faces an array of governmental fines and penalties, as well as liability to the misclassified workers.

California has raised the stakes with a new law, effective January 1, 2012, which adds Sections 226.8 and 2753 to the Labor Code. Section 226.8 prohibits any person or employer from willfully misclassifying an individual as an independent contractor, or from making any charges or compensation deductions (e.g., for goods, materials, or space rental) to such individual if it would be unlawful to make such charges or deductions to an employee. Section 226.8 imposes penalties of $5,000 to $25,000 for each violation.

The law does not specify how often a “violation” is deemed to occur, leaving open the possibility that multiple penalties could be assessed with regard to a single worker. A willful misclassification is defined as one that is “voluntary and knowing.” It is not clear how this standard will be interpreted by the courts.

Section 226.8 also requires any employer found to have violated the law to display prominently on its website for one year a specified notice relating to the violation.

Violations of the law by licensed contractors will be reported to the Contractors’ State License Board, which will initiate disciplinary action against the contractor.

Under Section 2753, a person who, for money or other valuable consideration, knowingly advises an employer to treat an individual as an independent contractor to avoid employee status for that individual shall be jointly and severally liable with the employer if the individual is found not to be an independent contractor. This provision can be expected to impact outside advisors such as accountants and human resources consultants. Employees advising their employer and attorneys providing legal advice are excluded from liability under Section 2753.

Compliance with the new law is complicated by the fact that the law does not provide a clear test as to whether a worker is an employee or an independent contractor. Under pre-existing law, a worker generally is considered an employee if the principal has the power to direct and control the manner and means in which the work is performed. However, various other factors will be taken into account, with different tests under California and federal law, necessitating a fact-intensive analysis for each case.

One compliance strategy for a business that wants to avoid the burdens of employment administration and the risks of improper classifications is to secure workers through a separate services company, which employs the workers provided to the business, as opposed to having the business directly retain independent contractors.

In any event, companies who want to use independent contractors should consult with legal counsel, given the difficulty of making proper classifications and the potentially steep costs of failing to do so. Obtaining competent professional advice can reduce the likelihood of incorrect classifications, and also can give an employer a basis for maintaining that a misclassification was not “willful.” In addition, carefully prepared agreements with contractors and other appropriate documentation (e.g., a contractor’s business license and proof of insurance held by the contractor), while by no means determinative, can help a company to substantiate the legitimacy of an independent contractor relationship.