Important Legal Compliance Update: Employee vs. Contractor

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Important Legal Compliance Update: Employee vs. Contractor

I don't often write directly about legal compliance issues in this blog, but a recent decision by the California Supreme Court has dramatically shifted the playing field for determining whether people working with California businesses are employees or contractors. Even if your company is not based in California, if you engage with residents of the State you will likely fall under its control. Some of the articles I've read on the subject mention that other state courts are following a similar course in re-defining who is an employee.

I won't go into details about the facts of the case, but you can read the facts here.

Business analysts, as well as legal professionals, fear that the Dynamex case could directly impact an entire range of companies who utilize people heretofore engaged in what has come to be known as the "Gig Economy." The Gig Economy comprises the millions of people who take on short-term projects or freelance work as opposed to holding one full-time job. A recent Harvard Business Review study indicates that 150 million people in North America and Europe now participate in the Gig Economy. What's more, according to research conducted by McKinsey showed that knowledge-intensive industries and creative occupations are the fastest growing sectors. That means the kinds of people that innovative companies like yours are increasingly seeking.

If you're a technology company, you may have contracted people to write code, perform lab or research work, or complete specific tasks relating to product development. If your company is developing an app to connect customers with a service delivered by people you pay to deliver it, you may have plans to grow an "army" of such service providers. Going forward, the test to determine whether such people are employees has completely changed (at least in California). Note that your company need not be a California business entity to be impacted by the new test; if you contract with California residents, you're likely going to be held as doing business in California.

OK so what's the big deal, what has changed?

First of all, businesses will now have the burden of proving that a particular person was a contractor, not an employee. There is now a presumption that anyone working for your business is an employee. You'll have to prove, if challenged by someone working for you or a regulator, that the person was, in fact, a contractor. You probably already know that employee-employer relationships are governed by a wide range of regulation involving pay, work conditions, benefits, worker's compensation, health care, as well as requirements that you make timely payroll tax payments to the state and federal governments. All of these things cost money, probably 20-30% more cost for employees versus contractors for the same work.

Think of companies such as Uber or Lyft that contract with thousands of people as independent contractors. The lower costs of using contractors versus employees are baked right into their business model. What will they do? Charge you and me a higher fee for rides probably. But how will that impact our use of their rides? What would happen to their business models if, say, 5% fewer people opted for an Uber or Lyft ride? One reason I decided to write about the Dynamex case here is that many of you are creating your business models, or are engaged in funding your companies under business models that could really be affected by this sea-change in the contractor versus employment relationship determination process. Some of you may even need to consider a pivot to your entire business model. Others may simply need to account for higher forward costs for human resources.

If your business model involves using the Gig Economy for a large amount of your human resources, you should probably contact your legal counsel right away to determine whether, in your state, or states where you'll engage with people as independent contractors, those people are likely to be classified as employees.

The test for determining employee versus contractor in California is now called the "ABC Test." Since I'm not an attorney, I won't try to interpret what the elements of the test might mean for your business. But I will briefly explain then based on the articles I've read on the subject.

Part one of the test essentially says that the Company must prove that the worker is "free from the type and degree of control and direction the hiring entity typically exercises over its employees." According to several legal writers, this is not a dramatic departure from previous law. But remember, the burden is now on your company to prove that the amount and nature of control over someone's work activities isn't tantamount to an employment scenario.

Part two of the test states that the company must show that the worker "performs work outside the scope of the hiring entity’s business, and whose work, therefore, would not ordinarily be viewed by others as working in the hiring entity’s business." This is where business models dependent on the Gig Economy could face problems. It may come down to how a court or regulator decides to classify your business, regardless of how you classify it. Uber says it provides a transportation network. They likely view their business as chiefly the technology infrastructure enabling them to direct an available driver to your precise locale. But a court or regulator could easily classify Uber as simply a transportation company.

What's the difference?

If Uber is a technology company it could argue that most of its "employees" are engaged in developing and servicing the technology infrastructure which just happens to be in the area of transportation. But if regulators or a court determines that Uber is merely a taxi service then most of its personnel is engaged in the core business of providing rides. Big difference!

Part three of the test requires the company to show that "the worker in question is customarily engaged in an independently established trade, occupation, or business." You might be able to establish this by showing that the person has taken steps like incorporating his or her business, getting a business or trade license or advertising. Importantly, you cannot satisfy part three of the test simply by showing that your company doesn't prohibit a worker from engaging in independent business.


Now, the idea here is not that anytime you bring a plumber or electrical contractor into your office to fix a drain or upgrade an electronic system you've created an employment situation. However, what about all those "freelance" software programmers contributing time and know-how to the development of your technology system? How about the research analysts that test products, compile data and write reports about your product's capabilities? It is going to come down to a classification based mostly on parts two and three of the new test.

Failing any one of the three parts of this test will preclude your company from treating a worker as an independent contractor rather than an employee.

Key Takeaway: Employees cost more than contractors. The Dynamex case could dramatically change the way millions of people in the economy are now classified. It will directly impact business models. I recommend taking a fresh look at your business model in light of the Dynamex case. If you're still in the formation stage, now is the time to consider what your model would look like if hundreds or thousands of people you plan to one-day contract with are going to be classified as employees. If you're raising capital for a going concern, you'll want to do an impact-assessment on your company's future prospects in the event that this kind of re-classification could seriously increase your costs.

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