From the Tax Law Offices of David W. Klasing - California Employees vs. Independent Contractors

IRVINE, Calif., Feb. 12, 2025 -- The modern workforce includes two primary categories of workers: employees and independent contractors. Both provide services in exchange for compensation, but the legal and tax implications could not be more different. Employers have drastically different responsibilities depending on which classification applies—particularly regarding employment and withholding taxes (often referred to as "trust fund taxes"). In light of California's evolving legal framework—along with the possibility of significant federal and state penalties for worker misclassification—it is imperative for businesses to understand how these classification standards have narrowed. A single Department of Labor or California Unemployment claim from a former independent contractor can easily trigger a high-risk state or federal employment tax audit, including an eggshell or reverse-eggshell audit, unearthing serious liabilities for back taxes, civil and criminal tax penalties, and interest.

Calling someone an independent contractor is not enough to make them one in a legal sense. If the government determines a worker was misclassified, the business may face:

• Wage and hour violations (e.g., underpaid overtime, failure to provide meal/rest breaks);
• Back payroll taxes and trust fund recovery penalties—potentially exposing business owners and responsible persons to personal liability under the IRS's Trust Fund Recovery Penalty (TFRP) if they willfully fail to collect or remit taxes;
• Additional California state fines from agencies like the EDD or the California Labor Commissioner's Office.

There are two broad worker categories:

1. Employees: Typically, subject to wage/hour laws, unemployment insurance, workers' compensation, payroll tax withholding (federal and state), and other statutory benefits.
2. Independent Contractors: Generally control the manner and means of their work, submit Form 1099-NEC to reflect their income, and pay self-employment taxes. While contractors enjoy more flexibility, they are not protected by minimum wage or overtime laws, nor do they qualify for standard employee benefits.

Historically, a more flexible common law test determined classification under both federal and California state law. However, recent shifts, particularly in California—have greatly restricted which workers can be validly categorized as contractors.

Since the Dynamex decision in April 2018 and the enactment of AB 5 (and subsequent amendments like AB 2257), California has pivoted away from a broad multi-factor approach to the more rigid ABC test. Under the ABC test, a worker is presumed to be an employee unless the hiring entity shows all three of the following:

1. A: The worker is free from the control and direction of the hiring entity regarding how the work is performed (both under contract and in practice).
2. B: The worker's tasks lie outside the usual course of the hiring entity's core business.
3. C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the services rendered.

Failing any of these prongs classifies the worker as an employee for California labor law and unemployment insurance purposes.

For federal tax purposes, the Internal Revenue Service (IRS) currently uses three core standards ("behavioral control," "financial control," and "relationship of the parties") to identify workers correctly, analyzing them under a 20-factor test. While not enumerated in a single statutory provision, these factors typically include:

• Control over the order or sequence of work.
• Degree of instruction or supervision.
• Method of compensation (hourly vs. by project).
• Flexibility of the worker's schedule.
• Provision of tools and materials.
• Potential to realize profit or loss and
• Other indicators focus on who controls the manner, means, and location of the work, as well as the worker's opportunity for profit or loss.

Misclassifying workers under federal law can result in large trust fund recovery penalties, making employers personally liable for unpaid withholdings.

Because AB 5 also introduced (and AB 2257 refined) numerous statutory exemptions to the ABC test, certain workers instead revert to the Borello standard. Borello is a more traditional, multi-factor approach that hinges on the right to control the work details, among other criteria (like who supplies tools, how payments are structured, and whether the worker performs identical services for different clients). Even so, Borello still presumes the worker is an employee unless proven otherwise. The following are examples of occupations which are determined by the Borello test:

• Doctors and psychologists
• Contractors
• Real estate agents
• Freelance writers
• Barbers, hair stylists, manicurists
• Tutors
• Insurance brokers
• Financial service operatives
• Lawyers
• Architects

The discrepancy between employees and contractors has been made even more controversial in California recently due to Proposition 22, a balloted legislation package that passed in November 2020. The citizens of California voted to pass the proposition, which classifies all app-based delivery service workers and ride-sharing drivers as independent contractors, regardless of the ABC or Borello tests.

Proposition 22 applies to all workers who either provide delivery services through an online application or use their own personal vehicles to provide prearranged transport services through an online application. The passing of the legislation allowed large tech companies such as Uber, Lyft, and DoorDash to escape liability from lawsuits alleging violations of wage and hour requirements for employees.

Proposition 22 applies only if specific requirements are met:

• The company does not require workers to work on specific days or for a certain number of hours.
• The company does not force the worker to accept any service requests in order to retain access to the network.
• The company does not forbid the worker from working for other competitors at a time when they are not actively working for the company in question.
• The company does not forbid the worker from lawfully working in any other capacity.

Misclassification often drives payroll tax fraud because misclassified workers typically do not have taxes withheld. When discovered—whether by an IRS audit, an ex-worker labor complaint, or a California EDD investigation—the employing business can face:

• Trust Fund Recovery Penalty (TFRP): Making "responsible persons" personally liable for 100% of withheld (but unremitted) taxes
• Additional back payroll taxes, interest, and late filing tax penalties

For a glimpse at how severe these punishments can be, one can refer to any criminal tax case involving employers who deliberately avoided payroll tax obligations.

The difference between an employee and an independent contractor is significant in the eyes of the IRS and the state of California. In the case of an employee, the employer issues Form W-2 and is required to withhold federal and California employment taxes on the wages. Companies who file Form 1099 for an independent contractor may not withhold salaries for tax purposes. Companies split Social Security taxes 50/50 with their employees, whereas independent contractors (1099 recipients) are required to make their own estimated income tax payments, including self-employment taxes. Independent contractors can deduct any "trade or business" expenses on Schedule C related to the revenue they earn, whereas Schedule A deductions for most employees were eliminated under the Tax Cut and Jobs Act and are limited to unreimbursed employee business expenses for only a handful of protected groups.

If an employee is misclassified as an independent contractor in California, the violator will face severe penalties. A willful (or voluntary and knowing) misclassification of an employee carries a California civil penalty ranging from $5,000 to $25,000. The penalties are assessed per violation, which includes the misclassification of multiple employees as well as numerous consecutive misclassifications of the same employee.

If the employer misclassified the employee unwilfully, the key penalty mitigating factor for both California and the IRS would be whether the erroneous employee misclassification was made with reasonable cause. Most companies facing a worker classification issue generally become responsible for all unpaid income and Social Security taxes. The penalties and interest that are often involved can only be described as draconian by both practitioners and clients alike and can mean the demise of the affected business.

Willful Misclassification under California Labor Code §226.8 can trigger fines between $5,000 and $25,000 per misclassified worker. Each violation can multiply the total liability rapidly.

If an employer wrongly classifies actual employees as independent contractors, it may fail to withhold and remit the required payroll taxes. Once uncovered, the following categories of penalties may apply under the Internal Revenue Code (IRC):

1. Failure to Collect (Withhold) and Pay Tax
   • Liability and Responsible Person: Under IRC §3403 and Reg. §31.3403-1, an employer must withhold and pay over-employment taxes. If not, both the business and its "responsible persons" can be held liable—even up to their personal assets.
   • No Bankruptcy Escape: Personal bankruptcy typically will not discharge payroll tax debts, as in United States v. Sotelo (436 U.S. 268).
     
     
2. Failure to File
   • Penalties for Non-Filing: Employers who fail to file required tax returns on time can be penalized up to 5% of the unpaid tax per month, accumulating monthly.
   • Willful Noncompliance: If found willful under IRC §7203, fines can reach $25,000 (individuals) or $100,000 (corporations). If willful tax evasion occurs, IRC §7201 raises the stakes to a felony with potential jail time and even higher fines.
     
     
3. Failure to Deposit
   • Late Deposits: Under IRC §6656, penalties escalate with the lateness of the required deposit of withheld amounts. Repeated delays or large amounts exacerbate these fines.
     
     
4. Failure to File Correct Information Returns
   • W-2 vs. 1099 Issues: Misclassification can mean incorrectly filing a 1099 instead of a W-2. IRC §6721(a)(2) sets penalties varying by the degree of lateness or inaccuracy, reaching up to $250,000 for large businesses.
     
     
5. Fraudulently Withholding Information
   • False Statements: Employers who knowingly submit false or fraudulent wage or tax statements to the IRS can face a $50 penalty per statement (IRC §6674), plus potential fines of $1,000 and up to one year in prison under IRC §7204.

Employers who wish to avoid costly disputes and misclassification allegations should begin by thoroughly examining their workforce: determining whether the tasks performed are integral to the business, how much autonomy each worker holds in scheduling and performing their duties, and whether they independently manage their own enterprise. Detailed recordkeeping is essential, particularly if you plan to assert any statutory exemption under AB 5 or AB 2257. Maintaining documentation about why a worker was classified one way (employee vs. contractor) can help substantiate your decisions if an audit occurs.

Even so, legislative developments such as AB 2257, Proposition 22, and emerging case law continue to reshape the legal landscape. Accordingly, employers should remain vigilant—tracking regulatory updates and reevaluating their classifications as standards evolve. For instance, the IRS Voluntary Worker Classification Settlement Program (VWSP) offers qualifying businesses a chance to rectify past misclassifications with significantly reduced risk of penalties or interest. Before exploring any program or reaching out to government agencies for a determination, however, seeking seasoned legal counsel is critical. If any details are overlooked or misunderstood, you could still end up liable for misclassification, even if the government initially endorsed your classification.

At the Tax Law Offices of David W. Klasing, our dual-licensed Tax Attorneys and CPAs are invaluable for businesses wanting to resolve federal of California worker classification audits.

Misclassifying your workers might appear to be a cost-saving strategy, but this practice can ultimately damage your bottom line and potentially lead to the failure of your business. In extreme cases, it may be considered tax fraud. Additionally, significant time spent under this misclassification can result in overwhelming penalties, taxes, and interest, and in severe instances, it could even lead to imprisonment.

California's worker classification rules—shaped by AB 5, AB 2257, Proposition 22, and the interplay with federal 20-factor standards—are both intricate and ever-changing. If you suspect you may have misclassified workers, want to be proactive about payroll tax compliance, or face an impending audit or labor investigation, contact the Tax Law Offices of David W. Klasing to obtain reliable and precise legal guidance from our experienced dual-licensed employment tax audit attorneys and CPAs. We will take every measure possible to protect you and your company from back taxes and penalties for misclassifications on employment tax. We have an extensive background in handling worker classification audits and know how to preserve your interests with minimal tax and legal implications.

Our firm combines technical proficiency in tax law with strategic legal defense, ensuring a comprehensive approach to resolving your case. Whether addressing allegations of willfulness, countering the government's evidence, or guiding you through voluntary disclosures to limit prosecution risks, we deliver meticulous representation designed to safeguard your liberty, finances, and reputation. With the attorney-client privilege protecting sensitive information and a proven long track record in defending complex employment tax cases, the Tax Law Offices of David W. Klasing is your indispensable ally in confronting and overcoming these challenges. Don't let the stakes overwhelm you— Call us today at (888) 310-3543 or complete our online contact form to secure a reduced-rate initial appointment.

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