The employment landscape is getting more and more complicated as we venture further into the 21st century. As the lines blur between traditional employment and contracting for hire, it’s helpful to understand the key differences for the purposes of California employment tax liability. Both California and the IRS will expect you to know the difference between the various categorizations of workers.
For the purposes of employment tax law in California, the difference between employees and independent contractors is whether the entity that is paying for the services of the worker has control over the manner and means of the work. If this is the case, the worker is likely an employee. If the worker is in business for themselves, independent of corporate oversight, this indicates a business relationship with an independent contractor. Failing to properly identify the complex differences between the two categorizations can land a company in hot water regarding tax liability and IRS penalties and knowing the ramifications should impact the employment decisions that you or your company makes. These issues are nuanced and ever-changing. Contact our California Employment Tax Lawyers to learn more.
Who is an Employee Under California Law?
The state of California defines an employee broadly. According to California Labor Code, an employee is any person who is in the service of an employer under a contract of hire or apprenticeship. A contract of hire can be oral or written – you do not need a contract in writing to be considered an employee by law. Even if the employment is unlawful, the person will still be considered an employee. Non-U.S. citizens, minors, and interns are all considered “employees” by statute in California.
A worker who meets the following criteria is presumed under California law to be an employee unless all of the following conditions (known as the “ABC Test”) are proven:
- The worker is free from control and direction of the company in performing their work.
- The worker performs a function that is not within the company’s typical business.
- The worker frequently engages in that same function independently as a trade or business with others.
Exceptions to Employee/Contractor Classification in California
There are exceptions to these criteria. The following are examples of occupations which are not determined by the ABC test:
- Doctors and psychologists
- Contractors
- Real estate agents
- Freelance writers
- Barbers, hair stylists, manicurists
- Tutors
- Insurance brokers
- Financial service operatives
- Lawyers
- Architects
Whether these professionals are considered employees in California will be determined by applying the Borello test. The Borello test consists of eleven factors, but workers do not need to meet all eleven to be considered a California Employee. The most important factor of the group is whether the company receiving the service from the worker has control over the manner and means of how the work is done.
Proposition 22 for Gig Workers in California
The discrepancy between employees and contractors has been made even more controversial in California recently due to Proposition 22, a balloted legislation package which passed in November of 2020. The citizens of California voted to pass the proposition, which classifies all app-based delivery service workers and ride-sharing drivers as independent contractors, regardless of the ABC or Borello tests.
Proposition 22 applies to all workers who either provide delivery services through an online application or use their own personal vehicles to provide prearranged transport services through an online application. The passing of the legislation allowed for large tech companies such as Uber, Lyft, and DoorDash to escape liability from lawsuits alleging violations of wage and hour requirements for employees.
Proposition 22 applies only if certain requirements are met:
- The company does not require workers to work on specific days or for a certain number of hours.
- The company does not force the worker to accept any and all service requests in order to retain access to the network.
- The company does not forbid the worker from working for other competitors in the time when they are not actively working for the company in question.
- The company does not forbid the worker from lawfully working in any other capacity.
Difference Between Employees and Contractors for Tax Purposes in California
The difference between an employee and an independent contractor is significant in the eyes of the IRS and the state of California. In the case of an employee, the employer issues Form W-2 and is required to withhold federal and California employment taxes on the wages. Companies who file Form 1099 for an independent contractor may not withhold wages for tax purposes. Companies split Social Security taxes 50/50 with their employees, whereas independent contractors (1099 recipients) are required to make their own estimated income tax payments, including self-employment taxes. Independent contractors can deduct any “trade or business” expenses on schedule C related to the revenue they earn, whereas schedule A deductions for most employees were eliminated under the Tax Cut and Jobs Act and are limited to unreimbursed employee business expenses for only a handful of protected groups.
If an employee is misclassified as an independent contractor in California, the violator will face severe penalties. A willful (or voluntary and knowing) misclassification of an employee carries a California civil penalty ranging from $5,000 to $25,000. The penalties are assessed per violation, which includes the misclassification of multiple employees as well as multiple, consecutive misclassifications of the same employee.
If the employer misclassified the employee unwilfully, the key penalty mitigating factor for both California and the IRS will be whether the erroneous employee misclassification was made with reasonable cause. Most companies facing a worker classification issue at a minimum generally become responsible for all unpaid income and Social Security taxes. The penalties and interest that are often involved can only be described as draconian by both practitioners and clients alike and can mean the demise of the affected business.
Still Not Sure About Employees vs. Contractors in California? Call Us to Find Out More
If you aren’t sure how to file with the IRS or state of Californian or believe you may have fallen out of compliance with California or federal law, the knowledgeable dual licensed Employment Tax Attorneys & CPAs at the Tax Law Offices of David W. Klasing are here to help. Call our offices at (800) 681-1295 to set up an appointment online to talk about your situation.
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