Employee or Independent Contractor: A California View

California’s Employment Development Department (“EDD”) has long been known for aggressively targeting industries for review of independent contractors to determine whether they may be recharacterized as employees. These industries include construction, transportation and personal services.

The focus of this discussion is to provide a California viewpoint on independent contractor controversies, focusing on planning and representation before the EDD. Because of both subtle and not so subtle differences between the perspective of the EDD and the Internal Revenue Service (“IRS”) on independent contractors, a number of issues and opportunities may be overlooked.


A. Impact of Classification. For a California employer, worker classification as an independent contractor or employee has significant impact. Clearly, the direct impact is withholding and employer tax payments on workers’ classification as employees; with limited exceptions, no such withholding applies to independent contractors. Indirectly, taxes are also affected by employee status due to allowed unemployment claims. Such claims can increase an employer’s unemployment insurance tax rates. In addition, worker classification may affect whether worker’s compensation insurance coverage is required.

B. Right to Control. The leading California case, Empire Star Mines Co., Ltd v. California Employment Comm’n, 28 Cal.2d 33, 43 (1946) establishes the “golden rule” in California to determine whether a worker is an employee or independent contractor as follows:

In determining whether one who performs services for another is an employee or an independent contractor, the most important factor is the right to control the manner and means of accomplishing the result desired. If the employer has the authority to exercise complete control, whether or not that right is exercised with respect to all details, an employer-employee relationship exists.

C. Factor Analysis. Out of the case decisions, there has uniformly grown a preference toward basing conclusions on a “factor” type analysis involving reviewing the facts and circumstances of each worker and trying to fit those facts under factors indicating an employer-employee relationship. As a guideline, the following authorities have adopted lists of factors. These include

  • The IRS’s list of twenty (20) factors.
  • The EDD’s list of ten (10) factors.
  • Workers’ Compensation Appeals Board list of eleven (11) factors.

While the exact number of factors is not important, what is significant is the California perspective on these factors. Because the EDD uses statutes and cases which include those relating to workers’ compensation and unemployment insurance, a number of public policy considerations favor employment status to cover unemployed and injured workers. While the EDD’s latest version of their Publication DE-38 endeavors to provide and interpret an EDD issued 13 yes/no questionnaire, the law is far more complicated. In addition, certain federal policies have begun to creep into the analysis, including portions of an “economic realities” test used for purposes of the Fair Labor Standards Act.

D. Statutory Employees. California, like Federal law, defines certain workers automatically. In other cases, a worker may be an employee for state tax purposes but an independent contractor for Federal tax purposes. For example, commissioned artists are treated as employees for California tax law purposes of unemployment and disability insurance where they provide a “work for hire.” (See EDD Publication DE 231SE)

E. Federal (only) Safe Harbor Exemption. Under Federal law, if an employer (i) had a reasonable basis for treating a worker as an independent contractor, i.e. due to judicial precedent, prior audit or industry practice, (ii) properly reported worker payments and (iii) did not treat the worker (or a similar worker) as an employee, the employer is by statute protected from assessment of employment taxes and penalties. Act Section 530 to the Revenue Act of 1978. While this federal position has been in place for nearly 40-years and is binding upon the IRS, unfortunately the EDD does not recognize this safe harbor exception.

F. Penalties. Notwithstanding the lack of a state safe harbor, the EDD does recognize some level of relief from penalties where the Federal safe harbor applies. However, a good faith belief without some justification will not be sufficient. See In re Philip E. Brown v. State of California, 743 F.2d 664 (9th Cir. 1984).


To a great extent, the district offices are decentralized as to their selection of areas for audit examination and often the focus is on the predominant local industries. While for all offices the majority of the EDD audit examinations arise from worker’s compensation or unemployment insurance claims, targeted industry examinations have become increasingly popular.

Normally, the selection of targeted audit examinations is coordinated by the auditor in charge of the local district’s audit examination group. As a result, changes in the district administrators can affect industry target areas. Traditionally, in Sacramento, the building industry has been one of the heavily targeted industries for employment tax examinations.


A. Construction Contractors.

1. Proof of License. Since the enactment of California legislation in 1978, and its broadening January 1, 1991 (Assembly Bill No. 2667), California has treated construction industry subcontractors and jobbers as employees where the hirer does not have a license and proof is not provided that the subcontractor or jobber holds a contractors’ license. A number of EDD offices have used this legislation as the basis for an aggressive audit campaign of the construction industry.

A controversy that requires retesting is whether the failure of a worker to have a contractor’s license is a conclusive presumption on an employment relationship with regard to the employer. This controversy was determined in State Compensation Insurance Fund v. Workers’ Compensation Appeals Board, 40 Cal.3d 5 (1985), wherein such a failure was conclusive of employee status with regard to worker’s compensation coverage. In this 1985 decision, Judge Lucas, as the sole dissenter recognized that the requirement that the absence of a license was conclusive of employee status was intended solely with regard to an action against the worker and not the hirer, i.e., an FTB examination of deductible worker expenses. Because the case involved compelling public policy decisions toward covering injured workers, the majority of the court rejected this position.

As the same provisions apply with regard to employment taxes, it is possible that the law should be applied differently for employment tax purposes since there is no compelling public policy toward coverage. Under this distinction, the failure to provide proof of a contractor’s license should not be conclusive upon the hirer as to whether the worker is an employee. However, should a client choose to take this position, it should be clearly understood that the EDD will not concur.

2. The Law.

a. “Section 621.5. Unlicensed Contractors.

(a) ‘Employee’ also means any individual who is an employee, pursuant to Section 2750.5 of the Labor Code, of a person who holds a valid State contractor’s license pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code.

(b) When subdivision (a) does not apply, ’employee’ shall also mean any individual who is an employee, pursuant to Section 2750.5 of the Labor Code, of a person who is required to obtain a valid State contractor’s license pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and professions code.”

b. Unemployment Insurance Code Section 13004.5.

(Same language as Section 621.5).

c. “California Labor Code Section 2750.5. Rebuttable Presumption for Unlicensed Contractors.

There is a rebuttable presumption affecting the burden of proof that a worker performing services for which a license is required pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code, or who is performing such services for a person who is required to obtain such a license is an employee rather than an independent contractor. Proof of independent contractor status includes satisfactory proof of these factors:

(a) That the individual has the right to control and discretion as to the manner of performance of work and not the means by which it is accomplished is the primary factor bargained for.

(b) That the individual is customarily engaged in an independently established business.

(c) That the individual’s independent contractor status is bona fide and not a subterfuge to avoid employee status. A bona fide independent contractor status is further evidenced by the presence of cumulative factors such as substantial investment other than personal services in the business, holding out to be in business for oneself, bargaining for a contract to complete a specific project for compensation by project rather than by time, control over the time and place the work is performed, supplying the tools or instrumentalities used in the work other than tools and instrumentalities normally and customarily provided by employees, hiring employees, performing work that is not ordinarily in the course of the principal’s work, performing work that requires a particular skill, holding a license pursuant to the Business and Professions Code, the intent by the parties that the work relationship is of an independent contractor status, or that the relationship is not severable or terminable at will by the principal but gives rise to an action for breach of contract.

In addition to the factors contained in subdivisions (a), (b) and (c), any person performing any function or activity for which a license is required pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code shall hold a valid contractors’ license as a condition of having independent contractor status.

For purposes of workers’ compensation law, this presumption is a supplement to the existing statutory definitions of employee and independent contractor, and is not intended to lessen the coverage of employees under Division 4 and Division 5.”

3. De Minimis Exception. Furtado v. Schriefer, 228 Cal.App.3d 1608 (April 8, 1991). Painters. This case involves a housepainter who sued a homeowner under workers’ compensation law. The painter did not possess an active painting contractor’s license. The Court of Appeals ruled that if the housepainter is excluded from the definition of an employee under Section 3352 of the Labor Code (which includes any person employed for less than 52 hours), then he will be treated as an independent contractor.

4. Employee “Attribution”. EDD Employment Tax Notice No. 91-32 (November 15, 1991). Your subcontractor’s employees are your employees. This notice advises Tax Branch personnel of the EDD’s position on unlicensed contractors. While it is not surprising that the EDD takes the position that there must be proof of a contractor’s license and that proof of a license is not conclusive as to status, the notice contains more controversial provisions.

In particular, it takes the position that a general contractor is not only the employer of unlicensed subcontractors but it is also the employer the subcontractor’s workers, including both employees and unlicensed second tier subcontractors. This double presumption creates liability for layers of contractor and employment relationships with persons whom the contractor is wholly unaware. It also creates the possibility of double (triple?, quadruple?, etc.) taxation against the general contractor on payments to unlicensed subcontractors as the payments are distributed to lower level contractors and their employees.

While the EDD states in this notice that it is important that EDD staff take extra care to apply the law in an equitable manner, it is difficult to see how this position could be applied fairly. Its enforceability may be questionable as the notice does not constitute an approved regulation and arguably goes beyond the intent of the statutes. Indeed, the California Government Code prohibits the EDD’s right to enforce such a notice as a regulation as follows:

a. Government Code Section 11342(b). Regulation Defined.

‘Regulation’ means every rule, regulation, order or standard of general application, or the amendment, supplement or revision of any such rule, regulation, order or standard adopted by any state agency to implement, interpret or make specific the law enforced or administered by it, or to govern its procedure, except one which relates only to the internal management of the state.

b. Government Code Section 11347.5. Non-Regulations Unenforceable.

No state agency shall issue, utilize, enforce or attempt to enforce any guideline, criterion, bulletin, manual, instruction, order, standard of general application, or other rule which is a regulation as defined in subdivision (b) of Section 11342 unless the guideline, criterion, bulletin, manual, instruction, order, standard of general application, or other rule has been adopted as a regulation and filed with the secretary of state pursuant to this chapter.

B. Cab Drivers (and other service providers).

Risk of Economic Loss. Santa Cruz Transportation Inc. v. California Unemployment Insurance Appeals Board, 235 Cal.App.3d 1363 (October 11, 1991). The California Court of Appeals held that a cab driver who leased a cab from Yellow Cab was an employee rather than an independent contractor. The Court found that the company’s rules of conduct, exclusive control over city dispatches as well as other factors established an employment relationship. One interesting issue was whether the cab driver had an entrepreneurial risk of loss. The court found no risk of loss as earnings did not vary with driver skills, losses, if any, were on a shift-by-shift basis and no actual losses were shown. As a result, the court differentiated the potential for losses from entrepreneurial risk of loss.

While this decision seems rather limited, at first blush, the focus on entrepreneurial risk of loss has already began to percolate through the EDD and may prove a new weapon for the independent contractor versus employee debate.

C. Computer Industry.

1. Federal Approach. One area subject to ongoing heavy scrutiny by the EDD is the computer industry. While the IRS’s “20 Factors” traditionally cited originated in a revenue ruling dealing with the IRS’s view of the computer consulting industry, it in no way reflects current thinking. The pace of the computer industry has quickly outstripped the current rules.

Unfortunately, factor analysis fails to address the current computer industry. A rapidly growing number of computer consultants now band together on a project basis and do not fit clearly in the employer-employee role. With modems, electronic bulletin boards, networks and at home computers and offices, these people can work as loose consortiums contracting out and assembling highly specialized industry programs to computerize aspects of entire corporate departments and consumer industries. Under the 20 Factor approach, there is not a clear sense of control by a project leader.

2. California Approach. On the other hand, California has adopted a somewhat more workable, pragmatic regulation of the application of its rules to the computer services industry. First, these regulations create a favorable presumption for treating computer consultants as independent contractors where they act through a separately established and maintained corporation. Corporate maintenance must include filed articles of incorporation, a current statement of officers, annual Board and shareholder minutes, tax returns, a separate bank account and contracts to do business as a corporation.

Second, the regulation recognizes that certain factors that are normally indicia of an employment relationship are not relevant to determining the status of computer programmers. Rules limiting the time and use of a principal’s facilities for safety and security purposes does not indicate an employment relationship. On premises work will not indicate an employment relationship where work cannot be done elsewhere. Payment computed on an hourly rate is also not evidence of employment unless it is set by the principal. In addition, payment to a consultant for training that is unique to the work performed and is necessary for completion of a contract does not indicate employment.

Third, the regulations recognize that a worker’s participation in a “standard walk-through” in which the system design is critiqued and design integration discussed will not be indicia of either an employment or independent contractor relationship.

While these rules are somewhat more workable, there is considerable room for controversy where, for example, corporate form is not properly maintained or where some factors indicate an employment type arrangement. Because further clarification is unlikely, it is especially important that there be clear documentation of independent contractor status in dealing with computer consultants. With the advent of the recession and more computer consulting work being contracted out, this area is ripe for an explosion of audit examinations by the EDD.

D. Personal Service Industry.

1. Proposed Legislative Presumptions. Referral Agencies. With the unlikelihood of new state taxes, the EDD remains active in expanding the use of presumptions. The EDD has several times endeavored to place into legislation last minute language stating that “when an individual performs the primary service offered to clients or to the public by the business of the principal, there shall be a presumption that the individual is an employee…” This has on at least one occasion required a state legislator to seek a judiciary committee special hearing and waiver, to extract the offending language from last minute insert, wherein the EDD told the legislator, as a clear misrepresentation, that they were trying to just restate existing law.

The housekeeping industry was a leading opponent since many represent themselves as a referral service for independent contractors. Under this legislation, many of the housekeeping referral agencies would have been required to treat their subcontractors as employees.

Interestingly, during the legislative process, claims were made that executives in the EDD’s Tax Office were directed to work with opposing industries to create a more palatable proposal, but refused to do so. In addition, number of the housekeeping agencies that were vocal opponents received notices of EDD tax audit examinations.

While this proposed bill died, it is altogether possible that to remedy the state’s continuing financial woes, other presumptions will be proposed to expand employee coverage.

2. Target Audits. The personal service industry, including barbers, household workers and gardeners will continue to receive close scrutiny. While there is no clear definition of what businesses are covered, there is a strong perception of noncompliance by the EDD in this industry. In many situations, the resolution had to be undertaken by appeals. An outstanding illustration is the Happy Nails decision affecting 35 salons, wherein even after finding in favor, it required court action for another 12-years to resolve that the California Labor Commissioner’s refused to respect the CUIAB’s 2004-year ALJ decision.

E. Self-Reporting (DE 542).

Another area that is ripe for the EDD is a potential penalty for failure to file Form DE 542, report of independent contractors within 20 days of the earlier of payment of more than $600 or entering into a contract of more than $600 if a Form 1099 is required to be filed with the IRS. The penalty for not providing this notice is the result of the highest stated personal income tax rate under a stated statutory provision times the amount that should have been reported. Accordingly, even if properly classified as an independent contractor, the EDD has a provision which may impose substantial penalties for employing but not reporting independent contractors.


The importance of preventative planning to minimize employment tax exposure cannot be overstated. Preventative planning includes pre-hiring review, contract agreements and license verification.

A. Diagnostic Review of Independent Contractors. One preventative procedure is to maintain a pre-hiring checklist before approving all work. This checklist should consider common law treatment, state statutory treatment and any federal differences. The checklist should be applied to any service/labor provider (including one-time, part-time, temporary).

B. Contractor Agreements. A contract is not a panacea to all employee/ independent contractor issues, nor is it useful for all workers. It can, however, be a significant benefit to 1) document the independent contractor status, 2) maintain the formal character of the contractor relationship between the business and the worker, and 3) assure that the contractor is maintaining business licenses and paying income employment taxes.

There is no typical contractor’s agreement; the agreement should be tailored for the job performed and the industry involved.

C. Licenses. For the construction industry, the best preventative procedure is to consistently obtain and verify contractor’s licenses for all construction related projects. If laborer does not have a license, the hirer should verify that it is not required for the type of services performed. Licenses on file should be verified at least annually to confirm that licenses of all contractors are current.


Effective January 1, 1994, in limited circumstances, the EDD will accept a partial payment to satisfy an outstanding employer liability. Unfortunately, the requirements are limited to employers and individuals in dire circumstances and include the following:

1. Relief will be given only to employers with inactive out-of-business accounts and individuals personally liable, if the individual no longer has a business interest.

2. The employer or individual must have inadequate income to pay annually both interest and 6.7 percent of unpaid taxes.

3. The employer or individual must be relatively insolvent.

4. The liability for taxes must be undisputed and final.

5. An offer must include either a full payment or a proposal to pay in installments over five years.

6. If the amount of forgiven taxes is more than $10,000, the offer must be approved by the Unemployment Insurance Appeals Board.

7. The offer must be more than the EDD could expect to collect over four years.

As employment taxes and individual liability for responsible persons are not extinguished by bankruptcy, this provision at least provides the opportunity for a fresh start after five years.


In addition, the EDD offers a settlement program with respect to audit examinations where an appeal is filed for a hearing before an administrative law judge before the California Unemployment Insurance Appeals Board. When reviewing an offer, the EDD is required to consider the risk of loss and the cost of litigation as balanced against the benefits of reaching a settlement agreement. Fairness, financial hardship and the survival of the business, factors normally not considered during audit or before the CUIAB, may be considered by the EDD to establish a settlement amount provided it is not the sole reason for entering into a settlement agreement.


While in this summary, I am not covering the appeals process, it is important to understand these differences, as the issue of worker classification arises the moment a worker is hired. Keeping a checklist, adequate documentation, and engaging persons who are treated as and truly have the skills and capacity to be an independent contractor are the best strategies to minimize the risk of examination, and to be able to respond to an EDD examination. While contracts are helpful and important to have, they are not conclusive as to independent contractor status.

We are always open to help with respect to worker classification problems. Cameron Hess may be reached at chess@wkblaw.com or (916) 920-5286.


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