The Supreme Court of California issued a ruling on April 30, 2018, which is likely to have a significant adverse impact on business owners. The primary issue in the matter of Dynamex Operations West Inc. v. The Superior Court of Los Angeles County was whether an entity that hires an individual worker can classify such a person as an employee or an independent contractor.

The ruling now creates a rebuttable presumption that such individuals are considered employees. The ruling, however, is limited to only California’s wage orders. As such, it would not currently apply in other contexts such as for workers’ compensation or for tax purposes. Therefore, an entity may be able to classify a worker differently depending on the context.

Wage Orders

In 1913, the Industrial Welfare Commission (IWC) was established in California in order to regulate wages, working hours, and working conditions. In 2004, the legislature of California defunded IWC, however, the wage orders established by IWC are still enforced to this day by the California Department of Industrial Relations, Division of Labor Standards Enforcement.

There are a total of 17 wage orders (not including the minimum wage order), 16 of which are broken down within various industries. Some examples include the Manufacturing Industry, Personal Services Industry, and Transportation Industry. The last wage order is for Miscellaneous Employees, which consists of individual workers who are not covered in any of the first 16 categories.

The primary purpose of a wage order is to regulate certain activities that are meant to protect the workers, such as hours of employment, overtime, wage levels, and the working conditions within each industry. For example, employers who hire truck drivers must provide their drivers a 30-minute break per every five hours of work unless the work period does not exceed six hours.

Economic Reasons For Classifying Workers As Independent Contractors

There are many reasons for classifying workers as independent contractors. Generally, it costs more for employers in aggregate to pay to employees than to independent contractors. Additionally, the hiring of an employee usually ends up triggering other expenses that otherwise would not have been made towards independent contractors. These expenses include employer-provided benefits, office space, and equipment.

In addition to the foundational expenses, there are also required payments and contributions employers must generally make on behalf of their employees. These include the employer’s share of the employee’s Social Security and Medicare taxes (“self-employment taxes”), the state unemployment insurance, and workers’ compensation insurance. While the latter two payments may vary from state to state, the self-employment tax is a federally fixed amount which totals 7.65% of the employee’s compensation whose annual taxable income generally does not exceed $128,400.

Practical Reasons For Classifying Workers As Independent Contractors

One obvious reason for such a classification is that the employer generally has more control over the staff or the ability to determine whether to have any staff in the first place. Employers generally have greater flexibility in hiring and firing independent contractors than employees. Such a leeway also reduces the likelihood of a business owner’s potential exposure to a lawsuit in response to a firing or a layoff.

Employees also have a wide array of protections under both federal and state law. These protections may range from the right to receive minimum wage, taking sick leave, having the right to form a union, and promulgating a lawsuit based on wrongful termination. In addition, an employer may suffer the additional depletion of resources that generally come with lawsuits (in the form of time, money and stress), if the employer potentially faces civil liability under the theory of vicariously liability for an unlawful act committed by an employee.

The Road To The Dynamex Ruling

The California courts have wrestled with the distinction between employees and independent contractors for some time now. The distinction has come up in various contexts. For example, in the context of workers’ compensation, the Court carved out a six-factor test in S.G. Borello & Sons, Inc. v. Department of Industrial Relations (1989).

The Borello factors consisted of the following: (1) the level of control of details by the employer on the worker’s activities; (2) the worker’s investment in the materials required for the task; (3) the worker’s opportunity for profit or loss depending on his managerial skills; (4) the level of skill required for the particular service; (5) the degree of permanence of the working relationship; and (6) whether the service is an integral part of the employer’s business.

In Martinez v. Combs (2010), the Court interpreted IWC’s definition of “employ” in the context of wage orders. The Court found three alternate definitions, any of which may deem an individual worker an employee.

1. To Exercise Control over the Wages, Hours or Working Conditions;
2. To Suffer or Permit to Work; or
3. To Engage, thereby Creating a Common Law Employment Relationship

The first definition asks whether the hiring entity generally has the power to set and negotiate the wages, hours, or working conditions (e.g. meal and rest breaks) of the individual worker. The third definition characterizes “to employ” in a plain context where a basic common law employment relationship is created. In Dynamex, the central issue became the interpretation of the second definition, the “to suffer or permit to work” standard.

The Interpretation Of The Suffer Or Permit To Work Standard

In Dynamex, the court held that there is a presumption that the worker is an employee. To overcome the presumption, the employer must establish all three factors as applied in the “ABC” test. This is a critical point since if any of the three factors are not met, the employer will not overcome the presumption. Therefore, the particular worker will be deemed an employee if the burden cannot be rebutted in its entirety.

The ABC test consists of the following three factors: (1) the worker is “free from control” and direction over the performance of the work, both under the contract and in fact; (2) the work provided is “outside the usual course of business” for which the work is performed; and (3) the worker is customarily engaged in an “independently” established trade, occupation or business.

“Free From Control”

The Court used cases from Vermont and Washington to provide guidance on the control factor. In the Vermont case, the court held that knitters who worked at their own pace from their own home at their own time on the days they wanted to work were nevertheless under the control of the employer because the employer dictated the pattern and style of knitting.

In the Washington case, a truck driver hired by an entity was not deemed free from control because the entity required for the truck to be kept clean; for the driver to obtain the entity’s permission before taking passengers; for the driver to travel to the entity’s dispatch center in order to obtain assignments that were not scheduled in advance; and the entity had the ability to terminate the driver’s services for tardiness or for other policy violations.

“Outside The Usual Course Of Business”

The Court used cases from Maine, New Hampshire, and Connecticut to provide guidance on the outside course of business factor. In the Maine case, the court held that the harvesting of timber by workers was within the ordinary course of a timber managing entity, even though the entity was only involved in the purchasing and harvesting of trees.

In the New Hampshire case, the court held that because a resort advertised and regularly provided entertainment, the performance of live entertainers was within the course of the resort’s business. In the Connecticut case, the court held that an art instructor’s services were within the ordinary course of the museum’s business because the museum offered the classes regularly and continuously, determined the class hours, registration fees, instructor’s names, assembled brochures which announced the classes, and discounted the cost on classes for museum members.

“Independently Established Trade Or Business”

The Court used a case from Virginia to provide guidance on the independence factor. In the Virginia case, the entity provided siding installers their own tools, but there was no evidence to suggest that the side installers had their own and distinct business cards, licenses, business addresses, phones, or that they received any income from any other party besides the hiring entity.

The Court stated that by the mere fact that an entity permits a worker to engage in a similar activity for other businesses is not sufficient to meet the independence factor. Thus, the worker must actually have an independent business or occupation in order to meet this factor.

The Implications Of The Dynamex Ruling

The Court’s reasoning behind the decision arguably comes down to the protection of workers at the expense of business owners. The court reasoned that the term “independent contractor” generally refers to someone who “independently has made the decision to go into business for himself or herself.” This shows that California is headed towards the literal interpretation of the word independent as it deals with the classification of independent contractors. However, such an approach may also adversely impact the workers themselves, since business owners are likely to be less hesitant to contract with a particular worker on a project-basis unless such an engagement will be an absolute necessity for the business owner.

The primary concern of the Court is that if the worker is unilaterally determined by the hiring entity to be an independent contractor, then “there is substantial risk that the hiring business is attempting to evade the demands of an applicable wage order through misclassification.” The Court added that if an entity is able “to obtain the economic advantages that a wage order imposes” by the virtue of the classification of the independent contractor status, such an act “unquestionably violates the purposes of the wage order.”

This ruling is likely going to open the floodgates to litigation in many contexts, not only as to those issues related to wage orders. There is expected to be a wave of litigation since the court set an “exceptionally broad suffer or permit to work standard.” The ruling will also likely open the door to its potential application in other contexts, such as workers’ compensation insurance. It may even lead to its adoption on a federal level, which may also affect the classifications for federal tax purposes or other classifications on the federal level.

Finally, business owners and other entities may want to consider reclassifying some, if not all of their workers, as a result of this ruling. The penalties for the misclassification can be hefty. They can include potential liability for meal and rest breaks, minimum wage, overtime, waiting time penalties, and other penalties. California also imposes civil penalties, which can range from $5,000 to $25,000 for each violation that is found to be the result of a willful misclassification or willful aid in misclassification of workers as independent contractors.

Have a tax or business question? Contact Haik Chilingaryan.