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Independent Contractors: El Dorado or Fool’s Gold?

Business owners who are struggling in a tight economy may be looking to shed some payroll costs by replacing employees with independent contractors. Some who pursue this strategy decide to lay off employees and hire independent contractors while others may rebrand some or all of their employees as independent contractors. This reclassification may result in lower payroll costs and more profitable workers, but is not without significant peril. State and federal governments have a strong incentive to make sure that businesses do not avoid taxes or circumvent employee protection laws by improperly labeling workers as independent contractors. Workers may also independently sue for misclassification. As a result, misclassification of any worker as an independent contractor may turn out to be much more costly than any benefits obtained through the misclassification. This article discusses the distinction between employees and independent contractors, the pitfalls associated with classifying workers as independent contractors, and offers suggestions on how to set up a working relationship that is legal and beneficial to both the business and the worker.

Hiring independent contractors in California may be advantageous to a business: Independent contractors may be cheaper, more efficient, and better motivated to work than employees due to the manner in which their compensation is structured. Independent contractors are paid based on the actual repairs they perform whereas employees are paid based on the number of hours they work. Independent contractors do not get paid overtime even when they work beyond a regular workday. Furthermore, if independent contractors fail to perform the repairs adequately they will not be paid, whereas employees must be paid for the hours they work but may be fired for poor performance. Payments made to independent contractors are ‘gross payments’, meaning that the independent contractor is responsible for paying all taxes, payroll deductions, workers’ compensation, and benefits such as health insurance and vacation time out of his or her own pocket. The main disadvantage of independent contractors is that a business that hires them must relinquish control over their day-to-day operations and permit them to function as their own bosses.

Being an independent contractor may be advantageous to a worker: Some workers like being independent contractors because they are their own boss and have an opportunity to make more money than employees. Independent contractors work any hours they want, hire other workers to help them complete jobs, have the right to refuse repair jobs they do not like, and can work for more than one business. Even though independent contractors do not get paid overtime, do not receive paid benefits, and pay their own taxes and workers’ compensation, they often earn significantly more than employees especially if they work efficiently and hire the right helpers. The main disadvantage of being an independent contractor is the economic risk of running one’s own business and the loss of legal protections that are afforded to employees.

Hiring independent contractors is not without risk: Merely converting workers into independent contractors, or indiscriminately hiring independent contractors, can lead to problems. Independent contractors may trigger a state or federal investigation or audit. In addition, independent contractors who have been terminated may file a lawsuit arguing that they were really employees who were misclassified as independent contractors and seek damages for failure to pay minimum wage and overtime as well as failure to provide rest and/or meal breaks. If administrative or civil proceedings demonstrate that the worker classified as an independent contractor was really an employee, the business will incur significant losses in the form of taxes, penalties, unpaid wages, interest, and attorneys’ fees.

A number of factors differentiate employees from independent contractors: Businesses must understand the legal distinctions between employees and independent contractors to avoid misclassifying employees as independent contractors. The distinction is often confusing because a line is being drawn in what may be a gray area. For example, everyone can tell the difference between a truck and a passenger car, but trying to conclusively determine whether an SUV is more like a truck or a passenger car is much more difficult. Governmental agencies and courts apply a broad test that examines every aspect of the work relationship to determine whether a particular worker is an employee or an independent contractor. The test consists of a number of interrelated factors that generally fall into three categories: behavioral, financial, and formal.

The behavioral factors look into whether or not the business has the right to control the manner in which the worker does his or her job. The focus is on the day-to-day interaction between the business and the worker, the type and degree of instruction being given, the manner in which the worker is evaluated, and any training that is being provided. A worker is an employee when the business has the right to direct or control the worker, and the worker is an independent contractor when such control is absent. The more the evaluations are based on how work is performed rather than end result and the more training is provided to the worker, the more likely that the worker is an employee rather than an independent contractor.

The financial factors focus on whether or not the business has the right to control the economic aspects of the worker’s job. The test focuses on the investment made by the worker in the equipment used to perform the job, the extent to which the worker’s expenses are reimbursed, the worker’s ability to make or lose money, the worker’s ability to work for others, advertise, and maintain a visible business location, and the method of payment. If a worker uses the employer’s equipment, gets his or her expenses reimbursed, is insulated by the business from risk of loss or from opportunity to profit, works only for one particular business, and gets paid by the hour rather than on a commission basis, then the worker is more likely to be an employee.

The relationship factors look at how the worker and the business perceive their work relationship. The factors include written contracts, employee benefits, permanency of the relationship, and the extent to which services being provided by the worker are a key activity of the business. A written contract stating that the worker is an employee, payment of employment benefits (insurance, pension, vacation or sick days), expectation that the relationship will be indefinite in duration rather than based on a project or time period, and activities performed by the worker being a key component of a business, will make it more likely that the worker is an employee.

Workers are often presumed to be employees: What the multi-factored test is getting at is whether, from a functional, economic, and formal point of view, the worker is running his or her own business or merely functioning as a small cog in the workings of a business. Even though most workers have some independent contractor attributes, they are very likely to be classified as employees unless the owner makes an honest, continuing and determined effort to make the workers be their own bosses. This strategy includes, but is not limited to, giving the worker a choice between being an independent contractor or an employee, giving up control over the worker’s day-to-day operations, leaving the worker free to work for other businesses and to hire his or her own employees, paying the worker based on the jobs finished (which may result in a much higher income than would be earned as an employee), and scrupulously documenting and monitoring the relationship. Categorizing workers as independent contractors can be very beneficial but is also risky and requires regular consultations with attorneys as well as a tremendous amount of discipline and legal planning.

Furthermore, an business should not attempt to hire independent contractors unless it is a win-win situation for both the business and the worker. The label of independent contractor should not be used as a pretext to get rid of employment regulations but to create a genuine opportunity for a more profitable relationship between the business and the worker. Unless a business is prepared to fully accept all of the drawbacks inherent in a decentralized working environment and is ready to scrupulously document and adhere to making workers truly independent, it should not attempt to classify any workers as independent contractors.

Employees can be incentivized to perform like independent contractors: Fortunately, workers can be classified as employees but paid a mixture of hourly pay and a bonus that encourages them to perform more efficiently because they receive incentives similar to those of independent contractors. Most workers are considered to be “non-exempt,” meaning that they cannot be paid a salary and must be paid on an hourly basis. However, written employment agreements with employees can guarantee payment of a lower hourly wage (at least minimum wage), appropriate overtime pay, and meal and rest breaks, while also paying a bonus based on jobs completed to the extent that the bonus owed exceeds the employees’ hourly pay. As a result, the employee would always be entitled to his or her hourly wages (including overtime) and the bonus would be calculated based on a percentage of money actually received from for the jobs the employee completed less the hourly wages due to the employee.

For example, if an employee was promised a 30% bonus and produced $10,000 in income for the auto body shop based on jobs the employee completed in a particular month, and the employee was paid $2,000 in wages for the specific hours worked during that month, then the employee would be owed a $1,000 bonus ($10,000 multiplied by 30% less $2,000). The employee would receive the $1,000 bonus on top of the $2,000 owed to him or her in wages for that particular month. If the employee was less productive, and produced only $5,000 in income for the auto body shop, then they would only receive wages and no bonus would be due. Thus, the employee would be guaranteed a minimum amount of pay based on the hours worked but his or her actual production would be the principal factor in how much an employee earned. This would cause the interests of the employees and owners to be more closely aligned without the risks associated with classifying workers as independent contractors.

Consult an attorney to stay out of trouble: It is always a good idea to talk to an attorney to make sure that workers are not being misclassified as independent contractors and that those workers who are employees have a compensation structure and working conditions that comply with state and federal employment laws. It is always best to seek help in the planning stages or before a problem arises but it is never too late to try to address employment and independent contractor issues.

Martin Zurada regularly advises and litigates on behalf of California businesses serving San Franscio and the California Bay area, including independent contractor and employment issues.

Please remember — this article only provides general legal information but not legal advice. You should consult a lawyer who will provide you with legal advice by applying the specific laws in your state to your specific factual circumstances.

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