Whether by mistake or on purpose, businesses may improperly treat their workers as independent contractors instead of as employees. Doing so can be very costly. Misclassifying workers may violate tax and labor laws and could be discovered in many ways, such as in a government audit or when a worker files a claim for uncollected payroll taxes or unemployment benefits.
Businesses may prefer to treat their workers as independent contractors to avoid paying for employee benefits and workers’ compensation insurance, but their workers might not make the required estimated tax payments as independent contractors. Tax authorities are therefore often aggressive in cracking down on the misclassification of workers as independent contractors.
Complicating matters are differing federal and state worker classification standards. For federal tax purposes, a worker is a common law employee if the business has the right to control what will be done and how it will be done.1 While the Internal Revenue Service has a 20-factor test,2 it advises that its primary method to classify a worker under the common law rules is to consider every piece of information with evidence falling into three main categories:
1) Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2) Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3) Type of Relationship: Are there written contracts or employee-type benefits ( i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business? 3
No single fact is determinative. Rather, the entire relationship and the extent of the business’s right and extent to control the worker are examined. A business may ask the IRS to determine the status of a worker4 and in certain circumstances, obtain relief of any assessed penalties.5
In contrast, California recently adopted a test known as the “ABC test” to determine whether a worker is an employee or independent contractor. It started in 2018 with the California Supreme Court decision in Dynamex Operations W. v. Superior Court and Charles Lee et al., Real Party in Interest.6 The California Supreme Court held that workers are presumptively employees for the purpose of California wage orders and that the burden is on the hiring entity to establish that a worker is an independent contractor. To establish that a worker is an independent contractor, the business hiring the worker must prove that all parts of ABC test are satisfied.7
The California legislature subsequently codified the ABC test with certain exceptions and expanded its application beyond wage orders.8 Under the California ABC test, a worker is now generally deemed to be an employee and not an independent contractor unless the hiring entity can prove that all three of the following conditions are met:
(A) The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
(B) The worker performs work that is outside the usual course of the hiring entity’s business.
(C) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.9
The ABC test is the default position and applies to most workers, but there are exceptions and different rules and tests that apply to some occupations, workers and contracting relationships.10 California businesses seeking to avoid application of the ABC test by using out-of-state workers must be careful as many other states have also adopted the ABC test.
What, then, should a receiver do if treatment of a worker as an independent contractor is questionable under any applicable standard? In such case, the receiver should be extremely cautious and quickly get labor and tax law advice.11 A receiver does not want to continue any unlawful behavior and potentially incur further penalties to the business in receivership and/or personal liability for any federal tax claims that may arise from the misclassification of workers.12
*Chad Coombs is chief tax counsel at Thomas Seaman Company in Irvine, CA and an expert in insolvency tax law.
1 See Treas. Reg. 31.3121(d)–1(c).
2 See Internal Revenue Ruling 87-41, 1987-1 CB 296.
3 www.irs.gov/businesses/small-businesses-self-employed/independent- contractor-self-employed-or-employee (as of October 6, 2023); Internal Revenue Manual Section 4.23.5.7.1;; IRS Publication 15-A, pages 4, 6-9 (2023); and IRS Publication 1779 (2023).
4 IRS Form SS-8.
5 See, e.g., the Voluntary Classification Settlement Program (IRS Form
8952) and Section 530 Relief (IRS Publication 1976). not be available for state tax purposes.
6 4 Cal.5th 903 (Cal. 2018).
7 Id. at pages 956-957.
Such relief might
8 See California Assembly Bill 5 (AB 5) enacted in 2019 and California Assembly Bill 2257 enacted in 2020 (revising AB 5); California Labor Code Sections 2775-2784; and California Unemployment Insurance Code Section 621.
9 See California Labor Code Section 2775(b)(1) and California Unemployment Insurance Code Section 621(b). See also www.labor.ca.gov/employmentstatus/abctest/ (as of October 6, 2023) and https://edd.ca.gov/en/payroll_taxes/employment-status/ (as of October 6, 2023).
10 In addition, in November 2020, California voters passed Proposition 22 which allows businesses such as Uber and Lyft to treat their drivers as independent contractors. In March 2023, the California Court of Appeals in Castellanos v. State of California, 89 Cal.App.5th 131 (2023), overturned a lower court ruling that invalidated Prop. 22. In June 2023, the California Supreme Court agreed to hear the case (pending as of this writing).
11 For further discussion of worker classification issues, see Kalinski and Perez, Walking the Tightrope of Employment Tax Law, Los Angeles Lawyer, Volume 46, No. 6, page 22 (September 2023).
12 See 31 U.S.C. Section 3713 regarding personal liability of a receiver. See also Coombs, Tax Closure, Receivership News, Issue 76, page 22 (Winter 2022). A receiver could also be civilly liable under I.R.C. Section 6672 and/or criminally liable under I.R.C. Section 7202 for failure to pay withholding taxes to the IRS.