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Employee vs. Independent Contractor: The Profound Impact of Worker Classification on Your Business

Posted by HMS Law Group | May 18, 2017 | 0 Comments


A business typically has two types of workers: independent contractors and employees. Every business must classify its workers in order to determine whether to withhold taxes and extend benefits or allow an independent contractor to handle taxes and benefits on their own. Although worker classification may sound like a straightforward task, it is often difficult because there is no single test for determining whether a worker is an employee or an independent contractor. Several state and federal agencies make such determinations, including the United States Department of Labor, the California Department of Industrial Relations, and the IRS. Since different agencies' guidelines apply, the same person may be considered an employee for one purpose and an independent contractor for another.


Classification will have profound effects on a worker's rights and entitlements as well as the company's legal obligations. It also affects a worker's eligibility for federal unemployment benefits, state workers' compensation, and various fringe benefit plans. Businesses may prefer to work with independent contractors for economic reasons because workers classified as “employees” carry additional costs: wages, vacation time, medical coverage, retirement benefits, and payroll taxes. Also, a business that has employees is liable for negligent acts committed by employees in the course of their employment. The business must follow requirements of state and federal law on matters of non-discrimination, employee discipline, and termination.

Nevertheless, the consequences of misclassifying employees as independent contractors can be severe and could result in litigation under laws set forth in the Fair Labor Standards Act (FLSA) and the California Labor Code. According to the California Department of Industrial Relations, “the potential liabilities and penalties are significant if an individual is treated as an independent contractor and later found to be an employee.


Correctly classifying workers can be challenging, but a few fundamental principles have emerged from court cases to make the process more transparent. The United States Department of Labor Wage and Hour Division (WHD) issued Administrator's Interpretation No. 2015-1 that provides consolidated guidance on how to apply classification standards. The framework for this interpretation is the Fair Labor Standards Act's broad definition of employment. The Administrator's Interpretation implies that there is an automatic presumption of employee status (which means that, as a starting point, all workers will first be assumed to have employee status) until the business can show sufficient proof to the contrary.

In order to prove the contrary, the Administrator's Interpretation asks that employers apply the Economic Realities Test with the following six questions:

(1) Is the work an integral part of the employer's business?

(2) Does the worker's managerial skill affect the worker's opportunity for profit or loss?

(3) How does the worker's relative investment compare to the employer's investment?

(4) Does the work performed require special skill and initiative?

(5) Is the relationship between the worker and the employer permanent or indefinite? and

(6) What is the nature and degree of the employer's control?

These questions will not result in a universal answer but must be considered in totality and within the circumstances of each situation.

The IRS also has a test to determine appropriate worker classification, which is comprised of twenty questions to determine worker classification for tax purposes. At the state level, the California Division of Labor Standards Enforcement (DLSE) uses the same rebuttable presumption of employee status as the IRS, and for most classification matters, the DLSE applies a multifactor test also referred to as an “economic realities” test that was adopted by the California Supreme Court in 1989.


Because the classification process is so complex and the costs of non-compliance can be substantial, it is imperative that businesses faced with worker classification matters seek guidance from a qualified California attorney. Rodney Moy at HMS Law Group can provide this experienced advice early in the classification process in order to help businesses prevent economic loss. When forming a new business entity, HMS Law Group LLP can offer guidance in these areas as well as review of ongoing pitfalls and opportunities for your business.

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