The California Supreme Court’s recent decision in Dynamex Operations West v. Lee is a game-changer for businesses that classify individuals as “independent contractors” rather than employees. Businesses must learn the new test for independent contractor status and assess their practices.

Businesses rely on independent contractors for legitimate reasons, including short-term projects of fixed duration, generally involving expertise that cannot be provided by an employee. Sometimes, however, businesses choose to use independent contractors (sometimes called “1099s”) as substitutes for regular employees. Some employers are motivated by administrative ease or budgetary considerations. Others wish to avoid providing employee benefits, or paying the payroll taxes and other costs associated with adding staff.

Misclassification of employees as independent contractors can result in serious consequences. From compensation and penalties for failing to comply with wage-hour laws, to liability for denied benefits that employees receive, not to mention penalties for underpayment of employment taxes, the potential exposure cannot be overstated.

However, assessing whether independent contractors are misclassified is not always easy. Federal and state agencies apply different legal analyses. California case law traditionally required a fact specific, multi-factor test, making it hard to predict how a court or agency will rule.

Enter the California Supreme Court’s decision in Dynamex. The Court adopted a rule that will determine whether an individual is an employee for wage and hour law purposes, but not necessarily for other areas of the law. The rule, called the “ABC test,” will make it hard for employers to classify individuals as independent contractors, except in limited circumstances.

The “ABC Test”

The Supreme Court held that a worker is presumed to be an employee under California’s wage orders unless the hiring business proves three conditions are met (A, B, and C). The hiring entity has the burden of proving all three elements. If just one element fails, the worker is an employee for purposes of wage-hour law.

Factor A: The business must not dictate the control and direction of the independent contractor’s work. This first requirement is similar to preexisting law in California as to the control over the “methods and means” of the work. To meet this requirement, a business should ensure written agreements require contractors to set their own hours, establish their own procedures for completing their work, and bring their own their own tools and equipment. Contractors’ self-determination over their work must exist in reality, in addition to being included in the contract. The hiring entity may specify the end result and assess the quality of the work. But the business cannot dictate the way the contractor goes about the task.

Factor B: The entity must demonstrate that the contractor’s services are outside the usual course of the entity’s business. This new requirement prevents a business from classifying as a contractor someone who performs the work that the hiring business does for its customers. Under the court’s strict interpretation, the focus is on the similarity of the contractor’s work to the hiring entity’s, not the location of where it is performed.

For example, in the Dynamex case, the company classified delivery drivers as independent contractors. Dynamex was a package delivery company. Therefore, Dynamex would have difficulty proving Factor B. Along the same lines, a tax preparation service likely should not contract with individuals as independent contractors to provide seasonal help preparing tax returns. In addition, “gig economy” businesses – such as food delivery – must look closely at whether their independent contractor arrangements will pass muster under this factor.

Factor C: The contracting business must establish that its contractors are customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed by the contractors. That is, contractors must be independent businesses, which existed before the hiring entity entered into the agreement with the contractor.

To fulfill Factor C, the business must prove facts such as the contractor has a tax i.d. number, is incorporated, has a business license, advertises its services to others, and performs work for other customers. The contractor’s having employees of its own is another relevant consideration favoring independent contractor status.

Many independent contractor agreements authorize the contractor to perform work for others. The authorization alone is insufficient. The focus is on whether the contractor actually, customarily, provides similar services to other businesses.

Key Takeaways

Some industries are governed by laws that may render Dynamex inapplicable. For example, certain health care delivery businesses (like acute care hospitals) generally do not “employ” physicians, even though they could qualify as employees under the ABC Test. Therefore, it is important to check with employment counsel to ensure the new rules apply.

When the ABC Test does apply, however, hiring entities must reconsider using independent contractors as substitutes for temporary workers. Independent contractor relationships also may not be used to “try out” an employee, or to create a “consultancy” if the contractor is not already a consultant providing services.

A solid independent contractor agreement remains essential, especially as to Factor A. The agreement must be modified to comply with the new requirements. However, as discussed, reciting the relevant issues in the contract means nothing if the parties’ actual practice does not comply with each element of the text.