Question: Recently some of my employees have asked to be reclassified as independent contractors in 2018 in order to claim the 20% pass-through income deduction under the new GOP tax plan. I read that employers can face substantial liability if they misclassify their employees as independent contractors. Does the fact that my employees are asking to be reclassified eliminate my risk?
Answer: Employers have always had incentives to classify workers as independent contractors, but now employees may have some incentives too. Specifically, under the new GOP tax plan that took effect January 1, 2018, individuals with pass-through income, such as sole proprietors and potentially independent contractors, will be able to deduct 20% of their revenue from their taxable income. While the details of this new provision are not finalized, individuals who have traditionally been classified as employees may be looking for ways to take advantage of this potentially significant deduction by asking to give up their employee status and become independent contractors.
This may seem like a welcome turn of events for businesses since they are not required to withhold and pay income taxes, Social Security taxes, Medicare taxes, and unemployment taxes for independent contractors, and many wage and hour laws do not apply to independent contractors. In reality, however, it is a trap for the unwary because the correct classification for a worker is not based on the label that the parties place on the relationship, but on the presence, or absence, of a combination of factors.
While different government agencies, including the Employment Development Department (“EDD”) and Internal Revenue Service (“IRS”), use slightly different factors to determine whether an independent contractor relationship exists, the most important factor is whether the principal has the right to control the manner and means of the person’s work. When the principal has the “right of control,” the worker is an employee even if the principal never actually exercises the control, and even if the parties agree to the independent contractor status. However, if the principal does not have the right of control, the worker will generally be an independent contractor.
While this right of control test seems simple, it is often difficult to determine when the right of control exists. Recognizing this, the EDD published a worksheet (DE 38), available at http://www.edd.ca.gov/pdf_pub_ctr/de38.pdf, which addresses the basic control test and other secondary factors through a series of 13 questions and various practical examples. Significantly, the worksheet clarifies that if the worker previously performed the same or similar services for the employer as an employee, it is an indication that the individual is still an employee.
The risks associated with misclassifying employees as independent contractors are significant. While workers may not challenge their classification as an independent contractor when they are still performing services, once the relationship ends, the worker may argue that he or she was an employee, misclassified as an independent contractor, to collect unemployment benefits. In addition, even if the worker never challenges the classification, the EDD, Franchise Tax Board, IRS and other agencies may audit the employer, and if it is found that workers were misclassified as independent contractors, these agencies may pursue the employer for significant back taxes and penalties.
While it may be tempting to say “yes” to an employee who asks to be reclassified, the risks associated with misclassifying employees far outweigh the benefits.