California joins a growing list of states that have enacted independent contractor misclassification legislation in the past four years.  This new law, signed by Governor Jerry Brown on October 9, 2011, adds harsh financial penalties for companies and persons who engage in “willful misclassification” of employees as independent contractors, as well as to consultants who advise businesses to do so.

What is “willful misclassification” under the new law?  The statute says willful misclassification “means avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.”

What else is prohibited by the new law?  Businesses are not permitted to impose a fee or make any deductions from the compensation of a misclassified  individual, including charges for space or equipment rental, goods, materials, maintenance, fines, or the like.   

How much are the financial penalties?  A lot.  A person or employer that violates the law is subject to a penalty of at least $5,000 up to a maximum of $15,000 for each violation, to be assessed by the California Labor and Workforce Development Agency or a court.  If, in addition, there is a finding that the person or employer has engaged in a “pattern or practice” of willful misclassification, then the penalties ratchet up even higher: fines of at least $10,000 up to a maximum of $25,000 for each violation.   It remains to be seen whether the misclassification of a class of workers would constitute a “pattern or practice” and whether a finding of willful misclassification of, for example, 24 workers all performing the same services, will be a single violation or result in a fine to be multiplied by 24.  If a multiplier is used, some businesses can be faced with six- or seven-figure exposures.

Are there any other penalties?  Under the new law, violators will be ordered to post a comprehensive  “I violated the law” notice on the company’s website or in an area accessible to all employees and the general public.  Further, contractors licensed under California’s License Law will be subject to disciplinary action up to and including debarment by the Contractors’ State License Board.

Is there anything else the law does?  Yes, two important things.  First, any penalties against an employer or person will be the responsibility of a successor owner or business entity.  Second, the law imposes joint liability on any consultant or other person that “knowingly advises an employer to treat an individual as an independent contractor to avoid employee status” if an individual is found not to be an independent contractor.  This latter prohibition exempts any “person who provides advice to his or her employer” and any “attorney authorized to practice law in California or another U.S. jurisdiction who provides legal advice in the course of the practice of law.

Which companies should take heed of the California Independent Contractor Law?  All businesses that use independent contractors are potentially subject to the new law and its harsh penalties.  As noted below, while the law does not affect the legitimate and proper use of independent contractors, this law is likely to focus increased attention in California and nationally on three sets of businesses:  (a) those that willfully misclassify employees as independent contractors; (b) those that have failed to properly structure, document, and effectuate their independent contractor models, and, hence, cannot pass scrutiny under the applicable test for determining a worker’s status; and (c) those that pay workers on a 1099 basis where such workers fall within the “gray area” between employee and independent contractor.  

Analysis and Takeaways: 

  1. This law does not prohibit misclassification of employees as independent contractors unless the misclassification was “willful,” as defined in the law as “voluntarily and knowingly.”  Companies that have a reasonable and bona fide belief that a worker or a class of workers are legitimate independent contractors are presumably not intended to be subject to the new law and its elevated level of penalties.
  2. A business that pays a worker or class of workers on a 1099 basis, where such workers fall into the uncertain “gray area” somewhere between employee and independent contractor, might have a legitimate defense to a violation of this law.  What constitutes “knowingly” under this new statute is likely to be one of the initial legal issues to be resolved by the courts.  Further, as noted below, employers would be well advised to enhance their level of independent contractor compliance for workers in the “gray area” to avoid being subject to unfavorable and costly administrative or judicial determinations that they have willfully misclassified certain individuals paid on a 1099 basis.
  3. Any misclassification, even if not willful, would nonetheless continue to violate a host of state and federal laws.  While an intention to properly classify workers as independent contractors might be a defense to liability under the new Independent Contractor Law in California, neither a proper intention nor bona fide belief may provide a defense from liability under most other state and federal tax, labor, and employee benefit laws governing “employees.”
  4. The law does not provide a definition of who is an employee and who is an independent contractor.  California, like most states, uses its own form of the general common law definition of “employee.”   California’s test is sometimes referred to as the “economic realities” standard, which is similar (but not identical) to the ”economic realities” test used in cases arising under the Fair Labor Standards Act (the federal wage and hour law).  Although the economic realities test under California law has a similar starting point as the classic common law test  (“the principal test of an employment relationship [in California] is whether the person to whom service is rendered has the right to control the manner and means of accomplishing the result desired . . . ”], the courts in California and the California Labor and Workforce Development Agency give different weight to certain factors than do courts applying the classic common law test for independent contractor status.  
  5. While both the economic realities and classic common law tests have a number of factors to be taken into account in determining whether a worker is an employee or independent contractor – for example, the IRS maintained for years its oft-quoted “20 factor test” and the California Labor and Workforce Development Agency lists 11 factors on its website describing the “economic realities” standard – the courts applying these tests have almost universally held that no one factor is determinative under these definitions of “employee.”  Thus, because these tests are fact-specific, theycan be subject to some confusion, which can result in a number of workers falling into the proverbial “gray area” between employee and independent contractor.
  6. This new law in Californiais a classic example of an “IC Neutral” law.  A number of states have sought to clamp down on independent contractors in their states by passing new labor laws containing a test that is tilted in favor of a determination that the individuals in question are employees and not independent contractors.  These new tests, oftentimes referred to as “ABC laws” (because they contain three factors that typically must all be satisfied to qualify for  independent contractor status) are most frequently enacted for purposes of unemployment and workers compensation coverage.  In addition, ABC laws have been enacted in a few states to crack down on misclassified independent contractors in selected industries, especially construction, where employee misclassification is regarded by legislatures as most prevalent.  These ABC laws are a dramatic departure from the court-approved common law test under most other state and federal laws.  ABC-type tests also cause a host of otherwise legitimate independent contractors to be treated as employees.  In addition, they contribute to even greater confusion among businesses and individuals because a state’s tax laws and the other labor and employment laws typically remain governed by the common law test or a variation of it.

Because California’s new Independent Contractor Law continues the general common law test  governing workers in the state, instead of altering the criteria used for determining a worker’s status, it can fairly be considered “IC Neutral.”  Workers who wish to be their own boss and conduct themselves as independent contractors, as well as companies seeking to retain individuals to provide services under an independent contractor business model, should  not affected by this new law if the structure, documentation, and day-to-day practices of the contractors and business entities satisfy the applicable test for IC status.

  1. Most importantly, companies can and should enhance their independent contractor compliance so they are not unwittingly swept up having to defend themselves in an enforcement proceeding or class action lawsuit focusing on alleged misclassification of independent contractor, whether in California or other states. The enactment of this new law confirms the value of using a methodology such as Pepper Hamilton’s IC Diagnostics™ to evaluate whether an existing position can be properly structured as an independent contractor and, if so, how it can be re-structured, documented, and executed in practice so as to maximize the likelihood that workers in that position will be held to be independent contractors and not employees under the laws of many states and under federal laws.