California Wage and Hour Pitfalls (Independent Contractor Classification, Employee Classification, And Wage And Hour Audits)

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July 16, 2018


A. Introduction

An individual providing services to a company may be classified as either an independent contractor or an employee. The employee-employer relationship differs significantly from the independent contractor-company relationship. Employees are subject to a number of statutory protections, including, but not limited to, workers' compensation coverage, unemployment benefits, prohibitions on various forms of discrimination, overtime pay, and minimum wage obligations. However, independent contractors are not considered "employees" for state or federal wage and hour purposes, and thus do not enjoy these protections.

It may be tempting for companies to avoid the perceived administrative headache of complying with all of the various laws governing employees by classifying a worker as an independent contractor. However, misclassification of an employee as an independent contractor also poses significant risks. Misclassification may lead to liability for unpaid wages, back taxes, and penalties. Many companies operate on the misconception that they will be safe from the significant penalties of misclassification just because the individual requested to be treated as an independent contractor, the parties have signed a consulting agreement, or the individual even performs work for more than one company. In reality, courts and administrative agencies look past labels attached to the relationship and perform their own analysis. In fact, the California Supreme Court has held that there is a general presumption that a person in service to another is a covered employee. S. G. Borello & Sons, Inc. v. Department of Industrial Relations.1

B. Legal Tests for Classification

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Determination of an independent contractor relationship depends on several factors. Each administrative agency that performs an independent contractor analysis and applies a slightly different set of factors. The factors may also be applied differently depending on the type of work performed. Below is a discussion of the different tests, how the tests are applied by different administrative agencies, and variations on the factors depending on the type of work performed.

1. California EDD Factors

If an individual is classified as an employee, a company must report the employee's earnings to the Employment Development Department ("EDD") and must pay employment taxes on those wages. If an individual is properly classified as an independent contractor, no such reporting and payment of taxes is required. Accordingly, the EDD has a vested interest in rooting out misclassification of independent contractors. The initial test utilized is whether the individual has the right to direct and control the manner and means by which the work is performed. If it is not clear from the face of the relationship whether the worker or the principal has the right of control, the EDD looks to the following factors:

(a) Right to control. The company's right to control the manner and means of performance is the most important factor. When the company has a right to exercise control, it is a strong indication that the person is an employee.

(b) Right to terminate at will. The company's right to terminate at will without cause or without notice is an indication of employee status.

(c) Distinct occupation. An important factor is whether the worker has an occupation or business distinct from that of the company. If success of the business depends on the worker's services, the individual might be deemed an employee.

(d) Level of supervision. Independent contractors do not work under the direct supervision of the company.

(e) Industry practice. The courts consider whether the kind of service in question is usually done by an employee or independent contractor.

(f) Own tools. Usually contractors furnish their own tools. Where tools are not significant to the position, no inference is created.

(g) Duration of service. The length of time an independent contractor performs a service should be short.

(h) Skill. Unskilled labor is usually supervised, and therefore creates an employee-employer relationship. The opposite is true of highly skilled positions.

(i) Own hours. Independent contractors set their own hours.

(j) Job location. Independent contractors generally not required to perform work in a specific area or a fixed route.

(k) Services do not have to be rendered personally. Independent contractors are hired to perform a job and it should not matter who performs it and/or how it is done. The independent contractor has the right to hire others to assist him/her.

(l) Method of payment. Where the worker is paid by the job, not the hour, there is a greater inference that the worker is an independent contractor.

(m) What the parties believe. Although it is not controlling, how the parties perceive the relationship is important. A contract for an independent contractor will be considered as evidence that a contractor relationship existed.

2. The IRS Factors

The factors used by the IRS to determine independent contractor status are extensively discussed in the IRS Training Manual on Worker Classifications.2 The IRS factors are more comprehensive than those used by the EDD and include the following:

(a) No instructions. An independent contractor does not receive instruction as to how to accomplish the job.

(b) No training. The company does not provide training to an independent contractor.

(c) Right to delegate. An independent contractors is hired for a specific result. It should not matter who completes the work.

(d) Service not essential to the hiring firm. A company should not depend on the work of independent contractor for its business to succeed.

(e) Sets own work schedule. An independent contractor determines his or her own schedule.

(f) Not long-term. The contracting relationship should not be long term. It can be frequent or repeating, but at irregular intervals.

(g) Has time to perform other work. Independent contractors should be free to work for whomever they please. A requirement of fulltime status often establishes an employer-employee relationship.

(h) Right to control their own workers. Independent contractors are free to hire and fire their own assistants.

(i) Job location. An independent contractor position should not necessarily require that the contractor work on-site at the company's location.

(j) Order of performance. Independent contractors determine the order and sequence in which to perform tasks on a job.

(k) Payment for completed task. Independent contractors are paid by the job, not the hour.

(l) Work for multiple employers. Independent contractors can work for more than one company at a time.

(m) Business expenses not reimbursed. Independent contractors are responsible for their own business expenses.

(n) Provides own tools. Independent contractors provide their own tools and equipment.

(o) Makes significant investment in business. An independent contractor's investment in his/her trade must be real and substantial.

(p) Makes services available to general public. Independent contractors make their services available by having more than one of the following (an office, assistants, business license, listing in business directories, advertising).

(q) Possible profit or loss. Independent contractors stand to profit from successful completion of a project, or suffer a business loss if not successful.

(r) Cannot be fired. Independent contractors are legally obligated to perform the terms of the contract. The contract cannot be discharged if they are meeting contract specifications.

(s) No payment for incomplete work. Independent contractors are generally obligated to complete the job or risk not being paid for work performed.

(t) No progress reports. Independent contractors should not have to provide interim progress reports, because they are hired for a result.

3. California Common Law Factors

California courts and administrative agencies generally apply common law principles to determine independent contractor status. The most important factor in evaluating independent contractor status involves the independent contractor's right to control the manner and means of accomplishing the project, even if the contractor did not exercise that right with respect to all details. Factors examined for that right of control include:

(a) No Control. The company's right to control the manner and means of performance is the most important factor. When the company has a right to exercise control, it is a strong indication that the worker is an employee.

(b) Right to Discharge at Will. If the relationship is not at-will, and the worker faces potential liability for an incomplete project, there is an indication of an independent contractor relationship.

(c) Distinct Occupation or Business. A worker who has an occupation or business distinct from that of the company is more likely to be considered an independent contractor.

(d) Custom and Usage in the Industry. If it is common in the industry that the type of work being performed is usually done by an independent contractor (i.e., with no supervision by the company), there is an indication of an independent contractor relationship, though the right-to-control factor is still relevant here.

(e) Skill. The more skill a worker must possess to do the particular job, the greater the inference of independent contractor relationship.

(f) Tools and Place of Work. Usually contractors furnish their own tools. Where tools are not significant to the position, no inference is created. Independent contractors generally not required to perform work in a specific area or a fixed route.

(g) Length of Time of Service. The shorter the relationship between the company and the worker, the greater the inference that an independent contractor relationship exists.

(h) Method of Payment. If a worker is paid by job rather than by time (weekly, monthly), there is a greater inference that the worker is an independent contractor.

(i) Work Part of Regular Business. If success of the business depends on the worker's services, the worker might be deemed an employee.

(j) Intent of the Parties. While not dispositive, courts will look at whether the parties intended to enter an employment relationship or an independent contractor relationship.

(k) Existence of a Contract. The lack of a contract is usually indicative of an employment relationship rather than an independent contractor relationship, but the existence of a contract will not be dispositive; rather, courts will look to the parties' relationship more than the terms of any contract.

(l) Possibility of Profit or Loss. Courts look to whether contractors face a possibility of profit or loss as a result of their services. Profit or loss implies the use of capital by the worker in an independent business; when workers are insulated from loss or are restricted in the amount of profit they can gain, they are usually employees.

4. California Workers' Compensation Law Test

This six-factor test is applicable in California workers' compensation cases under S.G. Borello & Sons, Inc.3 Several other states also follow this six-factor test as their common law analysis of worker status. Factors under this test include the following:

(a) Control. When the hiring firm has a right to exercise control, it is a strong indication that the person is an employee.

(b) Opportunity for profit or loss. If the worker stands to either profit from the relationship or lose money for an incomplete job, there is an inference of an independent contractor relationship is created.

(c) Investment in facilities or employment of assistants. If a worker invests in his own working facilities, away from the company's facilities and/or hires his own employees, there is an inference of the existence of an independent contractor relationship.

(d) Need for special skills. The more skill a worker must possess to do the particular job, the greater the inference of independent contractor relationship.

(e) Permanence of relationship. The shorter the relationship between the hiring firm and the worker, or the more irregular the intervals of work if the relationship is ongoing, the greater the inference that an independent contractor relationship exists.

(f) Integration into hiring firm's business. If success of the business depends on the worker's services, the worker might be deemed an employee.

C. Penalties

Employers who have misclassified an employee as an independent contractor may be subject to adverse consequences, such as (1) back withholding of taxes (state, federal and FICA); (2) interest; (3) wage and benefit liabilities; (4) civil penalties, including penalties for not providing itemized wage statements; (5) individual civil liability, including unanticipated tort liability to third parties and wrongful discharge liabilities; and (6) individual criminal liability.

Further, the Company may be sued by workers who believe they were misclassified. These lawsuits are often filed when the worker needs unemployment insurance, disability coverage, or workers' compensation insurance coverage. Additionally, because an individual the company has classified as an independent contractor is not covered by the company's workers' compensation insurance policy, the company could be liable for civil tort liability not only to the individual, but also to third parties who are injured as a result of the individual's negligent acts done in the scope and course of his or her duties. Cal. Lab. Code § 3706.

The company also may find itself in trouble if a misclassified individual is terminated and he or she proceeds to file a claim for unemployment compensation with the EDD. If the EDD becomes aware that the company may have misclassified, it may initiate an audit of the company. Such an audit is extremely burdensome on the company's time and resources, and will include a review of the classification of all of the company's "independent contractors," not just the initial contractor who filed for unemployment insurance. The IRS may, in turn, conduct a similar audit. If it is determined that an individual has been misclassified, the company may be required to pay certain back wages, payroll taxes and penalties, and overtime going back up to three years. The EDD may also cite the company with failure to provide an itemized wage statement to the employee each pay period. Cal. Lab. Code § 226.3, which has a penalty of $250 per employee for the first violation and $1,000 per employee for each subsequent violation. Therefore, penalties of just this one violation, going back three years, could exceed $35,000 per employee.

In recent years, several states have passed laws specifically aimed at curbing contractor misclassification and/or increasing penalties therefor. In California, Labor Code sections 226.8 and 2753 make it unlawful for any person or employer to willfully misclassify an individual as an independent contractor. These provisions also authorize the Labor Workforce Development Agency to assess civil penalties of not less than $5,000 and not more than $15,000 for each violation in addition to those already permitted by law. The civil penalties increase to between $10,000 and $25,000 for each violation if the person or employer has engaged in a pattern or practice of willful independent-contractor misclassifications. Perhaps most significantly, any employer found to have willfully misclassified employees as independent contractors may be required to post a notice regarding the violation on their websites or in an area accessible by all employees and customers for up to one year following the violation. Such postings likely will be reviewed by attorneys seeking targets for wage and hour class actions.

Beyond civil liabilities and penalties, employers who have misclassified independent contractors may face significant liability for back withholding of taxes. Below are the specific tax consequences that could be assigned by state and federal agencies:

EDD Back-Taxes. Under California law, an employer may be liable for up to 9.3% of wages for income tax, 1.3% of the first $31,767 of wages for State Disability Insurance and at least 3.4% of wages for State Unemployment Insurance. The EDD does not distinguish between intentional and unintentional misclassification.

IRS Back-Taxes. When a worker is misclassified as an independent contractor, the EDD and the IRS may collect back taxes and penalties from the employer. The employer may be liable to the IRS for up to 39.6% of all wages paid, representing unpaid income taxes. In addition, the employer must pay the IRS back taxes for FICA (OASD), FICA (HI), and FUTA.

Employers are liable for 12.4% of the first $65,400 of all wages for FICA (OASD), for 2.9% of wages for FICA (HI), and for 6.2% of the first $7,000 of wages for FUTA. The unpaid taxes owed to the IRS may vary based on whether the IRS assesses the misclassification as intentional or unintentional.

EDD Penalties. In addition to the back taxes an employer must pay, the EDD assesses four potential penalties for misclassification, including payment of 100% of the estimated tax plus a $20,000 fine; penalties for failing to pay taxes (10% of unpaid unemployment and disability insurance); penalties for failing to file taxes (10% of unpaid insurance and 50% for fraudulent failure to file); and criminal sanctions.

IRS Penalties. The IRS assesses seven potential penalties, including penalties for failure to pay taxes (1/2% of 25% of unpaid taxes per month); delinquency penalties (5% of 25% of unpaid taxes per month); penalties for negligent or intentional disregard of IRS rules and regulations (20% of unpaid taxes); penalties for fraudulent misclassification (75% of unpaid taxes if IRS finds fraud); penalties for unintentional failure to file W-2s ($50 per violation), intentional failure to file W-2s (the greater of $100 or 10% of unreported amount per violation); penalties for failure to send W-2s (assessed at the same rates as unintentional and intentional failure to file W-2s); and criminal sanctions.

D. Recommendations

Even with the most careful examination and planning, there is no guarantee that a court or other administrative agency will find that an independent contractor relationship exists. However, once a company has made an informed decision to proceed with classifying an individual as an independent contractor, there are additional steps it should take to reinforce the classification.

1. Reporting Obligations. A company hiring an independent contractor MUST file a report of this relationship to the EDD. This independent contractor reporting program is designed to locate parents who are delinquent in their child support obligations. The reporting obligation arises within 20 days of entering into a contract for, or making payments of, $600 in any calendar year to an independent contractor.

2. Tax Formalties. The company and the contractor should observe tax formalities as closely as possible. The company should require consultants to take responsibility in writing for all income and social security taxes. The company should be vigilant in filing Form 1099s and any other information reporting returns that may be required by the IRS with respect to the individual consultant.

3. Important Paperwork. If possible, the company should try to obtain the contractor's business license, fictitious name statement, and evidence of insurance. Keep records for independent contractors in vendor files and treat these individuals as vendors for accounting purposes (e.g., require invoices).

4. Use of Third Party Agencies. If it is the company's policy to contract with technical consultants through third parties, the company should require written assurances from the third party that payroll tax responsibility lies with that third party. Although such assurances may not be determinative of the company's liability, they will provide factual support in an audit for the company's "reasonable cause" for failing to withhold.

5. Regular Review. Regularly review existing independent contractor and/or consulting agreements to ensure that the individuals are correctly classified, as their relationships with the company continue and their obligations evolve.

6. Proper Classification. Do not treat the contractor as an employee. The company must give up control over the contractor in order to avoid liability. Further, be clear that the contractor is not entitled to use facilities or receive benefits that are offered to the company's employees. Be mindful that generally employees and not independent contractors receive training; wear uniforms; do not work for other customers besides the company; receive instructions; attend meetings; work regular hours; share office space and equipment; quit or are fired; and receive procedure manuals. The company should be careful to structure its relationships with consultants and other independent contractors so as to meet as many of the 20 factors as possible.


A. Introduction

Once the company has determined that an individual worker is properly classified as an employee rather than an independent contractor, the classification inquiry continues. This section of this memorandum discusses a company's classification of its employees as either exempt or non-exempt from the overtime requirements of federal and state law. It is not enough that the individual employee meet the federal requirements for exemption, the employee must also meet the California state requirements. Because the California requirements are more stringent than the federal requirements (and because an employee properly classified as exempt under California law will almost always meet the federal exemption test), this memorandum examines only the California requirements.

All employers in California are covered by the federal Fair Labor Standards Act ("F.L.S.A.") and the California Labor Code, which both require that "non-exempt" employees be paid a premium for overtime hours worked. Under federal law, non-exempt employees who work more than forty (40) hours in a week are entitled to an hourly rate of one-and-a-half (1½) times their regular rate of pay. California law further mandates overtime compensation when non-exempt employees work more than eight (8) hours in a day or six (6) days in a week.4 While both federal and state wage laws exempt numerous categories of workers from overtime pay requirements, the exemptions that are applicable to all companies are those for "executive," "administrative," "professional," "computer," "outside sales," and "inside sales" employees. Federal and state law define each of these exemptions differently, but both tests tend to require that an employee (1) be compensated a specified minimum amount; (2) be compensated according to a specified basis (e.g. salary); and (3) perform certain duties in order to qualify for a given exemption. If the employee fails to satisfy exemption requirements under either the federal or the state test, the employee should be classified as non-exempt.

Misclassifying a non-exempt employee under state law can subject an employer to potential liability for that employee's unpaid overtime for the last three years. Misclassifications under federal law subjects an employer to potential liability for both unpaid overtime and liquidated damages equal to that amount. Claims under the F.L.S.A. have a statute of limitations of two years for non-willful violations and three years for willful violations.5 State claims for violations of California's wage and hour laws have a statute of limitations of three years.6 Under both federal and state law, a separate cause of action accrues on each payday following a work period where unpaid overtime was earned.7

B. California Law on Exempt Classification

The primary sources of California's wage and hour laws are the Labor Code and the Wage Orders promulgated by the Industrial Welfare Commission ("IWC"). The IWC has promulgated seventeen Wage Orders for employees in twelve different industries and three groups of occupations, which establish minimum wages and conditions of employment (such as the payment of overtime compensation). The minimum wages and conditions of employment contained in each Wage Order are enforced by California's Department of Labor Standards Enforcement ("DLSE").

1. Overview of California Wage Order 4-2001

Unless they fall into one of the exemptions for Wage Order 4-2001, all of a company's California-based employees are subject to California law regarding overtime premium pay.8 These requirements cannot be waived.9 Employers and non-exempt employees may not enter into wage agreements whereby payment of a fixed salary to a non-exempt employee would include compensation for overtime hours worked.10

As with the F.L.S.A., executive, administrative, and professional employees are excluded from overtime requirements, as well as computer professionals and outside and inside salespersons. These exemptions are set forth in IWC Wage Order 4-2001. To qualify for one of these exemptions, an employee must meet certain compensation and duty-based requirements.

(a) Compensation Requirements

California's minimum salary threshold for executive, administrative, and professional employees is twice the current state minimum wage.11 This exceeds the federal threshold of $455 per week. Under both federal and state standards, outside sales representatives are not 5 29 U.S.C. § 255(a). subject to compensation requirements. Individuals participating in a national service program such as Americorps are also excluded.

Wage Order 4-2001 requires that executive, administrative and professional employees all be compensated only on a "salary basis."12 For compensation to qualify as a "salary basis," employees must be paid a predetermined weekly amount. In addition, an employee must be paid his/her full salary for any week where s/he performs any work, without regard to its quality or quantity. This rule is subject to a number of exceptions: (1) employers may deduct pay for full day absences due to personal reasons; (2) deductions for full day absences due to sickness or disability may only be made in accordance with a bona fide sick plan, policy, or practice of providing compensation for such absences; and (3) employers can prorate salary during the first or last week of employment and when an employee takes unpaid leave under the Family and Medical Leave Act.13 Employers who deduct pay for reasons not outlined above face a significant risk of losing an employee’s salaried status. Deductions for partial days of missed work are treated with particular suspicion, unless they fit within the third exception above. Although the Wage Order refers to a minimum monthly salary, employees can also be paid on a weekly, bi-weekly, or semi-monthly basis without threatening their exempt status.14

The DLSE also allows employers to pay exempt employees additional compensation of a nonsalary basis without violating compensation rules.15

(b) Duty-Based Requirements

Job titles alone cannot establish whether an employee is exempt. Rather, the employee's "primary duties" must consist of the exempt tasks outlined in the categories below.

Duty-based requirements under California law diverge in two general respects from the F.L.S.A. First, California requires that executive, administrative, professional, and computer employees "exercise discretion and independent judgment"16 in order to meet duty-based requirements.17

Second, the Wage Order tests whether an employee is "primarily engaged in" exempt activities, which is somewhat different from the federal "primary duties" test.18

2. California Exemptions

(a) Executive Employees

To meet compensation requirements, an executive employee must be paid at least $2,773.34 per month on a salary basis. To meet the duty-based requirements, an employee must (1) be primarily engaged in duties and responsibilities involving the management of the enterprise or a recognized department/subdivision; (2) "customarily and regularly" direct the work of two or more other employees; (3) either have the authority to hire, fire, promote or change the status of other employees or be given particular weight in such decisions; and (4) customarily and regularly exercise discretion and independent judgment.

(b) Administrative Employees

To meet compensation requirements, an administrative employee must be paid at least $2,773.34 per month on a salary basis. To meet the duty-based requirements, an employee must (1) either be primarily engaged in office or non-manual work directly related to management policies or general business operations of the employer or its customers; or primarily engaged in the administration of an educational establishment in work directly related to academic instruction or training; (2) customarily and regularly exercise discretion and independent judgment; and (3) regularly and directly assist a proprietor or an exempt executive or administrative employee; or perform specialized or technical work requiring special training, experience or knowledge under only general supervision; or perform special assignments or tasks under only general supervision.

(c) Professional Employees

To meet compensation requirements, a professional employee must be paid at least $2,773.34 per month on a salary basis.19 To meet the duty-based requirements, an employee must (1) be licensed or certified by the state and primarily engaged in either the practice of law, medicine, dentistry, optometry, architecture, engineering, teaching or accounting; or be primarily engaged in an occupation commonly recognized as a "learned or artistic profession"; and (2) customarily and regularly exercise discretion and independent judgment.

In order for an occupation to qualify as a "learned or artistic profession," the employee must (1) be primarily engaged in work that is predominantly intellectual and varied in character and cannot be standardized in relation to a given period of time; and (2) be primarily engaged in either work requiring knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized intellectual instruction and study; or work that is original and creative in character in a recognized field of artistic endeavor.

(d) Computer Professionals

To meet compensation requirements for the computer professional exemption, an employee must be paid either an hourly rate of at least $39.90, or an annual salary of $83,132.93 ($6,927.75 monthly) beginning on January 1, 2013.20 Employers seeking to pay computer professionals on a salary basis (rather than at the hourly rate) must abide by certain compensation requirements common to all overtime exemptions in California, including the following: (1) employees must be paid a predetermined amount on a monthly or less frequent basis (bi-weekly or semi-monthly); and (2) subject to limited exceptions, an employee must be paid his/her full salary for any week in which s/he performs any work, without regard to quality or quantity of work. While exempt computer employees who are paid hourly do not need to be paid overtime, they must be paid for every hour of work performed each day.21

To meet the duty-based requirements, a computer professional employee must be:

_ Highly skilled and proficient in the theoretical and practical application of highly-specialized information to computer systems analysis, programming, and software engineering.

_ Primarily engaged in work that is intellectual or creative;

_ Primarily engaged in work that requires the exercise of discretion and independent judgment;

_ Primarily engaged in duties that consist of one or more of the following:

_ Applying systems analysis techniques and procedures, including consulting with users, to determine hardware, software, or system functional specifications;

_ Designing, developing, documenting, analyzing, creating, testing, or modifying computer systems or programs, including prototypes, based on and related to user or system design specifications;
_ Documenting, testing, creating, or modifying computer programs related to the design of software or hardware for computer operating systems; an

An employee does not qualify for this exemption if the employee:

_ Is a trainee or employee in an entry-level position;

_ Has not attained the level of skill and expertise necessary to work without close supervision;

_ Is engaged in the operation of computers or in the manufacture, repair, or maintenance of computer hardware and related equipment;

_ Is an engineer, drafter, machinist, or other professional whose work is highly dependent upon or facilitated by the use of computers and computer software programs and who is skilled in computer-aided design software but who is not in a computer systems analysis or programming occupation;

_ Is a writer engaged in writing computer-related material (such as technical manuals); or

_ Is creating imagery for effects used in the motion picture, television, or theatrical industry.

While employees exempt as computer professionals may have a bachelor's degree or higher, no particular academic degree is required for this exemption, nor are there any requirements for licensure or certification.

(e) Outside Salespersons

Outside salespersons are not subject to compensation requirements. Under Wage Order 4-2001, the definition of an "outside salesperson" is substantially identical to the F.L.S.A.'s definition and is defined as "any person, 18 years of age or over, who customarily and regularly works more than half the working time away from the employer's place of business selling tangible or intangible items or obtaining orders or contracts for products, services, or use of facilities."22

(f) Inside Salespersons

The inside sales exemption or "Commissions Paid Exemption" is met where: (1) the employee's principal function is selling a product or service; (2) the compensation for sales of the product or service is a percentage of the price of the product or service; (3) the earnings exceed one and one-half times the minimum wage ($12 per hour); and (4) more than one-half of the employee's earnings represent commissions.23

Wage Orders 4-2001 confirm that sales employees can be exempt from overtime requirements if the employee earns more than one and one half times the minimum wage and more than one half of the employee's earnings constitute commissions. However, under California law, the inside sales exemption applies only to overtime. This means that the company must comply with all other wage and hour requirements as if the employee was nonexempt.

For example, inside sales employees are entitled to a meal and rest period and the company must comply with time keeping and recording obligations related to non-exempt employees.

C. Enforcement and Penalties

To enforce overtime laws, the California Labor Commissioner may prosecute a civil action on behalf of any employee or class of employees with or without their consent. The Commissioner may seek to recover unpaid overtime compensation, attorneys' fees, costs and interest, as well as an injunction against further violations of the overtime premium provisions.24

Criminal penalties are also available, though rarely sought.25

When the Labor Commissioner has not instituted an action, employees may file private civil suits to recover the unpaid overtime compensation, together with interest and reasonable attorneys' fees. These suits can be brought individually and may also be brought by the employee as a representative action on behalf of other aggrieved employees. Employees may also initiate an administrative action with the DLSE, which tends to resolve claims more quickly but does not permit the recovery of attorneys' fees except on appeal.26

Under state law, overtime compensation must be paid no later than the payday for the next regular payroll period.27 Often, employee lawsuits include claims for statutory penalties related to an employer's failure to pay overtime compensation on time. Such claims have a three year statute of limitations.28 However, it should be noted that employees may initiate an unfair competition claim and seek damages related to the failure to properly pay overtime for the four year statute of limitations that to California's Unfair Competition Law. Unpaid overtime compensation owed to employees who have been discharged or quit is subject to an additional "waiting time" penalty of up to 30 days of wages.29

Whenever an action is initiated for unpaid overtime (whether by the Labor Commissioner or an individual employee), the overtime owed is computed on the basis of the salary that the employee was actually paid. That is, employers are not permitted after-the-fact to claim that they would have paid a misclassified exempt employee a lower hourly wage. Instead, the misclassified exempt employee's weekly salary is divided by forty (40), regardless of whether the salary was intended to compensate the employee for more than forty (40) hours of work.

The resulting number is deemed the misclassified employee's "regular rate" of pay. The overtime rate owed is calculated on the basis of this regular rate, as set forth in the Introduction of this section.


A. EDD Audits

Audits by the California Employment Development Department (EDD) often arise when someone who has been classified as an independent contractor applies for unemployment, SDI, or workers’ compensation benefits.

During the audit, the EDD auditor typically reviews the employer’s books and records to confirm that individuals have been properly classified as either employees or independent contractors.

The audit will usually apply to all of the employer’s independent contractors, not just the contractor who initially triggered the audit by filing for unemployment, SDI, or workers’ compensation benefits.

1. Communications with EDD

Companies should contact employment counsel immediately upon receiving notification from the EDD that (1) the company has been selected for an employment tax audit; (2) the EDD wants the company to respond to a “Pre-Audit Questionnaire,” or (3) further information is needed regarding an independent contractor who has applied for unemployment insurance, SDI, or workers’ compensation benefits

Companies should request that their employment counsel be designated as their representative in the audit by completing and submitting the EDD’s Power of Attorney form.

2. General Pointers for an EDD Audit

It is a good idea to follow these general guidelines in the event of an EDD audit:

(a) do not agree to allow the EDD to conduct an in-house audit (i.e., at the company’s workspace);

(b) be careful about communicating with the EDD directly; use your attorney to communicate with the auditor;

(c) be careful in communicating with contractors and employees about the audit; the EDD will contact these individuals directly for information as part of the audit;

(d) be wary of the audit period; do not over-produce information A spirit of cooperation is useful and can be helpful in persuading auditors that misclassification was not intentional, which may cause the EDD to waive penalties for intentional misclassification

3. EDD Assessment

If the auditor concludes that the client misclassified employees as independent contractors, the EDD will issue a “Notice of Assessment,” which indicates the net amount the company owes as a result of contractor misclassification, including taxes, penalties, and interest. The employer may pay the assessment amount, appeal the assessment, or both.

B. Other Agency Audits

The federal Department of Labor and the IRS can also initiate worker misclassification audits. These two agencies signed a Memorandum of Understanding in 2011 to work together in misclassification audit efforts. As a result, misclassification audits have been on the rise in the last few years.

The following issues are some of the most common triggers to initiate a worker misclassification audit by the DOL or IRS:

_ an independent contractor files for unemployment or worker's compensation claiming employee status.

_ W-2s and 1099s overlap for the same employee in the same year;

_ independent contractors file IRS SS-8 Forms seeking government determination of their classification status;

C. Preventing Audits

Most importantly, make sure you audit yourself before the government audits you! Conduct a self-audit -- preferably by a third-party outside legal counsel experienced in the field who can identify red flags and work with you to address any areas of concern. IRS and DOL audits can generally go back three years. Thus, employers should conduct internal audits at least this often.

Consider having your independent contractors enter into independent contractor agreements acknowledging the intent of the relationship and waive any right to company sponsored benefits. Be sure to review benefits plans to ensure a clear definition of "plan participant."

It is also a good idea to create separate policies and procedures for independent contractors and contingent workers. Equally important is to train your managers to effectively and consistently apply these policies.

Finally, it is critical that the job responsibilities for an employee differ from those of an independent contractor. The IRS and the DOL look primarily to the factor of how much right to exercise control an employer has over a purported independent contractor, and how that control is actually exercised.

To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

1 48 Cal.3d 341(1989).

2 See Note, while all states have classification tests based on common law and/or rules promulgated by state-specific equivalents to California's EDD, the IRS factors are a federal standard and are applicable to workers in all jurisdictions. Companies that retain contractors who travel significantly or who perform services in a state different from the employer should look to the IRS factors in evaluating worker status.

3 48 Cal.3d 341(1989).       

4 A non-exempt employee in California is entitled to one-and-a-half (1½) times the employee’s regular rate of pay for hours worked in excess of eight (8) hours per, and twice the regular rate for hours worked in excess of twelve (12). In addition, anytime a non-exempt employee works more than six (6) consecutive days in a workweek, s/he is entitled to one-and-a-half (1½) times the regular rate for the first eight (8) hours worked on the seventh day, and twice the regular rate thereafter. Cal. Labor Code § 510.

5 29 U.S.C. § 255(a).

6 Cal. C.C.P. § 338(a); Aubry v. Goldhor, 201 Cal. App.3d 399, 404 (1988).

7 29 C.F.R. § 790.21(b); Aubry, supra, 201 Cal. App. 3d at 406; Biggs v. Wilson, 1 F.3d 1537, 1540 (9th Cir. 1993).

8 See Cal. Labor Code § 510, supra, footnote 4.

9 Cal. Labor Code § 219.

10 Cal. Lab. Code § 515(d).

11 The state minimum wage is currently $8.00 per hour. Accordingly, the minimum compensation requirement for exempt employees is $16.00 per hour, $640 per week, $2,773.33 per month, or $33,280 per year.

12 This is unlike the F.L.S.A., which permits fee basis compensation for administrative and professional employees. Note, outside sales employees may be paid on any basis in California, and not necessarily a salary basis.

13 29 C.F.R. § 541.602. The California definition of "salary basis" is modeled on the federal definition, with a few notable exceptions. For instance, the DLSE makes its own determination of what represents a 'bona fide' sickness or disability plan; does not allow any kind of disciplinary deduction; and does not provide a safe-harbor provision for improper deductions made by employers. D.L.S.E. Manual §§ 51.6.6-

14 Cal. Labor Code § 204; D.L.S.E. Opinion Letter 2002.03.01.

15 D.L.S.E. Opinion Letter 2002.03.01.

16 Executive, administrative and professionals must "customarily and regularly" exercise discretion and independent judgment, while computer employees must meet the higher standard of being "primarily engaged in" work that requires the exercise of discretion and independent judgment. Wage Order 4-2001 cites the federal definition of discretion and independent judgment set forth in 29 C.F.R. §541.202.

17 Cal. Labor Code §§ 515(a), 515.5.

18 In determining "primary duties," the more qualitative federal test examines how an employee spends his/her time; the relative importance of such exempt duties in an employee’s job; the employee’s freedom from supervision; and the wages of other employees performing similar non-exempt tasks. 29 C.F.R. § 541.700. In contrast, the quantitative California test for "primarily engaged in" looks first and foremost at whether an employee spends 50% or more of his/her time on exempt work, and also takes into account the employer’s realistic expectations and the realistic requirements of the job. Wage Order 4-2001. The IWC has ruled that its quantitative test is more protective of employees than the federal test and will use the quantitative test in any analysis. See Statement as to the Basis of the October 2002 I.W.C. Orders.

19 Certain doctors may be excluded from this requirement. See Labor Code § 515.5 (permitting physicians and surgeons to be paid on an hourly basis and still be exempt from overtime requirements, as long as the hourly wage meets or exceeds the statutory minimum, currently $72.70 per hour).

20 Note that the California Department of Industrial Relations is responsible for adjusting the pay necessary to qualify for the computer professional exemption in October of each year, to be effective the following January. Employers can check the following website each year to determine the applicable rate:

21 Computer professionals compensated on an hourly basis must be paid for each hour worked even though no overtime premium applies. For example, if a computer professional is compensated at an hourly rate of $39.90 and he or she works 45 hours in a week, the employee would need to be paid $1,795.50 for that week ($39.90 per hour x 45 hours).

22 See 8 Cal. Code Reg. § 11040(2)(M).

23 See Peabody v. Time Warner Cable, Inc., 689 F.3d 1134, 1138 (9th Cir. 2012).

24 Cal. Labor Code §§ 98.3, 1193.6, 1194.5.

25 Labor Code § 1199 provides for misdemeanor penalties of fines of not less than $100 and/or imprisonment for not less than 30 days. See also Cal. Lab. Code §§ 215-216.

26 Sampson v. Parking Service 2000 Com, Inc., 117 Cal. App. 4th 212, 227 (2004); Cal. Labor Code § 98.2(c).

27 Cal. Labor Code § 204.

28 Cal. C.C.P. § 338(a).

29 Cal. Labor Code § 203.

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