California, Surprise…Your Subcontractors Are Your Employees!

By Abe Livchitz, Senior Tax Manager
ASL Construction Group

The issues related to proper worker classification impact many businesses, including contractors. The rules are often unclear and their application is based on each employer’s specific facts and circumstances. An Internal Revenue Service or California Employment Development Department audit resulting in the reclassification of workers can have a significant bottom line impact. As a result, it is important to correctly determine if your workers are employees or independent contractors. If workers are reclassified as a result of an audit, employers can be liable for payroll taxes, wage withholdings and possible penalties. In 2012, California enacted Labor Code Section 226.8 that imposes a minimum penalty of $5,000 for each violation of “willfully misclassifying an individual as an independent contractor”.

Unfortunately, the criteria used by the various federal and state authorities to determine if a worker is an employee are not identical. As a result, it is possible for a worker to be properly classified as an independent contractor for federal tax purposes and as an employee under California law. The factors considered by the IRS are summarized on Form SS-8. The factors used by the EDD are outlined in Publication DE 231.

California, unlike the IRS, has a unique rule specifically applicable to the construction industry. Under California Labor Code Section 2750.5, a contractor who engages the services of an unlicensed subcontractor (or construction worker) to perform work requiring a license is by statute the employer of the unlicensed subcontractor or the worker even if they could be classified as an independent contractor under the usual common law rules. This rule applies to treat the unlicensed subcontractor and the subcontractor’s employees as statutory employees of the contractor hiring the unlicensed subcontractor. As a result, payments to an unlicensed subcontractor (and the payments made by the unlicensed subcontractor to its employees), would be subject to California payroll taxes and wage withholdings. An unlicensed subcontractor may meet the federal requirements to be treated as an independent contractor but would be a statutory employee under California labor law……surprise! This situation can commonly occur when hiring an out-of-state subcontractor to do work in California and the subcontractor does not obtain a California contractor’s license. If the out-of-state subcontractor fails to file California payroll tax returns, the hiring contractor would be liable for the unreported payroll taxes and wage withholdings.

Since the unlicensed subcontractor (and its employees) are required to be treated as employees for labor law purposes, they could also be treated as employees for workers compensation requirements.

To avoid this surprise, a best practice is to verify that a subcontractor has an active California license (out of state licenses do not qualify) before engaging their services. In addition, reporting payments made on Form 1099-MISC would be consistent with federal classification as an independent contractor. Upon audit, if it is discovered that a subcontractor was unlicensed, the EDD can abate the required income tax withholding (on payments made to the subcontractor) if payments have been reported on a properly filed 1099-MISC form.