Fines and Penalties if California Employees Are Misclassified as Independent Contractors
|Prepared By: Melissa C. Marsh, Los Angeles Employment Attorney
Written: September 2010 - Last Updated: January 2012
Many California employers have an unprecedented rate classified their workers as "independent contractors" to avoid the costs and expenses associated with payroll, overtime pay, workers' compensation insurance, disability, and other traditional employee benefits and protections. In addition to defending claims brought by aggrieved workers, businesses operating in California should be aware that the IRS and various state agencies have significantly increased compliance audits to ensure businesses are complying with employment tax laws and withholding requirements.
In California, the state agencies most involved with determining whether an employee is misclassified as an independent contractor include: the Employment Development Department (EDD), which is concerned with employment-related payroll taxes (See, California Labor Code §§ 2802 and 3710.1, which allows the EDD to go back three years and seek reimbursement for unpaid payroll taxes, unemployment insurance, disability insurance, workers' compensation insurance, and to assess both fines and penalties for violations of various California Labor Code violations); (2) the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour, overtime, and other California Labor Code rules and provisions apply; (3) the Division of Workers’ Compensation (DWC), which is concerned with workers injuries and the workers' compensation insurance; and (4) the Contractors State Licensing Board (CSLB). At the federal level, the IRS is conducting random audits, and businesses found to have misclassified their workers presently face a fine of up to $5,000 per misclassified employee.
Effective January 1, 2012, Sections 226.8 and 2753 have been added to the California Labor Code authorizing California's Labor and Workforce Development Agency to assess civil penalties of not less than $5,000 and not more than $15,000 for each violation in addition to those civil penalties already permitted by law. The civil penalties increase to $10,000 and $25,000 for each violation if the Agency determines that the employer has engaged in a pattern, or practice, of willful misclassification of its employees as independent contractors. The new law further authorizes an individual to file a complaint with the Labor Commissioner and the Labor Commissioner to assess the above-mentioned civil penalties against the employer if the Labor Commissioner determines that the employer has in fact misclassified the employee. If the employer is a licensed contractor, the new law further requires the agency to notify the CSLB, and requires the CSLB to initiate its own action against the contractor.
In addition to any fines or penalties assessed by either the IRS or a state agency, the misclassified employee can seek up to three years worth of unpaid wages (including overtime and meal and rest break violations), unreimbursed businesses expenses, and penalties for violating various California Labor Code provisions. See, Labor Code §203, §210, §226.3, §2802 and §3710.1; and California Unemployment Insurance Code §§1112, 1113 2, and 2118). California business owners may also face exposure to tort liability for injuries suffered by employees when workers compensation insurance was not secured (Labor Code §3706), for unfair business practices (Business and Professions Code §17200), and even potential criminal liability under Labor Code §3700.5.
1. Record Keeping Requirements.
Pursuant to California Labor Code § 210, a misclassified worker may claim that the business failed to follow California’s timing and recordkeeping requirements as set forth in the California Labor Code. If the Court determines the worker was in fact an employee, the court may award penalties of $50 or $100 per employee per pay period plus up to 25% of the wages not paid to each employee each pay
2. Itemized Wage Statement Violation.
Pursuant to California Labor Code § 226.3, a misclassified worker may claim that the business violated the statutory obligation to provide itemized wage statements each pay period. If the Court determines the worker was in fact an employee, the court may award additional civil penalties in the amount of $250 per employee for the first citation and $1,000 per employee for each subsequent citation. It should also be noted that under California Labor Code §226.6, a knowing and intentional violation of these requirements is a misdemeanor.
3. 30 Days Pay.
Pursuant to California Labor Code § 203, the failure to pay a terminated employee all wages due and owing in a timely fashion can subject an employer to a penalty of up to 30 times the employee’s daily wage without regard to the actual amounts of unpaid wages. Needless to say, when a worker is misclassified it is a given that the payroll taxes have not been paid and in turn that the misclassified worker was not therefore paid all wages due and owing at the time of termination.
4. Federal Tax Penalties.
Employers who misclassify employees as independent contractors may be required by the IRS to pay all of the employee's unpaid FICA (Social Security), FUTA (Federal Unemployment), and income tax withholdings. See, Robert Patrick Day v. Commissioner, U.S. Tax Ct. (Dec. 13 2000) Memorandum Decision, Docket No. 7118-98. Employers may also be assessed a penalty of $5,000 per misclassified worker plus 1.5% of the employee’s federal income tax liability plus 20% of the amount that should have been withheld for the employee’s FICA taxes. However, the employer may claim or seek a reduction of assessed penalties if the employer can prove s/he made a good faith mistake. See, I.R.C. §530 and Boles Trucking, Inc., v. United States, 77 F.3d 236, 239, (8th Cir. 1996).
The statute of limitations for imposing tax penalties is three years from the time the employment tax returns specific to the misclassification periods were actually filed. I.R.C. §6501(a).
California employees misclassified as independent contractors can complete IRS Form SS-8 and IRS Form 8919. If the IRS determines that the employee was in fact misclassified as an independent contractor, the IRS will credit the unpaid taxes to the employee's social security and medicare records.
5. California State Unemployment Insurance.
Pursuant to California Unemployment Insurance Code §§1112 and 1113 2, if a court determines that a worker was misclassified, the employer will be assessed amounts due for state income tax withholding, unemployment insurance contributions, and disability insurance contributions, unless the employer can show the income was reported and all taxes due were paid by the employee. Employers who fail to pay for unemployment insurance benefits and/or state disability insurance benefits are not only required to pay the unwithheld amounts, but may also be assessed a 10% penalty and interest on the unpaid contributions.
6. California State Income Taxes.
Employers who misclassify employees as independent contractors are liable for the state income tax amounts not withheld unless the employer can show that the contractor appropriately reported income and paid state income taxes due. The showing required usually involves the filing of a form prepared by the employer and signed by the employee attesting that income received was reported and taxes were paid. Failure to make appropriate withholdings for state income tax payments from employee paychecks is a misdemeanor and a California employer, if convicted, may be fined up to $1,000 and/or sentenced to serve up to one year in prison. (CA Unemployment Insurance Code § 2118)
But My Workers Signed an Independent Contractor Agreement.
California employees and employers should be aware that the fact that a worker signed an independent contractor agreement, or was paid as an independent contractor, that is, without payroll deductions and with income reported on IRS form 1099 if of no, or little, significance in determining employment status. Both the California Labor Commissioner and the courts will look behind any such purported agreement and examine the underlying nature of the relationship to determine whether the worker was misclassified.
In a wage claim where employment status is an issue, the DLSE will often use the five-prong economic realities test to decide the issue. In a withholding tax claim, the IRS will apply its three-pronged test: (1) behavioral control; (2) financial control; and (3) the type of relationship.
- Behavioral Control: If the employer controls when and where the work is performed, provides the tools, equipment, and space where the worker is to perform their duties, suggests or insists on the order in which tasks are performed, and/or provides the worker with training, then the worker should be classified as an employee.
- Financial Control: If the worker is paid a regular wage ("x" amount per week), or has not made a significant investment in their own business, the worker is probably an employee.
- The Relationship: In a typical employer-employee relationship, the worker works for and at the discretion of the employer for an indefinite period of time. An independent contractor is usually hired for a specific project, or for a short period to perform a specific task that is not integral to the business of the employer. Independent contractors also typically have the freedom to, and do, work for more than one company at any given point of time.
In general, if the employer has control over when and where the work is performed, in what order tasks are be performed, supplies the worker with the tools and equipment needed to perform the work, and/or if the tasks performed by the worker are integral to the business of the employer then the worker should be classified as an employee.
So what is a task that is integral to the business?
The California Court of Appeal in JKH Enterprises v. Department of Industrial Relations, 142 Cal.App.4th 1046 (2006) highlighted the dangers faced by California employers that improperly designate a worker as an independent contractor. JKH Enterprises operated a courier business and had classified its drivers (couriers) as independent contractors. The Labor Commissioner issued a stop order pursuant to California Labor Code section 3710. In the second round of inspections, JKH was issued another stop order and fined a penalty of $1,000 per driver. JKH Enterprises appealed the decision to the California appellate court which upheld the Labor Commissioner's decision on the basis that the company's drivers were integral to its business, and therefore were employees of the company, not independent contractors. The California Supreme Court denied a petition for review, and the appeals court decision became final.
At bottom, under JKH Enterprises, California employers should classify any worker that is performing a task that is integral to the business as an employee.
Misclassifying an Employee as Exempt From Overtime.
Another hot area of employee misclassification is improperly labeling an employee as exempt from overtime. Many highly paid employees in the financial and pharmaceutical sectors, as well as in commission based jobs are being misclassified as exempt from overtime.
Drug Reps. In In re Novartis Wage and Hour Litigation, the Second Circuit determined that pharmaceutical representatives (a.k.a. "drug reps") are NOT exempt from overtime under the "outside sales exemption" because they cannot close a sale. According to the second circuit court, if a sales representative merely provides information, or promotes demand, but cannot close a deal, or "obtain commitments to buy," then that employee is not engaging in "sales" and does not qualify for the sales based overtime exemption. In the instant case, the drug reps also did not qualify for the administrative exemption from overtime because the drug reps had no authority to make any important administrative decisions.
Loan Officers. On March 24, 2010, the Department Of Labor (DOL) issued Administrator's Interpretation No. 2010-1, under which it concluded that all financial service workers (loan officers, originators, consultants, etc..) may be entitled to overtime pay and are NOT exempt from overtime pay under the "sales" exemption. According to the DOL, if a worker collects and enters financial information, assesses or identifies particular loan products and compile customer documents for forwarding to an underwriter, or loan processor, they are engaged in the production work of their employers, not sales. Consequently, mortgage loan officers are non-exempt and are entitled to overtime pay.
For more information on exempt versus non-exempt from overtime, please see:
California employers are strongly urged to review their employment practices. Misclassifying employees as independent contractors, or as exempt from overtime, can lead to substantial consequences including:
- Stop orders and penalty assessments under California Labor Code section 3710.1;
- Liability for overtime compensation, meal and beak period pay, and other remedies available to employees under the Labor Code and Industrial Welfare Commission Orders;
- Exposure for tort liability for injuries suffered by a worker when workers compensation insurance is not secured (LC section 3706);
- Exposure for unfair business practices (B&P section 17200);
- Tax liability and penalties;
- Criminal liability (LC section 3700.5)
California employees are strongly urged to keep track in a separate work journal of all their work activities, including the hours worked each day, when they went to lunch and came back, when they took a break, days, or partial days they missed work and the reason why (vacation, sick day, etc..), and of any special occurrences. If an employee believes they are being mistreated, then documentation is everything.
Our employment law practice consists of: (1) assisting employees with their wage claims and (2) counseling employers who seek to comply with new state and federal employment laws, providing human resource training, and providing essential contracts and employee policies to prevent employee lawsuits. To schedule a consultation, please call 818-849-5206 or Send Us An Email.
California employment lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.
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