S.B. 459: California's Attack on the Independent Contractor Classification

It is not uncommon for business owners to avoid paying taxes and employee benefits (i.e. overtime pay) by hiring independent contractors instead of employees. These business owners are already at risk of an audit by the Employment Development Department and the IRS.  If the audit ends up in a reclassification, the business owner will be responsible for unpaid taxes, possible penalties and interests.  

Now, as a result of new California legislation, this practice of misclassifying workers can end up costing business owners and their advisers everything.    

• S.B. 459

As of January 1, 2012, the California Legislature enacted a harsh new law targeting the misclassification of workers as independent contractors by California business owners. Under S.B. 459, a business owner can be found to have engaged in the following unlawful activities:

1. The "willful misclassification" of an individual as an independent contractor and/or
2. Charging a willfully misclassified worker a fee, or making any deductions from compensation for any purpose that would have violated the law governing deductions from pay (Labor Code sections 221 and 224) had the worker properly been classified as an employee.  

Additionally, non-lawyer consultants are subject to joint liability for knowingly advising a business owner to classify a worker later determined to be an employee.

• Penalties

This laws allows California's Labor Commissioner or a court to levy a civil penalty of $5,000 to $15,000 for each violation found "willful." If it is also determined that the business owner engaged in a pattern or practice of "willful misclassifications" a civil penalty of $10,000 to $25,000 may be imposed. 

Additionally, this law also empowers the Labor Commissioner to assess additional damages of behalf of those misclassified (the workers themselves). As a result, if a business owner misclassifies a large group of workers as independent contractors, the business owner may be subject to a class action law suit by this group.  

• "Willful"

The key word here is "willful". "Willful misclassification" is defined as "avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor." Although this standard appears to be more stringent than the "voluntary and intentional" standard proposed in earlier versions of the law, it is still problematic because courts have defined "knowing" to included constructive knowledge. As a result, if it is found that the business owner should have known that the worker should have been classified as an employee, the misclassification will be found willful.  This is a very vague and subjective standard that will cause a lot of uncertainty and is unlikely to protect business owners who are simply mistaken about the proper classification.  

• Notice

In addition to the penalties, the law also requires the business owner to post a notice (either on its website or place of business accessible to all employees and the general public) at each location where a violation occurred.  This notice must contain the specific information about the violation, be signed by an officer and be posted for one year.  

In sum, this new law imposes potentially crippling and humiliating penalties upon California business owners who improperly classify their workers. Since the standards for determining whether a worker is an independent contractor or an employee are also often subjective, this law will likely excessively burden California business owners.  If the goal of the California legislature is to inflict fear in California business owners and thereby do away with most independent contractors, the new law will most likely succeed.  

This content is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.  

Voluntary Worker Classification Settlement Program: A Fresh Start for Employers

As part of its effort to provide a "Fresh Start" to taxpayers and businesses, the IRS created the Voluntary Classification Settlement Program (VCSP)  to allow employers to voluntarily reclassify their workers (or a class/group of workers) as employees for future tax periods.  

Many employers erroneously miss-classify their workers as independent contractors or non-employees.  Whether a worker is actually an employee or an independent contractor depends on the facts and circumstances involved.  Nevertheless, the classification issue is most often resolved based on whether the employer has the right to direct and control the worker as to how to perform the services.  There are many situations where correct classification is unclear.  

If the employer is audited and the independent contractors or non-employees are reclassified as employees, the employer will face a substantial tax liability, including interest and penalties, for three years of employment taxes. The VCSP allows employers to avoid this possibility by giving them the chance to preemptively reclassify workers.  The VCSP builds on the Classification Settlement Program (CSP) that has already been in place for years.  The CSP is available to employers already under IRS examination and allows prospective reclassification of workers as employees with reduced federal employment tax liabilities for past non-employment treatment.  The VCSP, on the other hand, allows taxpayers to reclassify without first going through the burden of an examination. 

The employer does not have to reclassify all workers in order to be eligible under the VCSP.  Nevertheless, if specific workers are reclassified as employees, all workers in the same class must also be treated as employees.  

In order to be eligible to participate in the VCSP, the employer: 

• Must have consistently treated the workers or a class/group of workers in the past as independent contractors or non-employees
• Must have filed all required 1099s for the workers for the previous three years.  These 1099s must have been filed within 6 months of their due dates (including extension) to qualify as having been filed.  
• Must not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.  If the employer has previously been audited regarding the classification of the workers, the employer must have complied with the results of the audit in order to be eligible. 

In order to participate in this program, Form 8952 must be filed at least 60 days before the employer wants to being treating the workers as employees.  The taxpayer should also provide the name of a contact person or authorized representative with a valid Power of Attorney.  The IRS will contact this person in order to complete the VCSP process. 

If the employer is accepted into the VCSP, the employer will enter into a closing agreement with the IRS to finalize the terms of the agreement and make full payment of the amount due.  

If accepted into the program, 10% of the employment tax liability that would have been due on compensation paid to the worker (or class/group of workers) for the most recent tax year must be paid.  This amount is determined under the reduced rates of section 3509(a) of the IRC.  Interest and penalties will not be assessed and the employer will not be audited on payroll taxes with regards to these workers for past years.  

Under section 3509(a), the tax rate for compensation up to the Social Security wage base is 10.28% in 2011 and 3.14% for compensation above the Social Security wage base.  Currently, the most recently closed tax year is 2011 so the 10.28% rate applies.  

For example: if in 2011 an employer paid $100,000 to workers that the employer wishes to reclassify under the VCSP, the employment taxes applicable to the $100,000 would be $10,280.  10% of this amount is $1,028.  (In this example all workers were compensated below the Social Security wage base). 

The employer must also agree to be subject to a special six-year statute of limitations (rather than the usual three years) for the first three years under the program.  

The IRS promises not to share information about an employer's participation in the VCSP with the Department of Labor or with any state agencies.  Furthermore, the IRS states that a rejection of the form 8952 will not automatically trigger a Federal audit.  

This content is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.