“Independent contractor misclassification” is a phrase that is misunderstood, misapplied, and misused – constantly. Why? It is a phrase used to cover an array of disparate situations.  It covers companies that engage in indefensible and inexcusable conduct, such as when a construction worker, custodian, or restaurant worker is paid in cash under the table or when an administrative assistant is wrongfully paid on a 1099 basis.  But the same term is also applied in a few states to de-legitimize IC relationships that are legitimate and lawful in almost all other states and by the federal government.  When used in that context, such as where ICs have some of their own customers but also choose to supplement their income by using a referral company that sends them additional customers seeking the types of services they provide, the phrase “IC misclassification” can justly be regarded as legally unjust to both independent contractors and businesses.  And there are at least three other types of so-called IC misclassification somewhere in between.  Thus, the phrase is best understood in the context of a spectrum, with five degrees of independent contractor misclassification: unpardonable; uninformed; unprepared; unintentional; and unjust. [1]

Before describing each type of IC misclassification, we will discuss a common situation involving two similar referral companies: one that refers benefits consultants and the other that refers financial analysts to their customers that need those types of talented service providers to better operate their businesses.  The referral companies specialize in the benefits and financial services areas and have a network of hundreds of consultants and analysts that, when available, provide services to the referral company’s clients through and in the name of the referral company.  Each of the referral companies have dotted their i’s and crossed their t’s to avoid retaining or exercising any direction or control over the manner and means by which the services are performed. The consultants and analysts are all in business for themselves as sole proprietorships or LLCs offering their services to multiple customers and other referral companies, or they have the right to do so, but wish to supplement their business by rendering services to the referral companies’ clients.

Each of these referral companies and consultants would likely satisfy the test for IC status under the federal Fair Labor Standards Act (FLSA) and the Internal Revenue Code, as well as most state laws governing ICs, and would be found to be operating in a legitimate and lawful manner. Yet, they are unlikely to pass a few states’ overly restrictive tests for IC status, such as the one that was recently been enacted in California and the test for IC status in Massachusetts. In those two states, those referral companies might be found to have engaged in “independent contractor misclassification” simply by referring those consultants, who are in business for themselves, to their corporate customers.

Following the recent passage of a law in California that narrowly defines who is and who is not an independent contractor in most industries, many legislators in other states and in Congress have begun to propose an array of laws in an effort to curtail IC misclassification.  Legislative bodies should not plunge into this area of the law, however, without first taking into account whether such laws would prohibit legitimate types of IC relationships, whether they will simplify or make even more complex the laws governing ICs, and whether there are more effective alternatives than the type of legislative change that was recently enacted in California.  Those considerations can best be addressed by understanding the five degrees of IC misclassification.

Defining the five degrees of IC misclassification

The five degrees of IC misclassification can be defined as follows:

Unpardonable – when a business knows it has no reasonable basis for classifying workers as ICs but does so anyway (this is indefensible wage theft).

Uninformed – when a business has no reasonable basis for classifying workers as ICs but has not bothered to learn the legal requirements.

Unprepared – when a business understands generally the applicable tests for IC status, but it is unclear whether or not particular workers can be classified as ICs under federal and most state laws, yet the business has chosen to classify the workers as ICs without taking meaningful steps to enhance its level of IC compliance.

Unintentional – when a business tries to understand and satisfy the applicable tests for IC status but, despite good faith efforts, the workers are found to have been misclassified as ICs under federal and most state laws solely because the business may not have dotted all its i’s and crossed all its t’s in structuring, documenting, and implementing its IC relationships.

Unjust – when the workers are properly classified under federal and most state laws but not under one of the few overly restrictive state law tests for IC status or where a state law test is dependent on a single factor that is not clearly defined.

A recent example of unjust IC misclassification

Recently, California enacted new legislation, Assembly Bill 5 (A.B. 5), which was signed into law on September 18, 2019 and becomes effective January 1, 2020.  That law codifies the California Supreme Court’s decision in Dynamex Operations West v. Superior Court, which was issued on April 30, 2018. As we noted in a blog post that day, Dynamex created a so-called ABC test similar to the labor standards test for IC status in Massachusetts.  This type of ABC test requires companies to satisfy each of three strict criteria in order to establish independent contractor status, dramatically changing decades of settled law in California.

Prior to Dynamex, IC status was determined in that state by applying a multi-part test issued almost 30 years earlier by the California Supreme Court in the Borello case, which weighed and balanced a number of factors.  This is similar in nature to the test used under the federal FLSA and most state lawsEssentially, Dynamex instantly turned tens of thousands of California businesses and independent contractors in scores of industries that were operating for years in compliance with settled law into companies that, overnight, might well be operating unlawfully.

The new California A.B. 5 test for IC status and the long-established Massachusetts labor standards test for IC status differ substantially from all other states’ ABC tests.  In every other state that has an ABC test, the “B” prong has two alternatives:  the work performed must either be “outside the usual course of the business for which such service is performed or . . . performed outside of all the places of business of the enterprise for which such service is performed.” (Emphasis added.)  However, the “B” prong of the Massachusetts labor standards test and the California test under Dynamex requires that a company prove that the contractor’s work is outside the usual course of business in order to establish IC status.  In other words, for some unexplained reason, the alternative way by which companies can satisfy prong “B” in the ABC tests in all other states was dropped. [2]

Thus, in the earlier illustrations, the benefits consultants and financial analysts would remain ICs if they performed their services from their own home office or rendered their services electronically or in an online manner in all states other than Massachusetts and California. Under the new A.B. 5 statute, though, they would now likely become the referral company’s employees, whether they like it or not.  They would not be lawfully able to maintain their own independent businesses and remain independent contractors if they used those referrals to provide consulting and analyst services in the name of the referral companies.

A.B. 5 began as a legislative effort to codify the Dynamex decision into statutory law.  The legislature, however, soon recognized that the multi-factor Borello test was a far more fair and reasonable test than the stringent Dynamex standard and would have turned legitimate IC relationships into violations of the law.  The legislature therefore carved out over fifty industries from the Dynamex ABC test.  For the businesses and independent contractors in those fifty industries, the legislation now provides that the Borello test should remain the standard for independent contractor status. [3]

It is likely that in the next legislative session in California, an equal or greater number of industries will also be granted exemptions from the Dynamex ABC test and instead will be governed by the multi-factor Borello standard. But, until that time, many companies (including thousands of small- and medium-size businesses) that had structured their businesses in a manner that complied with Borello – including some that have been found by the courts to have lawfully classified their contractors – have no other choice but to hope for an exemption or consider shutting down their operations in lieu of being subjected to business-ending damages and personal liability for violation of A.B. 5.

While many additional California businesses will seek an exemption in 2020 from the ABC test that is now codified in A.B. 5, those industries that may eventually succeed should not assume that they will satisfy the exemption for their industries.  Rather, they may not know for years if they qualify for a particular industry exemption.  In a reasoned article entitled “Complexity Is the Cost of California’s Worker Classification Law,” which appeared in Law360 on October 24, 2019, Professor Edward Zelinsky of Cardozo Law School concluded that many of the exemptions in A.B. 5 are “opaque” and “ambiguous.”

For example, Professor Zelinsky notes that the exemption for individuals performing marketing services only applies if they engage in “work [that] is original and creative in character and result of which depends primarily on the invention, imagination, or talent of the [individual].” As note in the Zelinsky article, at least until a body of case law develops over a number of years, “it will often be unclear whether marketing activity is creative enough or imaginative enough to qualify the marketer as an independent contractor for purposes of this A.B. 5 exemption.”  Professor Zelinsky also examined a few other equally “opaque” and “ambiguous” exemptions, including the professional services exemption where a business must show that the professional service provider “customarily and regularly exercises discretion and independent judgment in the performance of the services.”  He commented that “at least for the short run, and perhaps for the long run, this open-ended standard will entail substantial interpretative ambiguity, leaving the boundaries of the exemption unclear.”

As Professor Zelinsky concluded: “A.B. 5 does not make the law of employee status clearer, simpler or more uniform.  Indeed, A.B. 5 makes the law more complex and less uniform than it was before.”

There are many other deficiencies of A.B. 5 besides those identified by Professor Zelinsky.  For example, the new law covers some professionally licensed therapists, such as licensed psychologists, but overlooks others such as licensed clinical social workers, licensed marriage and family therapists, licensed professional clinical counselors, and licensed educational psychologists.

Another key deficiency of the A.B. 5 exemptions is that each requires that all of up to 10 or 12 specified conditions be met.  For example, referral agencies must meet each and every one of ten specified conditions to qualify for the Borello test, but cannot qualify if the referred professional provides services in the name of the referral company.  Similarly, business-to-business contractors must meet each and every one of twelve specified conditions to qualify for an exemption.  Few business-to-business contractors and few referral agencies, however, can realistically satisfy every single one of the 10 or 12 respective conditions for an exemption from the ABC test.  Thus, the exemptions are essentially unrealistic for most companies in those types of businesses.  The California legislature could have followed the lead of other states that have set forth an equally comprehensive list of factors for IC status, but provided that it is not necessary to meet each and every element to establish IC status. [4]

By creating such rigid exemptions, the Legislature overlooked the fact that many businesses in a particular industry may operate differently than others.  The Legislature also overlooked the fact that while some of the specified conditions are essential in determining whether an IC or employment relationship exists, such as whether the service provider is free from direction and control in connection with the performance of the services, some of the specified factors are marginal at best.  For example, a business-to-business service provider fails to qualify for the Borello test under A.B. 5 even if it meets 11 of the 12 specified factors but cannot meet the 12th factor that requires the service provider to render services “directly to the contracting business rather than to customers of the contracting business.”  Likewise a service provider that renders services to clients through a referral agency would not qualify for the Borello test even if it meets 9 of the 10 factors but cannot establish the 10th factor requiring that the rates it sets for services rendered be “without [any] deduction by the referral agency.”

Thus, A.B. 5 is more complex than the Borello test it supplanted, as Professor Zelinsky demonstrates in his article.  It is also under-inclusive in the types of professions and industries it exempts from the ABC test.  Finally, it is overly rigid in terms of requiring businesses and contractors to fit into a fixed, multi-factor business structure if they wish to qualify for an exemption from the ABC test.  In sum, it is hardly a model that should be emulated by other state or federal legislators. Yet there are some such legislators and governors who are headed in that direction instead of focusing on legislative and enforcement initiatives that will curtail unpardonable, uninformed, and unprepared IC misclassification – the intentional or reckless type where companies know or should know that they are violating the law.

Recent efforts at the state and federal levels may create more unjust and unwise IC misclassification

Despite the many deficiencies in A.B. 5, the California legislature should be applauded for recognizing that the ABC test articulated by the California Supreme Court was not suitable for businesses and contractors in many industries that should continue to be governed by the Borello test, which considers an array of factors in determining IC status.  Without those exemptions, tens of thousands of ICs and businesses would be in violation of the law because they would not likely satisfy prong B of the ABC test.

Legislators in other states and in Congress that wish to adopt an ABC type test or enact other rigid legislative schemes to curtail IC misclassification should recognize that an A.B. 5 type of bill would not only deter and eliminate unpardonable IC misclassification (otherwise known as payroll fraud or wage theft) as well as uninformed and unprepared IC misclassification, it would also sweep in all forms of unintentional misclassification and may even unjustly outlaw IC relationships that have for years been legitimate and lawful under almost all state and federal laws.

For example, in New Jersey, a Senate bill (S. 4204) was recently proposed that would create an ABC test with a prong B identical to A.B. 5; that is, the individual would be presumed to be an employee – even if the worker was free from control or direction over his or her performance and was customarily engaged in an independently established business, profession, trade, or occupation – if the service provided was not “outside the usual course of the business for which that service is performed.” Unlike California’s A.B. 5, no exemptions were proposed. An alternative, Assembly bill (A. 5936), would permit prong B to be satisfied if the service was performed either outside the usual course of business of the company or outside of all places of business of the company for which the service was performed.  That two-part prong B is the current law in New Jersey by virtue of a decision by the New Jersey Supreme Court issued five years ago and reported in a post on this blog. Any effort to further narrow the test in New Jersey, especially without any exemptions, would further de-legitimatize IC relationships that are currently lawful in that state.

In Congress, the Payroll Fraud Prevention Act of 2018 (H.R. 6189) was the subject of a hearing on September 26, 2019 before the House Subcommittee on Workforce Protections of the Committee on Education and Labor. This was essentially the same bill that was introduced in Congress no less than three times before by the same title: first in 2011 (S. 770), then again in 2013 (S. 1687), and then in 2014 (H.R. 4611), as we last noted in our blog post on May 20, 2014.  This 2018 bill would expand the federal Fair Labor Standards Act (which currently addresses minimum wage, overtime, and child labor laws) to cover misclassification of employees as ICs.  It would also create a new definition of workers called “non-employees,” impose upon businesses the obligation to provide a classification notice for both “non-employees” and “employees,” would make the misclassification of “employees” as “non-employees” a new labor law offense, and would expose businesses to fines of up to $5,000 per worker for each violation of the law.  H.R. 6189 would also impose burdensome recordkeeping requirements on all businesses – not just on those that used ICs or other categories of non-employee workers. The Payroll Fraud Prevention Act is reminiscent of the New York Wage Theft Prevention Act enacted in 2011 that required notices by all employers in that state, only to be repealed in large measure effective in January 2015 because of the outcry from companies that the notice provisions went too far.

Instead of seeking to change existing law in a manner that would effectively eliminate the overwhelming number of ICs, legislators should instead seek greater enforcement of existing laws including existing tests for IC status.  This is precisely what former Labor Secretary Thomas Perez and former Wage and Hour Administrator David Weil had consistently endorsed when they were carrying out their duties at a national level to accommodate the valid interests of both workers and businesses.

An increase in enforcement of existing laws would likely solve the problem

With many commentators and legislators in the past year urging new tests for IC status, it is worthwhile to recall that those two high-level former government officials in the Obama Administration did not suggest that the test for IC status be changed or that the FLSA be amended; rather, they endorsed the current FLSA test for IC status and sought to increase enforcement at the federal and state level.

Secretary Perez testified before Congress in 2015 that there is an important place in the American economy for independent contractors. At a March 18, 2015 House Education and the Workforce Committee hearing on “Reviewing the President’s FY 2016 Budget Proposal for the Department of Labor,” Secretary Perez responded to a question by a Congressman asking what more can be done to deter worker misclassification. Secretary Perez responded: “One thing we’ve been doing is work very closely with states, and we’ve entered into MOUs [memorandums of understanding] with 20 states, ranging from Utah and Alabama to Massachusetts, because this problem’s not a red or blue problem, it’s a problem — a national problem that has three sets of victims: the worker him or herself; the employers who play by the rules — they can’t compete for contracts, they can’t compete for businesses because they pay their taxes; and then the tax collector, because when a business is cheating, they’re not paying their workers’ comp taxes, my U.I. taxes go up because the pool has gotten smaller. And so those three types of victims are why we’re working with states across the country on this issue. It’s a very significant problem. I believe that there’s an important place for independent contractors, but I also believe that there’s ample evidence that that’s been abused.”

The other high-ranking former government official charged with eliminating IC misclassification made public comments in a similar vein. When he served as the Wage and Hour Administrator at the U.S. Department of Labor, Dr. Weil stated that although an independent contractor relationship should not be used to evade compliance with federal labor law, the use of independent contractors [is] not inherently illegal [and] legitimate independent contractors are an important part of our economy.”  Even after leaving government, Dr. Weil has expressed the view that the FLSA in particular is remarkably well-suited for analyzing worker status, but he has registered his objection to the alleged failure of the courts to expansively interpret the FLSA test.

There is little question that an increase in enforcement, as former Labor Secretary Perez called for in 2015, would effectively put a dent in unpardonable IC misclassification and also propel companies that engage in uninformed, unprepared, and unintentional IC misclassification to take steps to ensure they comply with the law.

The U.S. Department of Labor and state counterparts have issued reports over the years that as part of their coordinated enforcement efforts, they have identified or recovered for workers tens of millions of dollars in unpaid unemployment and payroll taxes. [5]  Just over a month ago, the U.S. Department of Labor announced that it had recovered a record $322 million in wages owed to workers in Fiscal Year 2019, and part of that recovery included amounts paid by companies found to have engaged in IC misclassification.  It is abundantly clear – and a matter of common sense – that every dollar invested in adding enforcement officers to eliminate unpardonable, uninformed, and unprepared IC misclassification will yield far more money in uncollected taxes than would be needed to pay for additional government enforcement officers and their overhead costs. [6]

Increased enforcement efforts at the federal and state level would also serve to level the playing field for those businesses using an employee model that cannot compete against companies whose use of ICs falls into one of the first three types of IC misclassification.

In addition to increased enforcement, class action plaintiffs’ lawyers have recovered even far more than have the federal and state governments by enforcing private rights of action to sue for IC misclassification based on existing laws.  In our monthly review of IC misclassification cases, we have reported on hundreds of multi-million dollar settlements – not only seven-figure payments by companies alleged to have engaged in IC misclassification, but an increasing number of settlements in the tens of millions of dollars and even a $100 million settlement in the past year.

Maintaining existing laws would be welcomed by the overwhelming number of ICs

There is an additional and equally compelling reason why the solution is not to enact stricter tests for IC status that will, as A.B. 5 will do on January 1, 2020, turn thousands of law-abiding businesses into offenders and convert legitimate ICs into employees.  This further reason is that an overwhelming number of ICs would prefer not to be turned into employees but would rather remain ICs, at least according to two independent studies conducted by the federal government.

In 2015, the U.S. Government Accountability Office (GAO), in a 72-page report to Congress, stated on page 24 of its Report entitled “Contingent Workforce: Size, Characteristics, Earnings, and Benefits,” that it had asked an array of workers the question: “Would you prefer a different type of employment?” 85.2% of independent contractors responded “No” to the question. Similarly, when the independent contractors were asked if they were satisfied with their jobs, the responses as reported on page 24 of the Report were stunning: 92% they were satisfied with their jobs, with 56.8% of them saying they were “very satisfied”. In contrast, only 45.3% of full-time employees reported that they were “very satisfied” with their jobs.

The 2015 GAO Report also asked about benefits: 75.6% of regular full-time workers said “Yes” to the inquiry, “My Fringe Benefits Are Good.”  While one might expect that ICs are displeased with their fringe benefits, the study concluded just the opposite:  61.0% answered “Yes” to the same question “My Fringe Benefits Are Good.”  Thus, even though ICs had a slightly lower satisfaction rate with their fringe benefits than regular full-time employees, ICs were still as or more satisfied with their work arrangements as were full-time employees, even with less benefits. While the study does not ask why, it is likely that many of those ICs would say, “two of the benefits I like most are being my own boss and having more flexibility than if I was working as an employee somewhere.”

In 2018, the Bureau of Labor Statistics (BLS) issued a study entitled “Contingent and Alternative Employment Arrangements.” One question reported on page 15 of the study was whether ICs preferred their alternative work arrangement or would prefer a traditional work arrangement.  Of those independent contractors who had an opinion, 89.9% said they preferred their alternative work arrangements, while only 10.1% said they would prefer traditional employment.  This is a critical factor that many legislators, commentators, and those in academia seem to overlook or minimize.

Of course, these statistics are not a valid reason for legislatures to overlook intentional forms of misclassification.  California’s 2011 IC misclassification law prohibited and penalized “willful misclassification,” as we reported in a post on this blog over eight years ago.  If changes are to be made to existing laws, that statute at least focused on the three types of IC misclassification that are legitimate targets for legislators:  unpardonable, uninformed, and unprepared.  Unintentional IC misclassification was not a focus of that law.

In conclusion, the question is not, what should be done to combat IC misclassification?  It should be re-characterized as, what should be done to combat the first three degrees of IC misclassification:  unpardonable, uninformed, and unprepared? The answer is stricter enforcement of existing laws. That will fully protect businesses that comply with the law, adequately protect workers, raise a tremendous amount of tax revenues, level the playing field, permit legitimate ICs to remain self-employed, and allow small- and medium-size companies with legitimate IC relationships to remain open for business.

Written by Richard Reibstein

[1] This commentary reflects the personal views of the commentator; it does not reflect the views of the publisher’s law firm or any of the publisher’s clients.

[2] It is noteworthy that Massachusetts has a different (and less strict) form of ABC test for unemployment insurance purposes than it does for labor standards purposes.  The Massachusetts labor standards ABC test stood as an anomaly until the California Supreme Court in Dynamex chose to adopt it for certain types of wage claims in California.

[3] Some of the businesses exempted from the Dynamex ABC test, provided certain requirements are met, are as follows: licensed insurance agents; certain professionals (physicians and surgeons, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, and accountants); referral agencies connecting clients with service providers  in the following industries that meet all of 10 specific ‎requirements: graphic design, photography, tutoring, event planning, ‎minor home repair, moving, home cleaning, errands, furniture assembly, animal services, dog ‎walking, dog grooming, web design, picture hanging, pool cleaning, and yard cleanup; and certain professional service providers in the following occupations that meet all of six specific requirements: marketing contractors, human resources administrators, travel agents, graphic designers, grant writers, fine artists, enrolled tax agents, payment processing agents, still photographers, photojournalists, freelance writers, publication editors, and newspaper cartoonists.

[4]   See, e.g., Florida test for IC status under the state’s workers’ compensation law, where 4 of 6 factors may be met to qualify for IC status.  Fla. Stat. 440.02.

[5] For example, as we noted in a February 5, 2015 blog post, the New York Joint Enforcement Task Force on Employee Misclassification issued a report on February 1, 2015 citing that task force agencies conducted over 12,000 audits and investigations, resulting in detection of employee misclassification involving over 133,000 workers, culminating in the discovery of $316 million in unreported wages, leading to the assessments of $40.4 million in unemployment insurance contributions.

[6]  For those who may think the U.S. Department of Labor has not been aggressive in enforcing the nation’s labor laws, the commitment of the Wage and Hour Administrator and the Solicitor of Labor has been demonstrated by its record $322 million recovery last year in unpaid wages. See also the high-profile IC misclassification lawsuits maintained by the U.S. Department of Labor recently, as reported in the past year in this blog on March 11, 2019 and November 12, 2018.