Many employers utilize independent contractors to generate payroll savings for their businesses and to avoid the administrative hassles associated with the traditional employment relationship. Whether a worker can be validly classified as an independent contractor depends on certain legal criteria, however, not merely the desires of the parties. In the wake of the California Supreme Court’s decision last week in Dynamex Operations West, Inc. v. Superior Court of Los Angeles, the circumstances in which employers can classify workers as independent contractors are now more limited. In light of the liability that can flow from the misclassification of a worker as an independent contractor, California employers should be alert to the change in the law and strategically assess whether workers classified as independent contractors actually satisfy the new legal criteria.

In Dynamex, delivery drivers claimed in a class action lawsuit that Dynamex misclassified them as independent contractors rather than employees. Dynamex is a same-day courier and delivery service whose customers include the general public and a number of large companies, such as Office Depot, for whom it delivers purchased goods and picks up returns. In 2004, Dynamex converted all of its drivers from employees to independent contractors to save money. Dynamex continued to obtain its own customers and set the prices it charged for its services. Although drivers were required to provide their own vehicles and pay for all of their transportation expenses, they had to wear Dynamex shirts and badges. The drivers were free to set their own schedule, but deliveries were assigned by Dynamex dispatchers at Dynamex’s sole discretion and drivers had no guarantee of the number of deliveries offered.

The California Supreme Court considered the criteria that courts should utilize to distinguish independent contractors from employees under the California Wage Orders and unanimously adopted the restrictive standard commonly known in other jurisdictions as the “ABC test.” Under this test, a company that wishes to classify a worker as an independent contractor bears the burden of proving that:

  1. the worker is free from the control and direction of the hirer in the performance of the work, both under the terms of the contract and in fact;
  2. the worker performs work that is outside the usual course of the hiring entity’s business; and
  3. 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.

The hiring party must satisfy all three criteria in order for a valid independent contractor relationship to exist.

To explain its decision, the Court offered the example of a plumber hired by a retail store to repair a bathroom leak. In such a situation, the plumber is performing work that is not part of the store’s usual business and therefore is not reasonably viewed as working in the hiring business. In contrast, when a bakery hires a cake decorator to assist in creating custom-designed cakes, the cake decorator is part of the hiring entity’s usual business operations and would be viewed as an employee.

The criteria previously used to distinguish employees from independent contractors focused primarily on whether the business had the right to control the manner and means of the work performed. Under that more flexible standard, employers were more likely to succeed in establishing the existence of bona fide independent contractor relationships.

The distinction between employees and contractors is important for several reasons. A worker’s status as an employee or contractor determines whether the employer must withhold payroll taxes from the worker’s pay and whether the worker will be covered by workers’ compensation insurance. In some cases, it determines whether the worker is eligible for overtime compensation, whether he or she will be eligible for group health insurance coverage and whether he or she will participate in other benefits like vacation.

The Dynamex opinion leaves unanswered the scope of the ABC test’s application. The Court limited its ruling to wage and hour claims based on a Wage Order adopted by California’s Industrial Welfare Commission. The law is therefore unclear clear as to whether the ABC test applies to claims not based on a Wage Order, such as a worker’s reimbursement claim for business expenses, which is governed by Labor Code Section 2802.

If employers believe that any of their existing workers may be misclassified as independent contractors in light of the Dynamex decision, they should carefully consider their options before acting. Clumsy or poorly conceived reclassifications may serve only to exacerbate an employer’s liability.

What Should Employers Do Now?

As a result of the California Supreme Court’s decision, California employers can anticipate a significant rise is misclassification claims brought by independent contractors. Employers may best prepare themselves by undertaking the following tasks:

  • Review existing classifications with the protection of attorney-client privilege – Employers should review the validity of their existing contractor classifications under the new Dynamex standard. Prudent employers will conduct any assessment of their contractors under the guidance of counsel to assure that the outcome of the assessment is protected by the attorney-client privilege and cannot be used against the company in the event of a later dispute.
  • Address re-classifications strategically and carefully – If an independent contractor classification is identified as potentially vulnerable to a challenge, confer with counsel and consider the potential options strategically. Employers should remember that re-classification can serve as a double-edged sword – it can eliminate potential future liability, but can also increase the risk of liability for the period during which the contractor classification was in effect.