Is Everyone Now an Employee in California?

By Jeffrey Davine

On April 30, 2018, the California Supreme Court issued its opinion in Dynamex Operations West, Inc. v. The Superior Court of Los Angeles County.  It is likely that this case will drastically alter the landscape in California as to how workers are classified.  From a tax perspective, the result could be significantly increased costs and administrative burdens for businesses operating in California.

Worker Classification.
For tax purposes, workers are divided into two categories- employees and independent contractors.  The tax withholding and reporting obligations with respect to each category of worker are substantially different and significant dollars can turn on how a worker is classified.

Tax Withholding and Reporting.
If a worker is properly classified as an employee, the employer is required to withhold and remit income and employment taxes from wages or salary paid to the worker.  An employer is also required to remit its share of certain employment taxes for each employee.  At the beginning of the following year, an employer is required to issue IRS Form W-2 to each employee that sets forth the amount earned and the taxes withheld during the prior year.

If a worker is properly classified as an independent contractor, no withholding or remittance of any income or employment taxes is required.  The only reporting required is that the recipient of the services must issue IRS Form 1099 to the independent contractor if the amount paid during the year was $600 or more.

Clearly, it is less expensive and less burdensome for a business if it is able to treat a worker as an independent contractor instead of as an employee.  As a result, many businesses try to classify workers as independent contractors.  Unfortunately, making a mistake in the classification process can be expensive.

Risks of Misclassification.
The downside of incorrectly classifying a worker as an independent contractor can be significant from a tax perspective.  Among other things, an employer can be liable for the taxes that it should have withheld from the employee’s compensation as well as the employer’s share of the employment taxes that should have been paid.  In addition, the employer will be liable for interest and, quite possibly, penalties.  If the misclassification applies to a substantial number of workers over several years, the resulting liability could be devastating for a business.

Determining Worker Classification.
Up until now, in determining if a worker should be classified as an employee or as an independent contractor for California income and employment tax purposes, the principal inquiry was whether the hiring entity had the ability to control the “manner and means” or the details as to how the worker completed his or her work.  To make this determination, a list of factors was examined.  These factors included such things as whether the worker was engaged in a separately established occupation or business, whether the worker could be discharged at any time without cause, the skill required to perform the services and accomplish the desired result, whether the worker or the service recipient supplied the tools, equipment, and place of work, whether the work was an isolated event or continuous in nature, whether the work was part of the hiring entity’s regular business, and the relationship (employee or independent contractor) the parties believed that they were creating.  When applying these factors, almost every case was unique and turned on its specific facts.

Effect of Dynamex.
It appears that the Dynamex case could drastically alter this analysis.  It should be pointed out that Dynamex was not decided in the context of an income or employment tax dispute.  It was decided in the context of a California Industrial Welfare Commission wage order.  As a result, until definitive guidance is provided, it may be asserted that the analysis expressed in Dynamex does not apply in determining a worker’s status for tax purposes.  The language used in the Supreme Court’s opinion, however, is broad and it makes reference to the economic and tax consequences of worker misclassification.  Moreover, as a practical matter, it is likely that the California Employment Development Department, which oversees worker classification issues for California income and employment tax purposes, will rely upon, and cite, Dynamex when making a determination as to the employment status of a worker.

If the so called “ABC” test articulated in Dynamex[1] is adopted as the standard for determining whether a worker is an employee or an independent contractor, practically speaking, the overwhelming majority of workers will be classified as an employees because it will not be possible for a business to satisfy the “B” test unless the worker is truly outside the scope of the hiring entity’s business.  This means that, unless a worker is truly providing a unique and isolated service for a business (such as a plumber who is engaged to fix a leaky pipe or an electrician who is engaged to fix an electrical problem), there is a high probability that the California Employment Development Department will demand that the business treat almost every worker as an employee.

For businesses that are operating on thin margins, this has the potential to be devastating and could result in some of them ceasing to do business in California or simply playing the audit “lottery” and hoping that they won’t be discovered.  It could also mean that workers may be classified as employees for California income and employment tax purposes and as independent contractors for federal income and employment tax purposes.  This could be an administrative nightmare.

If it is ultimately determined that the Dynamex analysis applies to the classification of workers for California income and employment tax purposes, it would appear that the only way to alter the law would be for the California Legislature to enact a statute that overrides Dynamex.

The Dynamex case is likely to have a severe impact on businesses operating in California.  Time will tell how widespread this impact will be.  In the interim, businesses operating in California who are treating workers as independent contractors would be well advised to closely examine the types of services provided by these workers.  If the services are not clearly outside the scope of the entity’s business operations, they should carefully consider whether these workers should be reclassified as employees.

[1] The “ABC” test provides that a worker is properly classified as an independent contractor if the hiring entity can establish that: (A) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both as provided in the underlying contract and in fact; (B) the worker performs work that is outside the usual course of the hiring entity’s business; and (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

Please feel free to contact any member of the MSK Tax Practice Group if we can be of assistance.

 

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