Employee or Independent Contractor?

I first came upon this issue some years ago, when I produced an independent motion picture (Pterodactyl Woman From Beverly Hills – look it up). I had no experience with filmmaking, and had never run a business before, so we paid everyone – actors, artists, drivers, electricians, etc. – with 1099s, treating them as independent contractors. It seemed like a good idea, because there was minimal paperwork, and we didn’t pay the workers’ payroll taxes out of our limited budget… But the California Employment Development Department (EDD) disagreed. It turns out there are very specific rules defining who is an independent contractor and who is an employee. It was an expensive lesson.

What’s at Issue

When an employer treats a worker as an employee, the employer is required to pay 7.65% Social Security and Medicare taxes (in addition to the same amount that is deducted from the employee’s pay) as well as unemployment and other state payroll taxes. This not required for independent contractors, so there is a considerable cost difference.

When a worker is treated as an independent contractor, they are considered to be running their own business. This means they have to pay 15.3% for Social Security and Medicare taxes (both the employee’s and the employer’s portion) over and above their income tax. They do not pay unemployment tax, and can’t draw unemployment, because they are considered to be self-employed, and they probably pay more for their tax return, because it is now a more complex return.

What Are the Rules?

There is a lot of literature on the subject, and there has been a fair amount of room for interpretation, but California recently made it much more difficult to treat workers as independent contractors. Let’s look at the test that came out of a California Supreme Court ruling from 2018.

1.  Is the worker free from the control and direction of the employer in connection with performance of the work a) under the contract, and b) in fact?
2. Is the worker doing work that falls outside the usual business of the employer?
3. Does the worker ordinarily do independent work of the same nature as the work they are doing for the employer?
4. Is the worker actually in business for themselves?

The second question is the killer for many employers. I can be an independent contractor because I do taxes, which is not my clients’ business. But are you designing or selling the company’s product, providing the company’s services, shipping its products? Then you are an employee.

Here are some more thoughts:

• Are you paid by the hour or by the job?
• Can you quit and walk away, or are you obligated to complete the job?
• How long is the engagement?
• Are particular skills required for the job?
• Who provides the equipment used on the job?
• Are you a shareholder or have a financial interest in the employer?
• Do both parties actually believe it is a contract engagement, and not a regular job?

Penalties for Employers

There are federal and state penalties for misclassifying employees as independent contractors.

The IRS may require the employer to pay not only the employer’s portion of Social Security and Medicare taxes, but also the employee’s portion. There can also be a penalty of $5,000 per misclassified employee, and 1.5% of the employee’s income tax on the wages, as well as an additional 20% of payroll taxes that were not withheld.

There are state penalties as well. California, for example, requires the employer to pay unpaid income tax, unemployment insurance and disability insurance. Plus interest, of course. Penalties can range from $5,000 to $25,000 depending on whether the employer has a pattern of misclassifying employees.

What Can the Employee Do?

In my situation with the film production, one of the actors filed an unemployment claim, and the EDD noticed we had never filed payroll taxes. Even if this hadn’t happened, one or more of the workers could have reported the situation.

A misclassified employee can file IRS form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding”.  Google it. This will result in the IRS making an evaluation, and if the worker is determined to be a misclassified employee, the employer will be required to pay at least the employer portion of payroll taxes. The worker can also file a wage claim with the state.

In my experience, my clients who are misclassified employees are reluctant to report the employer for the violation. They are concerned about losing their jobs, of course, and reporting violations is a sure-fire way to piss off your boss. It’s a whole different situation after they leave the job, though. Meanwhile, we can only hope for more active enforcement by the IRS and the state.