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California employee/contractor classification

San Diego business lawyer Sergei Tokmakov
(858) 205-5665

Anybody that works for you is either your employee or an independent contractor. Tax consequences of classifying somebody as an employee are expensive which is exactly why both IRS and the California Employment Development Department (EDD, the agency that collects employment taxes) go to great lengths to ensure that your workers are classified properly. Both IRS and EDD publish brochures with examples that help you with the classification. 


Some general guidelines for employee classification are:

- uses your tools and equipment;

- follows your directions and instructions on what is th eproper procedure to complete the job;

- follows the schedule that you provide;

- works on your premises;

- works only for you and no other business;

- receives benefits such as paid vacation, holiday pay or health insurance.

When you hire a California employee, your business must comply with certain requirements:

- Purchase workers' compensation insurance;

- Notify the EDD of your hires within 20 days of the employee's first day on the job;

- Withhold federal income and FICA taxes (Social Security, Medicare, etc.). report withholdings to the IRS and the employee on a W-2 form;

- Withhold California state income taxes;

- Pay (match) the employer's share of each employee's Social Security and Medicare taxes;

- Comply with federal (OSHA) and California's (DOSH) job safety regulations;

- Withhold employee's contriibutions to the State Disability Insurance (SDI);

- Pay federal and California's unemployment insurance taxes.

This list looks overwhelming, and it is. Nevertheless, your business model must be able to afford compliance with the relevant employment laws in order to avoid costly penalties and lawsuits. In the alternative, think whether it is possible to accomplish the tasks you need done with independent contractors only. A qualified business lawyer will be able to make sure that you are in compliance with all the relevant laws and regulations.

Independent contractor

A worker is more likely to be classified as a contractor if s/he:

- uses own tools and equipment;

- sets own schedule and decides how to best complete the job;

- is responsible for own expenses incurred;

- has own office space;

- advertises;

- works for other businesses or individuals.

Note that if you pay any independent contractor more than $600 a year, you must report those payments to the IRS, send the copy of Form 1099-MISC to the independent contractor and notify the EDD.

Of course, it rarely happens in real life that a particular worker would only have characteristics from one list and none from the other. In close calls, it is better to err on the side of classifying somebody as an employee rather than risk the hefty penalties that the IRS and the EDD can assess. Seek qualified counsel for assistance, or call the IRS or the EDD and ask. The agencies would rather see your workers classified as employees.

The IRS Classification

For federal tax purposes, the IRS has adopted its own standard of contractor/employee classification. Although the IRS test is the most widely used standard of independent contractor classification, other tests apply to distinguish employees from independent contractors for other specific purposes, such as exemption from the FLSA, federal employment discrimination law.

The test revolves around three primary categories:

 (1) Behavioral control. Does the employer have the right to control (not necessarily actual control) the worker and direct his work? Degree of instructions and/or training given?

(2) Financial control. Are expenses reimbursed? Who invested in tools? Does the worker market himself to the public? Flat fee per project (more typical for a contractor) or hourly rate (more likely an employee). Able to take a loss on the project? (employees usually do not take losses).

(3) Type of relationship. Is there a contract? Employee-type benefits?

The IRS Safe Harbor

Section 530 of the Internal Revenue Service Act of 1978 created a safe harbor which protects businesses from liability for misclassification in some cases. 26 U.S.C. 3401. The Section 530 safe harbor is available if the employer had a reasonable basis for the misclassification, treated the worker and all similarly situated workers consistently as independent contractors, and reported all federal tax returns in a manner consistent with the independent contractor classification. The Section 530 safe harbor only taxes owed by the employer.

This note by San Diego business lawyer Sergei Tokmakov is for general educational purposes only. It does not constitute legal advice because your specific case may be different. Readers should seek qualified counsel for assistance. This article may be reprinted, provided that all credit information and this paragraph remain intact.

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