A California Supreme Court decision issued in late April drastically changed the requirements to classify workers as independent contractors for the purposes of California wage and hour laws. In Dynamex Operations West Inc. v. Superior Court, the Court overruled the previous multi-factor test for classifying workers as independent contractors and replaced it with a new test. Where the previous test was a balancing of factors that provided for much more uncertainty and, arguably, more manipulation of the facts, the new Dynamex test starts with the presumption that all workers are employees and then requires an employer to prove that all of the following are true before a worker can be identified as an independent contractor:

1. The worker is free from the control and direction of the company in connection with performing the work, both in reality and under the terms of the relevant contract;
2. The worker performs work that is outside the usual course of the company’s business; AND
3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work being performed for the company.

The first and third prongs of the new standard are similar to the previous test, which focused on the amount of control the employer exerted over the worker and also whether the worker had other sources of income besides the employer.

The second prong is the significant change – if the worker is performing work that falls within “the usual course of the company’s business,” then the person must be classified as an employee. Therefore, even if a worker is hired to take on overflow work or pick up intermittent jobs, if this work is in the scope of the company’s main business activities then the worker must be classified as an employee.

The decision will very likely be a blow to the growing “gig economy,” but the implications for small businesses and start-ups that have limited resources and may need more intermittent services is staggering. This new checklist test is much more stringent, and as a result the majority of workers in California should now likely be classified as employees (there have been some broad generalizations that plumbers and electricians will be the only remaining independent contractors…). As employees, the workers are entitled to overtime pay, meal and rest breaks, and at least minimum wage, and employers need to obtain workers compensation insurance for them and comply with other logistical requirements related to reporting and payment.

While workers providing ancillary services to businesses, such as lawyers and accountants (though it depends on the business, as these workers still provide work inside the course of some companies’ business), are likely still contractors under the new Dynamex standard, all employers need to honestly, and immediately, assess their workforce and determine if any contractors need to be reclassified. The new test went into effect as soon as the decision was issued in late April, so misclassified contractors need to be reclassified as employees as soon as possible. Misclassification lawsuits can result in enormous judgments, made up of backpay and penalties, that will very likely outweigh the “savings” of classifying a worker as a contractor.

If you need advice on this issue, contact us at info@bendlawoffice.com or (415) 633-6841.

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article. 

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An interview with Doug Bend by Nikole Mackenzie, a CPA and the owner of the owner of Momentum Accounting, on whether a California professional corporation should elect to be taxed as an S-corporation.

Nikole: It’s a pleasure having you! I’ve been following your articles on your blog, so I’m excited to finally have a chance to speak with you one-on-one.

Doug: Absolutely. It’s nice to be here, Nikole.

N: So, today I was hoping we could go over your thoughts on what professional service providers should do about incorporating their new ventures. What does someone need to know if they’ve just started out on their own?

D: Well, first of all, in California, certain professions that require a state license are prohibited from forming a limited liability company or a traditional corporation. Most of the companies affected by this are in the financial, legal and medical fields.

N: What would you recommend then for companies in those industries?

D: In most cases, I would tell them to incorporate as a professional corporation and elect to be taxed as an S-Corporation.

N: What are the advantages to being taxed as an S-Corp?

D: If you do not elect to have your California professional corporation taxed as an S corporation, the default is for it to be taxed as a C-Corporation.

N: And what exactly does that mean?

D: Well, as a C-Corporation, your professional corporation would pay federal taxes on its profits and you would also pay individual taxes if you receive salary, bonuses, or dividends from the corporation.

N: How would being an S-Corp differ?

D: By electing to be taxed as an S-Corporation, your professional corporation would instead be a pass-through tax entity, like an LLC or a partnership.  Electing to be taxed as an S-Corporation may also allow you to pass losses from the business to your personal income tax return, where you can use the losses to offset income that you may have from other sources.

N: Ok. And can you talk about how the owner might take out a “reasonable salary?”

D: If the corporation pays you a “reasonable salary,” you may not be required to pay self-employment taxes on any additional corporate profits that are paid to you as dividends as a shareholder in addition to your reasonable salary.

N: That does sounds very advantageous—especially for those just starting out.

D: It is. It’s a great way to help small business owners who are sole proprietors get some financial breathing room.

N: Now, what would the disadvantages be?

D: The main drawback of electing to have your professional corporation taxed as an S-Corporation rather than a C-Corporation is that, in a C-Corporation, the cost of the premiums for shareholder benefits, such as insurance coverage, are deductible as a business expense. In addition, the shareholders may not be taxed on the value of the benefits.

N: Are there any restrictions on who can be a shareholder of an S-Corp?

D: Yes.  The Internal Revenue Code limits the number of S corporation shareholders to 100 or less. Also, S corporation shareholders can only be individuals, estates and certain types of tax-exempt entities and trusts, and the individuals must also be U.S. citizens or permanent residents.

N: And what about stock?

D: S-Corporations may only issue one class of stock, whereas C-Corporations can have different classes of stock that have different rights and liquidation priorities.

N: What would you recommend to someone who is just starting their professional corporation?

D: I would tell them to consult with their CPA or tax professional to make sure being taxed as an S-Corporation is the best fit for them. That being said, for most California professional corporations, electing to being taxed as an S-Corporation rather than a C-Corporation is likely to provide the most tax savings.

N: Thank you so much, Doug! I think that just about answers everything we were hoping to cover.

Doug Bend is the founder of Bend Law Group, PC, a law firm focused on advising small businesses and startups. To find out more, please contact Doug at doug@bendlawoffice.com.

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