How does a startup determine whether a worker is classified as an employee or an independent contractor?

Determining whether a worker is classified as an employee or an independent contractor isn’t based on the type of contract you’ve signed with the worker. Instead, the classification will depend on the applicable law (i.e. jurisdiction) and the subject matter.

Individual workers are presumed to be employees, unless the company meets its burden at establishing that the individual falls within a non-employee category, such as an independent contractor. The test a company must use to establish that a worker is an independent contractor can vary depending on the jurisdiction and subject matter at issue. For example, the standard to classifying a worker as an independent contractor for tax purposes may vary from the standard used for unemployment insurance or minimum wage/overtime purposes. Similarly, within a specific subject matter, one state’s standard may vary from another state’s standard, and the state’s standard may vary from the federal standard. If you are thinking that this way of legally addressing classification is unnecessarily complicated, you are correct (but rules are rules).

With that said, in passing AB 5, California as a default uses the “ABC” test to determine whether a worker is properly classified as an independent contractor for basic wage-and-hour and unemployment insurance purposes. This is one of the, if not the, strictest independent contractor standards in the United States. Under the “ABC” test, an individual worker is an employee unless the hiring entity demonstrates that all of the following factors are satisfied:

• Factor A: The person 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.
• Factor B: The person performs work that is outside the usual course of the hiring entity’s business.
• Factor C: The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Factor A anticipates that the hiring entity will not, under contract or in practice, exercise control typically seen exercised over employees. In other words, apart from generally requesting the type of deliverables desired and setting general deadlines, the hiring entity should not provide equipment required to be used by the worker and/or set the worker’s times and length of work, the method of producing the deliverables, ability or inability to work for other entities, and/or location of the work. “[D]epending on the nature of the work and overall arrangement between the parties, a business need not control the precise manner or details of the work in order to be found to have maintained the necessary control that an employer ordinarily possesses over its employees, but does not possess over a genuine independent contractor.”Dynamex Operations W. v. Superior Court, 4 Cal. 5th 903, 958 (2018).

Factor B tends to be the most difficult to meet. It requires that the nature of the work the worker provides be outside the usual course of the hiring entity’s business. The term “usual course of business” is not statutorily defined. Instead, the inquiry is a general one to determine if the services can be “reasonably viewed as providing services to the business in a role comparable to that of an employee, rather than in a role comparable to that of a traditional independent contractor.” Dynamex, 4 Cal. 5th at 959. In practice, the usual course of business is not just a single business practice the hiring entity operates; it instead tends to include any business venture, even if not the biggest or one of the biggest, that can be said to be part of the hiring entity’s business model (i.e., how the hiring entity makes its money). The California Supreme Court used the following basic examples to show how stark the differences between the hiring entity’s usual course of business and the worker’s services are expected to be:  

[O]n the one hand, when a retail store hires an outside plumber to repair a leak in a bathroom on its premises or hires an outside electrician to install a new electrical line, the services of the plumber or electrician are not part of the store's usual course of business and the store would not reasonably be seen as having suffered or permitted the plumber or electrician to provide services to it as an employee. On the other hand, when a clothing manufacturing company hires work-at-home seamstresses to make dresses from cloth and patterns supplied by the company that will thereafter be sold by the company, or when a bakery hires cake decorators to work on a regular basis on its custom-designed cakes, the workers are part of the hiring entity's usual business operation and the hiring business can reasonably be viewed as having suffered or permitted the workers to provide services as employees. In the latter settings, the workers' role within the hiring entity's usual business operations is more like that of an employee than that of an independent contractor.

Dynamex, 4 Cal. 5th at 959 (internal citations omitted).

Factor C requires the hiring entity to show the worker is engaged in an independently established business in the same nature of the services the worker provides to the hiring entity. “Such an individual generally takes the usual steps to establish and promote his or her independent business—for example, through incorporation, licensure, advertisements, routine offerings to provide the services of the independent business to the public or to a number of potential customers, and the like.” Dynamex, 4 Cal. 5th at 962. Even if the individual has taken these steps to establish an independent trade, if the individual’s services to the hiring entity are not in the nature of those the individual conducts as part of this independent trade or business (i.e., the individual provides translation services to the hiring entity but his or her independent trade is plumbing), the employer has likely failed to meet its burden under Factor C.

The ABC test tends to conflict with the emerging tech-based economy arising from recent technological advancements and has accordingly frustrated many modern companies. Indeed, advocates of the ABC test often see the economy as if it is still run through the formality of a 1960s factory, where employees must clock in at 9 am, take their meal breaks at noon, clock out at 5 pm (Monday through Friday), and retire from the same job forty years later. The Supreme Court’s oversimplified use of a basic retail store, manufacturing company, and bakery businesses in distinguishing their “usual course of business” from that of an electrician and plumber is an example of this outdated view of the economy. The modern tech-based economy no longer has such formal boundaries, at least not to the same extent. A worker in today’s economy can drive customers in the morning, grab groceries for customers in the afternoon, and do ad-hoc home repairs for customers in the evening, all in one day’s work and in the times and conditions largely determined by the worker. Businesses in turn are increasingly no longer specializing in specific nature of business (i.e., driving, delivery, home-repair, etc.) but, like the old job boards, are merely establishing software platforms through which independent workers in the community can connect with potential customers they wish to service in whatever way they wish to serve them. One worker can do all the foregoing activities, from driving customers to doing ad-hoc home-repair work, through a single software application, and could decide when, if at all, to do it. Yet, the ABC test’s outdated view of the economy can prevent it from recognizing that a company is not actually in the business of doing those activities just because it provides a platform for customer and worker to meet, or that a worker is engaged in an independently established trade, even if the worker’s trade is to do multiple different activities in one workday or workweek.

The ABC test has exceptions to it (borne in part from independent contractors themselves complaining to the California legislature about the rigidity of the ABC test). For example, the ABC test does not apply to certain app-based drivers; a licensed physician and surgeon, dentist, podiatrist, psychologist, veterinarian, lawyer, architect, engineer, private investigator, or accountant; certain securities broker-dealer or investment adviser or their agents and representatives; and, under certain circumstances, photographers, photojournalists, freelance writers, editors, cartoonists, and marketing, human resources, and graphic design workers. 

Where an exception to the ABC test applies, the test established by S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations, 48 Cal.3d 341 (1989) is often used (“Borello test”). The Borello test is more flexible than the ABC test. It relies upon multiple factors, none of which are dispositive on their own, in determining whether a worker is an independent contractor. The primary factor considered is whether the potential employer has all necessary control over the manner and means of accomplishing the result desired, although such control need not be direct, actually exercised or detailed. This control factor, is considered along with other factors, which include:

1. Whether the worker performing services holds themselves out as being engaged in an occupation or business distinct from that of the employer;
2. Whether the work is a regular or integral part of the employer’s business;
3. Whether the employer or the worker supplies the instrumentalities, tools, and the place for the worker doing the work;
4. Whether the worker has invested in the business, such as in the equipment or materials required by their task;
5. Whether the service provided requires a special skill;
6. The kind of occupation, and whether the work is usually done under the direction of the employer or by a specialist without supervision;
7. The worker’s opportunity for profit or loss depending on their managerial skill;
8. The length of time for which the services are to be performed;
9. The degree of permanence of the working relationship;
10. The method of payment, whether by time or by the job;
11. Whether the worker hires their own employees;
12. Whether the employer has a right to fire at will or whether a termination gives rise to an action for breach of contract; and
13. Whether or not the worker and the potential employer believe they are creating an employer-employee relationship (this may be relevant, but the legal determination of employment status is not based on whether the parties believe they have an employer-employee relationship).

On the tax front, the IRS and other government agencies have developed several “multi-factor tests” for employers and the agencies to use to determine whether a worker should be classified as an employee or an independent contractor. To add to the complexity, no single factor in the IRS’ tests is determinative of a worker’s status.

Here are the factors in the IRS’s 20-factor “right-to-control” test:

• Level of instruction given to the individual
• Amount of training provided before the individual can perform the task
• Degree of business integration
• Extent of personal services
• Control of assistants (Is the individual supervising employees?)
• Continuity of relationship (What is the length of the job? Is it regularly renewed?)
• Flexibility of schedule
• Demands for full-time work
• Need for on-site services
• Sequence of work
• Requirements for reports
• Method of payment
• Payment of business or travel expenses
• Provision of tools and materials
• Investment in facilities (Is the facility being modified so the individual can work?)
• Realization of profit or loss
• Work for multiple companies
• Availability to public
• Control over discharge
• Right of termination

The IRS has since condensed these 20 control factors into the following three main factors to help determine the classification of an employee:

• Behavioral Control: This factor considers whether the employer has a right to direct or control how the worker does the work. Notice the wording: it is your “right to control” that determines whether a worker is an employee or an independent contractor, not whether you actually control your worker.
• Financial Control: Considers whether the employer has the right to control the economic aspects of the worker’s job—for example, the degree to which the worker is free to make a livelihood elsewhere.
• Relationship Status: Considers how the company and the worker perceive their relationship to each other. This last factor contemplates whether there is a written contract, whether the worker’s services are a key activity of the company, and whether the worker receives benefits.

The above overview is not exhaustive. Some details have been omitted, including as to the application of the noted standards (including the exceptions), and other subject matters may use different standards altogether. Please feel free to contact WSGR to obtain more information about proper contractor classifications.

If you choose to hire independent contractors instead of employees, the practices outlined below will help you continue to legitimately classify workers as independent contractors:

• Don’t supervise the independent contractor or his or her assistants. The independent contractor should perform services without—or with minimal—direction.
• Don’t let the independent contractor work at your offices unless the nature of the services requires it.
• Don’t give employee handbooks or policy manuals to the independent contractor.
• Don’t establish working hours for the independent contractor.
• Don’t give independent contractors so much work or such short deadlines that they are effectively working full-time for you.
• Don’t provide ongoing instructions or training.
• Don’t provide the independent contractor with equipment or materials unless absolutely necessary.
• Don’t allow the independent contractor to represent him or herself as an employee of your company (for example, by using the company’s business cards or stationery).
• Don’t give an independent contractor a title within your company.
• Don’t reimburse the independent contractor’s travel or other business expenses directly (these should be invoiced by the contractor).
• Don’t give an independent contractor employment benefits.
• Don’t require an independent contractor to give you formal written reports.
• Don’t invite an independent contractor to employee meetings or functions.
• Don’t refer to an independent contractor as an employee or to your company as the independent contractor’s employer.
• Don’t pay independent contractors on a regular basis as you would pay employees. Require independent contractors to submit invoices, and pay them as you would pay other outside vendors.
• Do follow the terms of your independent contractor agreement, including its termination provisions.
• Don’t give the independent contractor new work after the original project is completed without signing a new agreement.
• Don’t permit independent contractors to provide services in the usual course of your business.
• Confirm that independent contractors have an independently established trade in the same nature of the services provided to you.

After considering the factors above, if you decide that your workers are employees instead of independent contractors, you must make sure that payroll taxes are being withheld and sent to the applicable taxing authorities and that you are in compliance with all applicable employment laws. It may be helpful to engage a payroll company to help your company manage its payroll and employee benefits. Competition is making these services less expensive for start-ups to use. Payroll companies or your attorneys can provide you with company policies to ensure that your employees are being hired and treated appropriately and in accordance with the laws.

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