Don’t Make These Mistakes On Your Income! – What To Know About Reporting Income In California – A Quick Legal Guide
In California, workers who report their income on a Form 1099 are independent contractors, while those who report it on a W-2 form are employees.
Payroll taxes from W-2 employees are automatically withheld, while independent contracts are responsible for paying them. W-2 employees can also receive employment benefits, such as worker’s compensation and minimum wage protections.
California law on this topic is changing rapidly, as lawmakers struggle to keep up with the gig economy. Employers who pay workers as independent contractors but treat them like employees can be held liable for worker misclassification.
What is an independent contractor?
An independent contractor is a legal classification for a worker who takes jobs on a freelance basis. They are paid by their clients using Form 1099.
Independent contractors have freedom in how and when they work. They are not tied to a single boss or company. Instead, they can take jobs from a variety of different clients, even from clients who are in competition with each other. Independent contractors often work on numerous short-term or part-time projects or assignments.
What is an employee?
An employee is a legal classification for a worker who has entered an employment agreement with their employer and is paid a regular salary, hourly wage and/or commission. They are paid by their employer using Form W-2.
Employees are tightly restricted in what they do while on the job. Their boss can tell them what to do and how to do it. Employees may work full-time hours or part-time in their position.
What are the differences between the two?
Legally, the difference between an employee and an independent contractor is that an employee is covered by many provisions of California’s Labor Code, while independent contractors are not.
This has a list of widespread, practical effects. They include:
|Payroll taxes||Payroll taxes are automatically withheld for W-2 employees||Independent contractors have to pay their own payroll taxes to the IRS on their income tax return|
|Workers’ compensation||Most employers in California are legally required to cover their employees with workers’ compensation||Independent contractors are responsible for their own workers’ compensation coverage|
|Minimum wage laws||Covered||Not covered|
|Social Security and Medicare taxes||Automatically withheld by the employer||Independent contractors have to pay their own Social Security and Medicare taxes to the IRS|
|Unemployment insurance||Covered||Not eligible for unemployment benefits|
|Employment taxes||Employees do not have to pay employment taxes||Independent contractors have to pay self-employment taxes because the IRS sees them as their own employee|
|Health insurance||Eligible for employer-provided healthcare||Have to provide their own health insurance|
|Wage and hour laws||Covered||Not covered|
|Overtime pay||Eligible||Not eligible|
|Meal and rest breaks||Entitled to rest and meal breaks||Not entitled to paid breaks|
|Employer liability||The employer is generally held liable for damages from an employee’s negligence||Independent contractors are liable for their own mistakes|
The general theme is that workers with employee status have a firm employment relationship, while workers with an independent contractor status have far more freedom.
What is California employment law’s “ABC test”?
For most issues, California uses the ABC test to distinguish an employee from an independent contractor. The test focuses on the worker’s:
- Autonomy – If the worker is sufficiently free from the control of the company hiring them, then they may be an independent contractor.
- Business – If the worker performs work that is outside the usual course of the hiring entity’s business, then they may be an independent contractor.
- Custom – If the worker is customarily engaged in a business of the same nature of the work being performed, then they may be an independent contractor.1
If there is a worker classification dispute, the party that hired the worker has the burden of proving that the worker is not an employee.2 They have to prove this with more than a mere contract that states that the worker is not an employee.3 Instead, they have to show that, in practice, the worker satisfied the ABC test.
History of the ABC test
The test was created through common law by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court in 2018.4 It overruled an earlier case, S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations,5 in order to clarify California employment law and prevent the growing problem of worker misclassification in the gig economy, particularly by ridesharing companies like Uber and Lyft.
Exemptions to the ABC test
The state of California has since passed a new Labor Code section adopting the ABC test for worker classification issues. The new law, however, also recognized numerous exemptions to the test, including for:
- registered securities broker-dealers,
- licensed insurance agents,
- licensed medical professionals who work for a health care entity, including doctors, surgeons, and dentists,
- direct salespersons,
- licensed contractors,6 and
- certain bonafide business-to-business contracting relationships.7
If one of these exemptions applies, worker classification is determined using the old law, which uses the manner and means test. Courts look to whether the company has a right to control the manner and the means of the performance of the work.8
Applicability to California law
The ABC test tends to classify more workers as employees than federal law does, providing California workers more protection than in other states. However, it only applies to employment disputes arising from California’s:
- Labor Code,
- Wage Orders, or
- Unemployment Insurance Code.9
Does Assembly Bill 5 or Assembly Bill 2257 impact the ABC test?
Assembly Bill 5 was the 2019 California state law that adopted the ABC test for worker classification. Assembly Bill 2257 was signed by Governor Newsom and went into effect on September 4, 2020, to clarify the earlier law.
Both of these bills carved out numerous exemptions to the ABC test, allowing more workers to be classified as independent contractors in certain industries where it was customary, such as the music recording business in Los Angeles or in law firms.
What happens if a worker is misclassified?
Companies who misclassify their workers by labeling them as independent contractors, but treating them as employees, can face a lawsuit. Workers who have been misclassified can file a wage and hour lawsuit and recover compensation for the benefits that they were entitled to receive. This includes:
- unpaid overtime,
- unpaid wages for rest and meal breaks or minimum wage violations,
- attorney’s fees,
- penalties, and
- interest on unpaid wages.
If the misclassification was willful, the employer can face a civil penalty of between $5,000 and $15,000 for each violation. If there was a pattern and practice of willful misclassification, the fines go up to between $10,000 and $25,000.10
Requesting a classification determination
Workers can request a classification determination by the California Employment Development Department (EDD) if they suspect that they are being misclassified.
- California Labor Code 2775(b)(1) LAB.
- California Labor Code 2775(b)(1)(A) LAB. See also S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations, 48 Cal. 3d 341 (1989).
- Dynamex Operations West, Inc. v. Superior Court, 4 Cal.5th 903 (2018).
- S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations, Supra. See also Jose J. Mejia, et al. v. Roussos Construction, Inc. (Court of Appeal of California, Third Appellate District, 2022) 76 Cal. App. 5th 811.
- California Labor Code 2783 LAB.
- California Labor Code 2776 LAB.
- S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations, Supra.
- California Labor Code 2775(b)(2) LAB.
- California Labor Code 226.8 LAB. See also Fed. R. Civ. P. 23(b)(3); Bowerman v. Field Asset Servs., Inc., (9th Cir., 2022) 39 F.4th 652.