In this second of our series of blogposts on common misconceptions around hiring and working for startups, we address a common misconception around classification of independent contractors. Most startup owners do not want to deal with the costs of hiring employees. So, many engage new hires as independent contractors. The common misconception is that getting these new hires to execute a well drafted independent contractor agreement is conclusive of their status as independent contractors. While such an agreement is one indicator of the parties’ intent to establish an independent contractor relationship, it is by no means conclusive and offers little by way of protection against employment related claims (especially in California) if factually the relationship is more akin to that of employer and employee.
Various factors go into the analysis of classifying a new hire as an employee or independent contractor. The analysis is not identical across the board and often the test to be applied turns on who is investigating the alleged misclassification. For instance, the test the IRS applies is not identical to one applied by the Department of Labor.
Under federal Fair Labor Standards Act (“FLSA”), the definition of employee is vague— employee is defined as “an individual employed by employer”. In analyzing an individual’s status under the FLSA, courts have looked at the totality of the circumstances including contractual language. The test, commonly known as the “economic realities test”, generally looks at these factors:
- The extent to which the services rendered are an integral part of the alleged employer’s business.
- The permanency of the relationship between the principal and the alleged contractor
- The amount of the alleged contractor’s investment in facilities and equipment.
- The nature and degree of control by the principal.
- The alleged contractor’s opportunities for profit and loss.
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
To review the DOL’s guidance on the “economic realities test” further, visit https://www.dol.gov/agencies/whd/fact-sheets/13-flsa-employment-relationship
In California the applicable test is codified in Assembly Bill AB5 (which went into effect in January 2020) and is the so called “ABC test” which came out of the California Supreme Court’s ruling in Dynamex Operations West, Inc. vs. Superior Court of Los Angeles (2018) 4 Cal.5th 903. Under the ABC test, an individual is generally deemed an employee unless the hiring entity shows all of the following:
- The worker is free from the hiring entity’s control and direction in connection with the performance of the work both under the contract for the performance of the work and in fact.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
Following Assembly Bill 5, the California legislature passed Assembly Bill 2257, which exempts a substantial list of job categories from application of the ABC test. Assembly Bills 1506 and 1561 further modified and added various exceptions to the ABC test. Therefore, to determine whether an individual is properly classified as an independent contractor in California, the hiring entity not only has to consider the ABT Test but also analyze whether the hiring falls within one of the exceptions. The contracting agreement is certainly not decisive.
For more on AB 5 and its exceptions, visit https://www.labor.ca.gov/employmentstatus/faq/
As misclassifying a worker as an independent contractor can cost a business hundreds of thousands of dollars, it is important to carefully consider if a person can be engaged as an independent contractor with low risks of misclassification. It is prudent for businesses to consult with an appropriate attorney when in doubt.