Freelancers and independent contractors worldwide take pride in having plenty of job liberties. From being able to pick each gig to setting their own hours, this line of work suits self-reliant free spirits well.
However, there are two sides to each story — it’s not all coffee shops, lazy Mondays, fun and games.
With freedom come some duties unique to gig economy workers. Working independence also means that workers need to take care of legal matters on their own: taxes, rights, benefits, insurance, and other aspects otherwise regulated by the company HRs.
Employers who frequently work with independent contractors face more serious risks and legal issues, though. Employee misclassification and (accidental) tax evasion charges bear serious consequences, such as financial penalties with high-interest rates, and even temporary shutdowns.
No matter if you're an employer or a worker — if you’re a resident of California, this article is just the right thing for all your dilemmas. Here, we’ve compiled all the relevant laws that regulate independent contractors as freelance workers and explained their impact on employers and workers alike.
In the article below, we’ll go over:
- Independent contractor definition by California law (California Labor Code)
- What makes the Independent contractor status different in California:
-The Dynamex Decision
-The Borello Test
-Fair Labor Standards Act and the “Economic Realities” test
-The Assembly Bill 5 (AB 5) and the ABC Test
- Fair Employment and Housing Act (FEHA) — and does it apply to independent contractors
- How to use Form SS-8 to prevent misclassification
- Penalties for employee misclassification in California
There’s a lot to cover — so let’s jump right in!
Independent contractor definition by California law
Broadly speaking, independent contractors are defined as workers who enter the business for themselves, not on the employer’s behalf. They are self-employed and retain high levels of independence in their work. This includes deciding about their rates, payment methods, working hours, equipment, and place they are working from. According to the California Labor Code section 3353, an independent contractor is a "person who renders service for a specified recompense for a specified result, under the control of his principal as to the result of his work only and not as to the means by which such result is accomplished."
Therefore independent contractors are, well independent, and have the right to decide when to terminate the contract, and who they’ll work with. They can hold multiple clients at the same time, as much as they can manage. Independent contractors also get to keep all the profit earned from their own business.
According to the U.S. federal laws, three factors determine whether the worker should be classified as an independent contractor:
- Type of relationship — are the workers hired for certain projects and in the specific time frame (IC), or they’re hired indefinitely and do the work crucial for the company (employee)
- Behavioral control — who has the right to control the way job gets done
- Financial control — who controls the business aspects, invests in the equipment, sets the rates
Again: the higher the independence and the more specific tasks are, the greater the chance this worker should be considered as an independent contractor.
At the same time, independent contractors aren’t entitled to minimum wage, overtime pay, paid leave, rest breaks, and employee benefits such as retirement, health care and worker’s compensation insurance. Unemployment insurance, disability insurance, and unemployment benefits aren’t available to them. They can rely on the current state of the job market when determining their own rates and fees and need to cover these payments from the income they earn.
As far as taxes are concerned, independent contractors need to pay employment taxes (SE taxes) to cover social security and medicare, additional medicare tax, and federal income tax.
Read more about the taxes for independent contractors.
Certain tax deductions for independent contractors are available, to relieve their budgets.
All of the things mentioned above apply to independent contractors across the US, as well as those who live in California. We wholeheartedly recommend you to take a look at our complete independent contractor guide to get a full look; now, let’s have a look at what makes California independent contractor regulation different.
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Independent contractor status in California: Changes due to the new laws
Until 2018, these general rules described above were mostly enough to determine what it means to have an independent contractor status, and who should be considered a full-time employee.
However, the gig economy had inflated tremendously over the past few years. Companies who rely on gig workers (freelancers or independent contractors) saw this as a way to cut employment costs — at the expense of their workers, who now needed to cover everything with their humble, hard-earned income.
“Downgrading” the workers with employment status to independent contractors would mean exemption from paying payroll taxes mandated by the employment law (as we’ve mentioned in the first section).
Not all of these could be justified; several cases brought the attention to misclassification of employees as independent contractors. Most notable of them include the recent lawsuits by The California Labor Commissioner against Uber and Lyft — but before those, the Dynamex decision has set the course of action for independent contractors who lost their employee status overnight.
Dynamex Operations West, Inc. v. Superior Court — The Dynamex Decision explained
Dynamex is a courier/ delivery service that used to classify the drivers as employees according to California’s wage and hour laws. In 2004, they decided to start treating them as independent contractors to cut the costs those laws impose.
From then on, workers needed to purchase their own vehicles and pay for fuel, insurance, maintenance, and tools required to complete the work. In addition to that, they had to acquire the Nextel cell phone so they could communicate with dispatchers, as well as “work uniform” — Dynamex shirts and badges, and wear them during working hours.
Dynamex didn’t guarantee the type or number of deliveries they’d assign to the drivers. They could lay them off whenever they wanted, with a three-day notice. Workers were allowed to reject the delivery tasks, provided that they let the dispatcher know quickly. They could set their own working schedules but had to notify Dynamex about them in advance.
In 2005, a number of workers filed a class-action lawsuit against Dynamex Superior Court of Los Angeles. The main issue was the misclassification of employees as independent contractors, which deprived the employees of business expenses coverage and paid overtime.
Dynamex had appealed several times; before making the final decision, the ruling bodies tried deciding by examining the existing multi-factor tests: the Borello test and the FLSA test.
The Borello Test
This test is still in use, and it’s applied when Assembly Bill 5 and the more rigorous ABC Test cannot be used, or in case of statutory exemptions.
It’s also called the “right to control” test; it shows if the employer controls the means and the manner of work. If the employer has the right to control, the worker needs to be classified as an employee.
The Borello test consists of multiple factors, all of them listed here (see Q&A No5).
The Borello test was put together after a case that dates back to 1985: S.G. Borello & Sons, Inc. v. Department of Industrial Relations.
This company failed to provide the workers' compensation coverage for the migrant harvesters of their cucumber crops. Borello & Sons claimed that they were independent contractors, and as such excluded from the workers' compensation law.
Fair Labor Standards Act (FLSA) Test, or the “Economic Realities” Test
The FLSA test is applied by the California court, and it helps with determining the right worker classification.
Unlike the IRS common law prescriptions, the following factors aren’t considered when applying the FLSA test:
- The payment schedule and the way workers are paid
- The place where people work
- Whether the contractor is licensed by the local governing body or the state
- Whether there’s a written agreement about the worker’s status or not
What matters for this test is:
- Worker’s opportunity to make a profit or suffer from losses
- How involved the worker is in the employer’s core business aspects
- Relationship permanency
- How much the worker invests in working equipment
- The level of control workers/ employers have
- The way an employer’s business operates
The FLSA test is rarely used because it is quite different (and brings less advantage to workers) than the other means of worker protection. These standards are pretty vague when compared to the Dynamex decision, ABC Test, FEHA and other labor rules and regulations in California.
Assembly Bill 5 (AB 5) and the California ABC Test
Both the Borello test and the FLSA test proved to be inadequate in the Dynamex case, leaving too much space for interpretation.
California Wage Orders didn’t offer one precise independent contractor definition either — any person employed by the employer was considered an employee. Another earlier case, Martinez v. Combs, showed that there were 3 alternative ways to define what “employ” means:
- “to exercise control over the wages, hours or working conditions”
- “to suffer or permit to work”
- “to engage, thereby creating a common law employment relationship”
In the end, California Supreme Court decided in workers’ favor.
This case and all the confusion it produced pushed the officials to create a special state statute and protect the employees from being misclassified, so they can retain the benefits that don’t apply to the ICs.
California Assembly Bill 5 (AB 5) now protects the workers by putting the burden of proof on the hiring entities — the burden being correctly classifying the workers.
Additionally, AB 5 established the ABC Test — a three-pronged test that puts the workers in the “employee” category, unless the employer proves that:
- “The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such 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”
The employer needs to meet all three of these demands to prove that California wage orders don’t apply to independent contractors in question. According to the new standards, all of the workers are considered to be employees, unless the ABC test allows the employers to classify the workers as independent contractors.
But, there are certain jobs, services, and cases where the ABC Test cannot be applied.
AB5 Exemptions — 2020 update
In September 2020, CAL Governor Newsom signed the amendments to the AB 5 with immediate effect. These changes expanded the list of professions and services that require using the Borello test instead of the ABC test. Some of them include:
- Exempt occupations — many sorts of artists (musicians, visual artists, performance artists, etc), translators, CA licensed veterinarians, lawyers, architects, dentists, physicians, surgeons
- Professional Services exemptions — freelance writers and photographers, graphic designers, certain travel agents, securities broker-dealers, administrator of human resources, etc
- Business-to-business exemptions — bona fide B2B contracting meeting certain requirements
Here you can see the full exemption list.
Does California’s Fair Employment and Housing Act (FEHA) apply to Independent contractors?
FEHA prohibits employee discrimination based on:
- Race, nationality, religion, ancestry, age, genetic information
- Physical/ mental disability and medical condition
- Sex, gender, gender identity and expression, sexual orientation, marital status
- Military/ veteran status
This only applies to employees, but not to independent contractors.
“Persons providing services pursuant to a contract” are protected from unlawful harassment — and the definition of such persons goes in hand with a broad definition of independent contractors.
According to FEHA, “persons providing services pursuant to a contract”:
- Can decide upon the working place, time, and the way the work is performed
- Supply the work equipment on their own
- Does the work that requires certain skills not usually needed in the company (for example, IT firm hiring a freelance copywriter)
Still not sure about the worker’s status? Try Form SS-8
In some cases, it might be difficult to determine the correct employment status, even after completing the IRS 20 Factor Test. Employers who wish to avoid employee misclassification penalties and cannot do this on their own have two options:
- Contacting a law firm with experts well-versed in labor law and relying on their advice
- Filing the Form SS-8 to the IRS
Both companies and workers can file this form to the IRS, so the Service can determine the worker status.
Form SS-8 requests you describe the concrete situation in detail; you cannot describe the hypothetical situation, just the one that’s currently going on. This is tricky because filing the Form SS-8 still means that you need to file an income tax return on time.
You can see the official instructions here.
Penalties for employee misclassification in California
Employers who deliberately misclassified their employees as independent contractors to cut the costs are susceptible to various penalties from the IRS, California's Employment Development Department (EDD), the US Department of Labor and other institutions.
As mandated by California Code, Labor Code - LAB § 226.8:
- For each violation, the employer needs to pay a civil penalty ranging from $5,000 to $15,000
- In case the court or Labor and Workforce Development Agency determine that the employer’s behavior (misclassification) is repeating and has a pattern, they need to pay a civil penalty ranging from $10,000 to $25,000 for each violation
Here, “willful misclassification” means “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor”.
The IRS penalties are, however, much worse.
Employers who attempt to misclassify the employees as independent contractors can end up guilty of a felony or pay up to $100,000; in some cases, they can be sentenced to spend up to 5 years in prison.
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Disclaimer: This article has a purely informational nature and shouldn’t be used instead of legal advice.