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Employee Misclassification in California: MOU with DOL

02.08.2013

Author

Jeff Aleixo

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New MOU with DOL and Legislative Update

Employee misclassification has been a hot issue at both the federal and state levels, and the heat is not letting up anytime soon. In a climate of economic uncertainty, the idea that agencies can regain some of the estimated billions of dollars in tax revenue lost annually as a result of employee misclassification holds great appeal.

While roughly half of the states have taken action on this issue, one of the most active states on employee misclassification is California. Given the state’s significant solvency issues, it should come as no surprise that they are aggressively pursuing lost revenues. This past week, California was in the news again as a result of a new development in their employee misclassification efforts, so it seems an opportune time to do a status update.

On February 9th, the U.S. Department of Labor’s Wage and Hour Division entered into a memorandum of understanding (MOU) with California’s Secretary of Labor. California is the 12thstate to enter into such a partnership with the DOL’s Wage and Hour Division. Colorado, Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, Utah, and Washington have previously signed similar agreements.

These MOUs came about as part of the DOL’s Misclassification Initiative launched under Vice President Biden’s Middle Class Task Force with the goal of preventing, detecting, and remedying employee misclassification.

Employers are not required to complete Form I-9 for independent contractors. However, if the employer misclassifies an employee as an independent contractor, the employer may be held responsible and liable for failing to comply with Form I-9 employment eligibility verification and compliance.

There is a growing trend in formal information-sharing programs between government agencies in order to decrease the potential for any questionable employer actions. These include agreements between the Department of Labor and the Internal Revenue Service via Memorandums of Understanding (MOU), the IRS Federal Intergovernmental Partnering Program (FIPP), and the IRS/State Information Sharing Program.

Increased Information-Sharing Between Agencies

A 2011 report from California’s Employment Development Department (EDD) confirms the department’s current partnerships with federal, state, and local law enforcement agencies.

This latest MOU is part of a continuing trend to go hard on employee misclassification in the state of California. In October of 2011, California Governor Jerry Brown approved SB 459, which became effective on January 1, 2012.

The text of this bill cites data from a 2008 EDD report stating that the number of misclassified workers increased over 50% in the period between 2005-2007, a period during which the EDD recovered nearly $112 million in payroll tax assessments and over $40 million in employment tax fraud assessments.

New Sections of SB 459

SB 459 added new Sections 226.8 and 2753 to the California Labor Code. These new Sections prohibit employers from:

  • Willfully misclassifying an individual as an independent contractor (IC), where willful misclassification means avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.
  • Charging misclassified ICs for expenses that could not be charged to employees. For example: charging for space, equipment rental, goods, materials, maintenance, fines, etc.
  • Deducting from the pay of misclassified ICs where the deductions would be prohibited for employees.

Significantly, the new legislation also prohibits individuals from knowingly advising employers to treat an individual as an IC, despite the individual being found not to be an IC. Such individuals, such as financial, accounting, and human resources professionals would be jointly and severally liable with the employer for fines and penalties.

Employees advising their employers and attorneys providing legal advice to their clients are exempt.

Penalties for Violating The New Legislation

  • $5-15K per violation
  • $10-25K per violation if a pattern or practice of violations is found.*
  • Violators are also required to post a notice prominently on the company’s website, or in an area accessible to all employees and to the general public, stating that they have violated the law. This must be posted for a period of one year.
  • Contractors licensed under CA’s License Law will be subject to disciplinary action up to and including debarment by the Contractor’s State License Board.

*Note that it’s unclear how the concept of “pattern or practice” will translate in application. For example, if 30 workers in a similar position are deemed misclassified workers, will that count as a single instance of a violation, or 30 instances of a violation? If the latter, the fine may be large enough to put some employers out of business.

Costly fines can be avoided by conducting regular audits and finding possible irregularities on time. You can find detailed tips on how to ensure compliance in this comprehensive guide.

Enforcement for The New Legislation

The new laws will be enforced via Section 98 proceeding with the DOL Standard Enforcement (DLSE) and also likely via lawsuit and class action lawsuit brought by citizens using the Private Attorneys General Act (PAGA) to pursue civil penalties on behalf of the Labor and Workforce Development Agency. Civil suits brought by the Labor Commissioner are somewhat less likely.

A 2011 EDD report identifies a total of 430 cases under investigation for tax, unemployment insurance, and/or disability insurance fraud during calendar year 2010, and 58 criminal prosecutions completed during the same period. After one year into the new legislation, hopefully with the forthcoming report for calendar year 2012, it will be possible to get some insight into how SB 459 has impacted enforcement efforts and penalties for employers.

Payroll tax audits in California increased from 768 to 1,258 between 2009 and 2010, with the total dollar amount of payroll tax assessments jumping from $45 million in 2009 to $168 million in 2010.

Other Things to Know about SB 459

  • Any penalties against an employer will become the responsibility of a successor owner or business entity if one or more of the same principals or officers is engaged in the same or a similar business, so in case of an acquisition it is advisable to pay increased attention to any workers who are or have been classified as independent contractors.
  • Unfortunately, SB 459 provides no definition of employee or independent contractor, which does little to resolve the ambiguity around the distinction. While clear in many cases, some parts do not clearly fit one box or other, and continue to confound employers and subject them to risk.

Keeping an Eye on Legislation

While this legislation should not threaten employers who have a legitimate reason for which they have classified workers as independent contractors, as it is limited to willful misclassification, it should still ring an alarm for all employers that increased attention will be given to this issue. Employers may be in violation of any number of state and federal laws regarding employee classification regardless of intent or reasonable belief.

The best plan of action to limit exposure on worker classification is to consult with a professional and consistently apply the same criteria used by the agencies and courts in determining employee classification. In addition to this, employers in California need to remain compliant with different I-9 requirements in order to avoid severe fines for noncompliance.

California uses a modified form of the general common law definition of “employee”, which is also known as the “economic realities” standard.  The California Department of Industrial Relations, Division of Labor Standards Enforcement website lists 11 factors which constitute the “economic realities” standard. The IRS also has a similar 20 Factor Test. Employers may want to be familiar with both and use them as guides in determining their employer classifications, while keeping in mind no single factor listed is absolutely determinative, and each case is decided on an individual basis.

Use this comprehensive guide on employment eligibility verification to learn how to stay compliant and informed at all times while reducing the risk of fines and criminal penalties.

Update on CA Employee Classification

Proper classification of employees still remains an issue for employers and increases the risk of costly litigation. Misclassifying California employees as contractors can have harsh consequences, including penalties of $5,000 to $15,000 for each willful violation. Additional exposure can arise when misclassified workers, who would otherwise be entitled to employee benefits, have not received those benefits.

State agencies continue with enforcement efforts and the California Labor and Workforce Development Agency’s agreement to jointly investigate independent contractor misclassification with the IRS, reflects both agencies’ desire to increase enforcement. It remains to be seen whether the Trump Administration will redirect federal enforcement priorities away from independent contractor issues or decrease the applicable standards. Either way, there is no indication that state governments will stop challenging independent contractor classifications. Therefore, employers need to closely follow new legal developments, scrutinize existing relationships with independent contractors, and be ready to address potential exposure.

See how you can rely on electronic solution to save time, reduce the potential for errors leading to penalties, and stay in compliance with the necessary legislation.
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Editor’s Note: This post has been updated for accuracy and comprehensiveness.

Disclaimer: This article is general in nature and is not intended to replace the guidance of an employment tax expert and/or legal professional with regards to an appropriate course of action in your particular circumstances. Please consult with a professional for appropriate advice in your case. Pursuant to IRS “Circular 230” rules, any information included herewithin is not intended or written to be used for the purpose of avoiding penalties under the federal Internal Revenue Code.