State Laws Cloud the Use of Independent Contractors

This article first appeared in CFO.com.

With California likely to become the third state to restrict the definition of independent contractors, companies that use gig workers face new risks.

Forces leading to changes in state laws governing the classification of workers as either employees or independent contractors appear to be gaining momentum across the country.

The changes to the classification regime that are currently in the air or have been enacted significantly restrict companies’ ability to rely on independent contractors as workers. That in turn can materially alter the cost structure of those companies, lead to misclassification fines and other penalties, and even potentially threaten the fundamental economic viability of some businesses.

A number of factors are driving these changes:

• The heavy use of independent contractors in some prominent areas of the gig economy (think Uber and Lyft)
• Pressure from labor unions looking for new sources of union membership
• Frustration, experienced by both regulators and companies interested in staying on the right side of a misclassification claim, over having to interpret the ambiguous legal standards that have historically governed this issue

The classification of workers as independent contractors has typically been governed by state-law multi-factor balancing tests rather than bright line rules. From one point of view, this squishiness in the law has allowed companies to push the line aggressively — or get away with going over the line — and either start or grow their businesses using a generous dose of independent contractors rather than employee workers.

Why does this matter? From a federal or state tax point of view, at least speaking in a broad sense, worker classification theoretically does not affect tax collections. In an independent contractor arrangement, the contractor is responsible for 100% of the payroll taxes that in an employment scenario are divided between the employer and, through withholdings, the employee.

Nonetheless, governments and taxing authorities do care about this issue. If payroll tax payments shift from withholdings and contributions by employers to payments entirely by contractors, payroll tax collections are impacted from a timing-of-collections standpoint.

Furthermore, in addition to avoiding having to pay the employer share of payroll taxes, companies that use contractors in lieu of employees do not pay for workers’ compensation or unemployment insurance. Also, they are not subject to and do not bear the cost of minimum wage, overtime, and other rules (e.g., required work breaks) that are in play with employees.

The other side of that coin is that independent contractors do not get the hours, wage, and benefit protections that are afforded to employees under state law.

California gets stricter

Last year, the California Supreme Court joined Massachusetts and New Jersey in establishing the so-called “ABC test” as the relevant standard for distinguishing between employees and independent contractors for purposes of applying California wage and hours laws.

In an April 2018 decision in a case titled Dynamex Operations West, Inc. v. The Superior Court of Los Angeles County, the California court held that all three of the following factors must be satisfied in order to classify a worker as an independent contractor:

• The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of the work and in fact.
• The worker performs work that is outside the usual course of the hiring entity’s business.
• The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

The adoption of the ABC test by the three states has significantly narrowed the category of workers who can be treated as independent contractors.

In many instances, it is the (B) prong of the ABC test that proves to be problematic. While that factor may be included in traditional multi-factor state law balancing tests, the ABC test transforms it from one among a list of factors into an absolute, individual stand-alone requirement.

In California, the consequences of this change in the law have yet to play out fully. For one thing, there have been a number of legal challenges to the applicability of the new standard to particular industries.

For example, companies regulated as motor carriers have argued that any effort by the state to regulate the relationship between independent contractors and federally regulated motor carriers is preempted by federal law.

In the face of these legal challenges and the potential for a continuing patchwork of different classification standards for different aspects of the regulatory landscape (wage and hours laws vs. workers’ compensation, unemployment insurance, etc.), the California legislature has taken up legislation that would codify and expand the subject matter applicability of the Dynamex holding.

The California House has passed the bill, but as of early August 2019 the Senate has not. As it currently stands, it would exempt certain professions from the new standard. These include insurance agents, certain health care professionals, investment advisers, and real estate agents, among others.

For companies across a broad range of industries that operate in California and rely on independent contractor workers, the narrowing of the independent contractor category is a big deal. If this change takes hold and unfolds broadly in California, as it appears it will, certain industries may be fundamentally reshaped.

For example, a number of trucking trade associations have argued that the Dynamex test would end a prevalent business model in the trucking industry.

Many trucking companies supplement their use of employee drivers with drivers who are independent owner-operators treated as independent contractors. The (B) prong of the ABC test would require a re-classification of those independent owner-operators as employees.

Using a combination of employees and contractors can help companies make their labor costs somewhat less fixed. And, as proponents of the stricter ABC standard point out, it can lower overall labor, benefit, and administrative costs materially. For example, when independent contractors are laid off or injured on the job, it would effectively shift the burden of unemployment insurance and workers’ compensation to the state.

Two epicenters for the controversy in California over how workers are classified have been the ports of Los Angeles and Long Beach. The Teamsters Union has been leading a campaign against the widespread practice of drayage operators relying heavily on independent owner-operators as drivers.

As reported in the California press, the Dynamex decision has apparently prompted a number of trucking companies to convert their independent contractors into employees. Others have looked for a work-around by shedding their employee drivers and converting themselves into brokerage-only operations that rely exclusively on independent owner-operators as drivers.

Will more states jump in?

Lenders and potential acquirers dealing with businesses that depend on independent contractors need to take note and pay close attention — not just in California but potentially in other states. That’s particularly because a change in the classification law can happen quickly through new case law rather than through more cumbersome and easier-to-see-coming legislative change.

Furthermore, a change to the classification regime may be found to apply retroactively, as it has in California. That would open up companies, even those that are able to successfully evolve their business models to comply going forward, to significant back pay and other penalties. One 2016 study estimated that over 8% of the U.S. workforce consists of independent contractors. With the rise of the gig economy, that percentage is likely higher today than it was in 2016. It would behoove lenders and would-be acquirers to add this issue to their list of business diligence items to consider before they extend credit to, or acquire, businesses that use independent contractor workers to a significant degree. These actors may want to assess the relative likelihood of a change in the legal landscape in a particular state and analyze what would happen to the borrower/portfolio company’s bottom line should a change in the classification approach occur. Moreover, lenders should not go to sleep with respect to existing borrowers that appear to have weathered a transition in their business models to deal with a change in the classification law. A company that has moved to a 100% employee composition may be less able to absorb a downturn in its business than it would have been previously. That would be a result of higher labor, benefit, and payroll tax costs, and perhaps also the company’s somewhat diminished ability to downsize seamlessly by cutting back on work assigned to independent contractors rather than employees.