Successful businesses—whether they be corporations, limited liability companies (“LLCs”), sole proprietorships, or others—must retain talented workers who can help drive that success. An important consideration is whether the business treats those workers as independent contractors or employees. This classification creates important implications for both the business and each worker. Understanding the differences between independent contractors and employees, along with the legal and financial implications, is fundamental to a business making the correct worker classification, meeting its legal obligations to the Internal Revenue Service (“IRS”) and California Employment Development Department (“EDD”) (and/or other state employment departments), and avoiding personal liability to the business owners.
This article explores the most important distinctions between independent contractors and employees, examines the key legal tests a business must consider to ensure those classifications meet its legal obligations, and discusses options and opportunities to minimize personal liability of the business owner, both before and after a worker classification audit is initiated by the IRS or EDD.
Default rules for worker classification and general considerations
In general, worker classification follows from the needs of the business. In other words, if a business has certain requirements for its workers, then the worker classification will follow pursuant to the rules set forth by the IRS and EDD.
It is important to note that the IRS and EDD have a bias towards classifying workers as employees rather than independent contractors. Based on that bias, an audit by the IRS or EDD almost always will look to reclassifying independent contractors as employees (and not reclassifying employees as independent contractors).
IRS general common law test for worker classification
The IRS uses a three-part common law test to distinguish between employees and independent contractors. The first common law factor, behavioral control, looks at the degree to which a business directs or controls how the work is performed. If a business dictates (or has the right to dictate) a worker’s schedule, what tools or equipment the worker should use, and the methods for completing the work (among other factors), then the worker arrangement tends to that of an employee-employer relationship.
The second common law factor, financial control, evaluates whether the worker invests in their own tools and equipment (or whether they are purchased or reimbursed by the employer) and whether the worker has the opportunity (and risk) for profit or loss on the work being performed (or whether the worker is guaranteed a regular wage). In addition, the financial question looks to whether the worker advertises publicly and seeks out other business opportunities separate from the business in question.
The third common law factor considers the type of relationship, such as the existence of a written independent contractor agreement, the permanence of the worker relationship, whether the services provided by the independent contractor are part of the core services offered by the business (e.g., lawyer providing legal services to a law firm), and whether certain worker benefits (e.g., paid time off for vacation and illness, retirement benefits, unemployment and disability insurance) are offered. Employers should keep in mind that simply having a written independent contractor agreement will not serve as a safe harbor on this factor, as the IRS and EDD will focus on what services are performed regardless of what the agreement is titled.
Businesses must weigh these three factors in determining whether a worker should be classified as an employee or independent contractor. It is important to note that there is not a specified number of factors that dictate whether a worker is an employee or independent contractor, and some factors may favor one classification while other factors favor a different classification. Further, evaluating these factors may depend on the nature of the business or services being performed.
For example, a videographer hired by a law firm to record a deposition is more likely to be considered an independent contractor because videography generally is not part of the core services being provided by the law firm. In contrast, a videographer hired by a video production company to provide recording services is more likely to be considered an employee of the video production company because videography generally is part of the core services provided by the video production company.
It is important to note that remote workers are not automatically classified as independent contractors. While performing services remotely is one factor that may suggest that the worker is an independent contractor, all of the common law rules must be considered.
A business or worker may ask the IRS to officially determine whether the worker should be classified as an independent contractor or employee. This is done by the business or worker filing Form SS-8 (Rev. December 2023). This is a less common practice, as it can take six months or longer for the IRS to review and issue a determination. Nonetheless, for a business that regularly hires the same types of workers, and where the worker classification is not clear, it may make sense.
IRS exceptions for statutory employees and statutory nonemployees
Even if workers otherwise would be considered independent contractors, in certain circumstances they may still be considered statutory employees for certain employment tax purposes. These cases include (1) drivers who distribute food products or who pick-up and deliver dry cleaning, (2) full-time life insurance sales agents, (3) individuals who work at home on materials or goods that are supplied by a person and returned to that person, and (4) full-time traveling salespersons.
In contrast, the IRS provides for three categories of statutory nonemployees; these include direct sellers, licensed real estate agents, and certain companion sitters. In the case of direct sellers and licensed real estate agents, they are treated as self-employed if (1) substantially all payments for their services are directly related to sales performance (rather than hours worked), and (2) their services are performed under a written contract stating that they are not employees for federal tax purposes.
EDD general “ABC” test for worker classification
In California, the EDD follows the “ABC” test, which was originally adopted by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court of Los Angeles, 416 P.3d 1 (Cal. 2018) and then codified in California Unemployment Insurance Code (“CUIC”) §621(b), effective January 1, 2020. In general, the EDD presumes (that is, by default) that workers are employees unless they meet specific criteria to qualify as independent contractors. To meet the ABC test followed by the EDD, the business must demonstrate that (A) the worker is free from the direction and control of the business, (B) the work falls outside the usual work of the business, and (C) the worker routinely works in an independent trade, occupation, or business. Failing to meet any of these criteria results in classification as an employee.
Regarding condition “A,” the California Supreme Court in Dynamex cited as an example that condition A was not met in the case of a manufacturing company hiring a work-at-home seamstress working off of patterns provided by the company. For this condition A, it does not matter if the employee performs services on a seasonal or less than full-time basis, or whether the worker is identified as day laborer, part-time, temporary, or probationary; what matters is whether the company is directing the work being performed.
Regarding condition “B,” the California Supreme Court in Dynamex cited, as an example, that condition B was met in the case of a retail store that hires a plumber or electrician to perform services outside the usual work of the retail business.
Regarding condition “C,” the California Supreme Court in Dynamex pointed to incorporation, licensure, and advertisement by the worker as indications of services being provided as an independent contractor. It indicated that condition C might not be satisfied just because the business identifies the worker as independent contractor, or where the business and worker sign an independent contractor agreement. Thereby, the EDD does not look at whether the worker could perform the same services for other parties, but rather, its focus is on whether the worker actually performs such services for other parties.
To assist in determining worker classification, the EDD considers an extended list of factors. See Employment Determination Guide (DE 38) Rev. 4 (1-16). The EDD considers “yes” to any of the following to be a strong indication that the worker is an employee: (1) the business instructs or supervises the worker (rather than the worker making their own decisions on how to complete the job), (2) whether the worker can quit or be terminated any time (rather than being required to complete the contract), and (3) whether the work is a regular part of the business (rather than, for example, a retail shoe store hiring a plumber to fix the pipes or hiring a CPA to prepare its tax returns).
The EDD considers “no” to the following to be an indication that the worker is an employee: (4) the worker has a separately established business (e.g., advertising services, hiring and firing their own employees, etc.), (5) the worker is free to make decisions that would allow for profit or loss (i.e., economic risk), and (6) the worker has substantial investment in their job (e.g., tools, equipment, supplies, office, facilities).
The EDD provides various additional factors that include (7) whether the business has employees performing the same type of work as the worker who the business claims to be an independent contractor, (8) whether the business furnishes the worker tools, equipment, and supplies, (9) whether the work is considered unskilled, (10) whether the business provides training to the worker, (11) whether payment is paid as a salary or hourly wage, rather than by the job, (12) whether the worker previously worked for the business as an employee, and (13) whether the worker believes themselves to be an employee.
While worker classification audits can occur in any industry, the EDD has identified industries that are particularly prone to misclassification, including construction workers, seasonal workers, short-term workers, and outside salespersons. Similar to the IRS, a business may request a written determination by the EDD by completing the 79-question Determination of Employment Work Status for Purposes of State of CA Employment Taxes and Personal Income Tax Withholding.
EDD exceptions for certain industries, statutory employees, exempt workers, and app-based workers
California recognizes several exceptions to the EDD’s general ABC test for worker classification. Statutory employees (that is, workers who are considered employees regardless of the ABC test) include corporate officers. See CUIC §621(a). This category has been expanded to include LLC members where the LLC has elected for federal income tax purposes to be taxed as a corporation. See CUIC §621(f). There are three categories of statutory employees for workers performing services in a continuing relationship: (1) drivers engaged in distributing food products or laundry services, (2) traveling salespersons engaged full-time by a principal, and (3) home workers providing services for a person based on materials or goods provided by that person. See CUIC §621(c). Artists and authors may also be considered statutory employees under certain circumstances. See CUIC §§601.5, 621(d), 686. An unlicensed worker performing services for a contractor for which a contractor’s license is required is also considered a statutory employee. See CUIC §621.5.
In contrast, CUIC expressly exempts certain employment from some or perhaps all payroll tax requirements. There are many categories of workers, a few of which include agricultural labor, domestic services (up to a certain cash amount), church employees, and newspaper carriers. Also included are certain family employees, namely, where services are performed by children for their parents, parents for their children, or spouses for one another.
App-based drivers are considered independent contractors of the app-based network company (such as Uber and Lyft) if the network company does not prescribe days, times and minimum hours of work, the network company does not require the app-based driver to accept any specific service request, the network company does not restrict the app-based driver from performing services for other network companies, and the network company does not restrict the app-based driver from working in another lawful business. See California Business and Professions Code §7451.
A special set of rules also apply to salespersons who, depending on the circumstances, may be considered an independent contractor, common law employee, statutory employee, or excluded employee. Retail salespersons and telemarketers generally are considered employees. Real estate brokers generally are exempt from payroll tax requirements where they are licensed, substantially all compensation is based on sales rather than hours, and they enter into a contract with the company stating that they are not performing services as an employee.
Employer obligations to the IRS and EDD
If the worker is an independent contractor and the business pays the worker $600 or more in a year, the business must file Form 1099-MISC or Form 1099-NEC for the worker with the IRS. The business must also file a Report of Independent Contractor(s) (DE 542) with the EDD within 20 days of either making payments totaling $600 or more, or entering into a contract for $600 or more with an independent contractor in any calendar year. Where the worker is an independent contractor, no withholding from the contractor’s earnings is required.
In contrast, if the worker is an employee, the business that employs the worker must report the worker’s earnings to the IRS and EDD, withhold and deposit the amount of individual income tax, withhold and deposit the individual’s share of employment taxes on those wages, and pay the employer’s share of employment taxes on those wages. The employer is required to make those payments electronically on a specified schedule (monthly or semi-weekly). The employer generally is required to file annual and quarterly tax returns reflecting the payment amounts. Employment taxes to the IRS include Social Security, Medicare tax (including additional Medicare tax on employees earning over a certain amount), and federal unemployment tax. Employment taxes to EDD include Unemployment Insurance and Employment Training Tax calculated on those wages, as well as withholding and remitting State Disability Insurance and Personal Income Tax (“PIT”) due from the employee on wages paid (and withheld by the employer on the EDD’s behalf).
Consequences for businesses that misclassify workers
If a business classifies a worker as an independent contractor and has no reasonable basis for such classification, then the business may be held liable for employment taxes for that worker, which will be assessed at an increased rate. See IRC §3509. In addition, the relief provisions discussed below will not apply.
In addition, the IRS may apply a failure to deposit penalty to employers that fail to make employment tax deposits on time, in the correct amount, and in the correct way. Further, the IRS may apply an information return penalty and/or fail to furnish penalty for the business failing to file Form W-2 with the IRS and provide such Form W-2 to the worker (since the business had originally filed Form 1099 to report payments as if to an independent contractor).
In California, penalties that may be assessed for wage violations include an underpayment penalty, late payment penalty, penalty for failing to remit payment electronically, failure to remit payments electronically, and wage noncompliance penalty, among others. In addition, there are civil penalties for willful misclassification of up to $25,000 per violation See California Labor Code §226.8.
Potential personal liability for owners of businesses that misclassify workers
The IRS, to further encourage prompt payment of withheld income and employment taxes, enforces IRC §6672, which provides for the Trust Fund Recovery Penalty (“TFRP”). These amounts are called trust fund taxes because the withheld amounts are, in fact, the employee’s money being held in trust on behalf of the IRS. The TFRP may apply if the unpaid trust fund taxes cannot be immediately collected from the business; notably, the business does not have to cease operations for the TFRP to be assessed. The amount of the TFRP is equal to the unpaid balance of the trust fund tax, computed based on the unpaid income taxes withheld, plus the employee’s portion of the withheld FICA taxes.
The TFRP may be assessed personally against any person who (1) is responsible for collecting or paying withheld income and employment taxes, and (2) willfully fails to collect or pay those taxes. A “responsible person” is anyone who has the duty and power to direct the collecting, accounting, and paying of trust fund taxes. This person may be an officer, director, shareholder or employee of a corporation, a member or employee of a partnership, a manager or member of an LLC, or another person with authority and control over funds to direct disbursements. For willfulness to exist, the responsible person must have been (or should have been) aware of the outstanding taxes, and either intentionally disregarded the law or was indifferent to it. In other words, no intent or motive is required. In fact, using available funds to pay other creditors when the business is unable to pay the employment taxes is considered willfulness.
The California analog is CUIC §1735, which provides that any officer, major stockholder, or other person, having charge of the affairs of a corporate, LLC, or other employing unit, who willfully fails to timely pay required employment tax contributions, becomes personally liable for the amount of the contributions, withholdings, penalties, and interest due and unpaid. The EDD may assess those amounts and has all available collection remedies.
Options for voluntary compliance for misclassified workers and mitigating liabilities
If there is a reasonable basis (not willful or reckless) for not treating a worker as an employee, an employer may be relieved from paying IRS employment taxes for that worker under Section 530 of the Revenue Act of 1978. To qualify for Section 530 relief, the employer must have filed all required federal information returns (i.e., Form 1099-MISC) on a consistent basis without changing from employee (Form W-2) to independent contractor and must not have treated any worker holding a substantially similar position as an employee. In addition, the employer must have had a reasonable basis for not treating the worker as an employee, such as reference to a federal court case, consistency with prior IRS audit, consistency with industry practices, or another reasonable basis (for example, reliance on an attorney or accountant).
The Voluntary Classification Settlement Program (“VCSP”) is another option that allows businesses to reclassify their workers as employees, with partial relief from federal employment taxes. This is available for eligible businesses that agree to treat their workers (or a class or group of workers) as employees going forward. The VCSP applies to businesses who (1) have consistently treated the workers to be reclassified as independent contractors or other nonemployees, (2) have filed all required Form 1099s for the participating workers to be reclassified for the previous three years, and (3) are not currently under employment tax audit by the IRS, Department of Labor, or EDD (or other state agency). VCSP allows the participating business to agree to prospectively treat the class or classes of workers as employees for future tax periods and pay 10% of the employment tax liability that would have been due on compensation paid to workers for the most recent tax year. In exchange, the business is not liable for any interest or additional penalties and is not subject to a worker classification tax audit with the IRS for those workers being reclassified under the VCSP for the prior years.
An important tool in potentially reducing EDD tax liability is DE 938P, Claim for Adjustment or Refund of Personal Income Tax. Even if the EDD determines that the employer failed to properly withhold PIT from the wages paid to the workers, the employer may be able to gain relief from some or all of the PIT liability, and related penalties and interest using DE 938P. There are several methods for potentially adjusting a PIT assessment using DE 938P. One is to ask the worker to certify that the worker reported the wages on their California income tax return. Another is for the employer to sign a declaration that the worker was issued a Form 1099-MISC, Form W-2, or Schedule K-1, and that they were timely filed with the IRS and/or FTB.
Independent Contractor vs Employee FAQ
1. What is an independent contractor agreement?
An independent contractor agreement is a legal document that outlines the terms and conditions of the working relationship between a business and a self-employed individual providing services. This contract should clearly define the roles, responsibilities, payment terms, and scope of work, within the IRS and EDD legal framework.
2. Why is it important to have an independent contractor agreement?
An independent contractor agreement is a key element in the IRS general common law factors for worker classification. Beyond merely the existence of an independent contractor agreement, the substance of the independent contractor agreement clarifies expectations for both parties, reducing the risk of disputes over issues such as deadlines, payments, and ownership of work.
3. What are the key elements of an independent contractor agreement?
A robust independent contractor agreement includes several critical elements. Most importantly, the independent contractor agreement should clearly state that the individual is an independent contractor rather than an employee; this helps establish the contractor’s autonomy and prevents any ambiguity around employment classification. The remaining terms should support the independent contractor classification within the IRS and EDD legal framework. More specifically, the independent contractor agreement should name the parties involved, and whether the parties may assign payment or delegate services. It should specify the scope of work, payment terms, deadlines, and deliverables. Additionally, it is important that the independent contractor agreement include clauses addressing confidentiality, intellectual property rights, and methods for dispute resolution.
4. What is the difference between an employee and an independent contractor?
The primary difference lies in control and obligations. Employees usually work under the direct supervision and control of an employer. They receive benefits such as health insurance, paid leave, and other perks. In contrast, independent contractors manage their own schedules and decide how their work is performed, provided they meet the project requirements set by the business. They are responsible for their own taxes and do not receive employee benefits.
5. Why does the classification of employee vs independent contractor matter?
The classification of workers as employees or independent contractors impacts tax, legal, and financial obligations. For employees, businesses must comply with minimum wage laws, withhold taxes, pay employer contributions for programs like Social Security and Medicare, and potentially be required to offer health benefits. For independent contractors, these responsibilities shift to the contractor, saving businesses from the cost of payroll taxes and benefit contributions.
Misclassifying employees as contractors to avoid financial obligations can trigger severe penalties, back taxes, and lawsuits, creating liability for not only the company, but for the responsible persons, as previously defined.
6. What legal tests determine if someone is an employee or an independent contractor?
Various legal frameworks are used to distinguish workers as employees or independent contractors. The IRS uses a three-pronged common law test examining behavioral control, financial control, and the nature of the relationship. In contrast, California uses stricter criteria found in the ABC test. The IRS and California both have provisions for statutory employees (even if the workers might otherwise be able to be classified as an independent contractor) and for workers who are exempt from some or all the payroll tax provisions (even if they might otherwise be classified as employees). Businesses must carefully evaluate their worker classification methods to ensure IRS and EDD compliance.
7. How can a business reduce the risks of misclassifying workers?
To minimize misclassification risks, businesses should carefully evaluate the IRS criteria and California tests for worker classification. An independent contractor agreement is critical to establishing the worker’s role as a contractor, as another indication of the worker relationship being an independent contractor rather than an employee (although it is not enough by itself). Consulting with legal and tax professionals can also help ensure compliance with worker classification laws. In addition to clearly defining the working relationship between business and independent contractor, by clearly defining boundaries and expectations, an independent contractor agreement can help protect businesses from costly legal compliance errors.
Tyler Shewey is a partner in the Business and Tax law department at Berliner Cohen. He can be reached by telephone 408.286.5800 and via email tyler.shewey@berliner.com.