Problems can arise, however, when it turns out that some or all of the independent contractors are in fact misclassified, and are actually employees under the various tests applied by the federal government and California.¹ Misclassification can result in significant penalties for the employer under both tax and employment laws.

When the business is placed in receivership, the receivership estate, as the employer, remains liable for the status of the employees and the agreements the business has entered into with its independent contractors, as well as any obligations (such as tax filings) that arise from those relationships. Once the receiver is appointed, however, issues may arise relating to the classification of independent contractors as common law employees, and concerns may arise as to whether and under what circumstances the receiver may incur liability for any misclassification existing at the time that he or she takes control of the business. The receiver must quickly evaluate his or her obligations, if any, and move to correct any misclassification.

Classifying a Worker as Employee or Independent Contractor

Whether a worker is an employee or an independent contractor is a legal question, and in California this law is contained in the California Unemployment Insurance Code (CUIC). Interpretations of these laws are contained in regulations of the Employment Development Department (“EDD”). The definition of an employee is set forth in CUIC Sections 621(a) and (b), and Section 13004. Sections 621(a) and (b) state that an employee is:

1. Any officer of a corporation.
2. Any individual who, under the usual common law rules applicable in determining the employer-employee relationship has the status of an employee.

CUIC Sec. 13004 states that an “employee” means a resident or a non-resident individual who receives remuneration for services performed within California, including an officer of a corporation.

Additional guidance is given under California Code of Regulations, Title 22, Section 4304-1. This section provides the definition of an employee and sets forth the rules generally applicable to determinations of employee status. Section 4304-1 states, “(w)hether an individual is an employee for the purposes
of Sections 621(b) and 13020 of the code will be determined by the usual common law rules applicable in determining an employer-employee relationship.”

Section 4304-1 also provides that the most important factor in determining the difference between an employee and an independent contractor is the right of the principal (employer) to control the manner and means of accomplishing the desired result.²

Some workers are statutory employees under both California and federal law. These workers must be classified as employees (at least for certain purposes),³ even if they would be considered independent contractors under the common law test, and include the following:⁴

1. Any officer of a corporation is an employee of that corporation.
2. An agent or commission driver who distributes meat products, vegetable products, fruit products, bakery products, beverages (other than milk), laundry, or dry cleaning for someone else.
3. A full-time life insurance salesperson who sells primarily for one company.
4. A home worker who works by guidelines of the person for whom the work is done, with materials furnished by and returned to that person or to someone that person designates.
5. A traveling or city salesperson (other than an agentdriver or commission-driver) who works full time (except for sideline sales activities) for one firm or person getting orders from customers. The orders must be for merchandise for resale or supplies for use in the customer’s business. The customers must be retailers, wholesalers, contractors, or operators of hotels, restaurants, or other businesses dealing with food or lodging.
6. The author of a commissioned or specifically ordered work is a statutory employee of the person commissioning the work if the parties expressly agree in a written instrument signed by them that the work shall be considered a work made for hire, and the ordering or commissioning party obtains ownership of all the rights comprised in the copyright in the work.
7. Any person with a membership interest in a Limited Liability Company (LLC) treated as a corporation for federal income tax purposes is an employee of that LLC.
8. Any unlicensed contractor performing services requiring a contractor’s license is an employee of the licensed or unlicensed contractor who hired the unlicensed contractor.

Receiver's Obligations as to Employee Classification and Reporting

Where the receiver has control of all or substantially all of the business and assets of the estate, and the business is ongoing, the receiver is generally obligated to file federal and state tax returns (including payroll tax withholding forms) and other informational returns on behalf of the business. Federal and California law mandates that an employer report, collect, and pay over all required payroll taxes and withholdings. Failure to report and pay the taxes may result in personal liability for the ‘responsible person’ (which, in a situation where the receiver is exercising control over the business, may include the receiver) while the responsible person is in control of the business.⁵

Where an ongoing business in receivership has only employees, there generally should be no problem in determining the amounts of payroll tax withholdings that need to be reported and paid. However, where the ongoing business utilizes independent contractors to conduct some or all of its business, the receiver needs to be sure that the independent contractors have been properly classified, and that they are not, in fact, misclassified employees of the business in receivership.⁶

California Penalties

California Labor Code Section 226.8, which became effective on January 1, 2012, imposes penalties on employers who willfully misclassify their employees as independent contractors. Willful misclassification is defined as “voluntarily and knowingly misclassifying that individual as an independent
contractor.” Since any such misclassification will have been made prior to the appointment of the receiver, the receiver generally cannot be found to have willfully misclassified any employees. However, while not applicable on its face to receivers (who may step into the shoes of management of the
actual employer business in receivership), the recent case of Noe v. Superior Court (Levy Premium Foodservice Ltd. P’ship), No. B259570 (Cal. Ct. App. June 1, 2015) ("Levy"), raises interesting issues regarding the liability of co-employers. In that case, the California Court of Appeal held that section 226.8
extends to not only to the employer actually making the misclassification, but also to any employer who is aware that the co-employer has willfully misclassified their joint employees and fails to remedy the misclassification.

Section 226.8 is enforced by the California Labor Commissioner. The Labor Commissioner may investigate complaints by workers and, if necessary, initiate either a civil suit or a hearing before the Labor Commissioner pursuant to California Labor Code Section 98. While it had been thought that Section 226.8 could also be enforced through California's Private Attorneys General Act (which allows a private citizen to pursue civil penalties on behalf of the Labor and Workforce Development Agency, provided the citizen complies with the notice and waiting procedures of the Act), the court in Levy has
held that this remedy is not available.

The Levy case is the first appellate case to address issues arising under Section 226.8, and its importance arises from its discussion of the scope of application of Section 226.8’s provision that it is “unlawful for any person or employer to engage in . . . [the] willful misclassification of an individual as an independent contractor.” Under the court’s analysis, the term “engage in” is given a broad interpretation. Under this interpretation, it may be argued in the future that a receiver who has taken over management of a business that has misclassified employees as independent contractors and does not correct the misclassification (and report and collect payroll withholdings) might, by such inaction, incur liability.

The penalties for violating Section 226.8 could result in fines against the receivership estate of between $5,000 and $15,000 per violation, in addition to any other fines allowed by law. If the employer is found to be engaged in a pattern of violating this law, the fines may be increased to between $10,000 and $25,000 per violation.

California also imposes tax penalties for misclassifying workers. These penalties include repayment of back payroll taxes, subject to interest and a 10% penalty on the unpaid taxes. Failure to withhold and pay payroll taxes can also result in a misdemeanor charge, and the employer can be fined up to
$1,000 or sentenced to jail for up to one year, or both.

Internal Revenue Service Penalties

The IRS also imposes strict penalties for misclassifying workers, whether intentional or unintentional. For unintentionally failing to withhold federal income tax, the penalty is 1.5% of the wages paid. The penalty is doubled to 3% if the employer did not file a Form 1099-MISC for the worker with the IRS. The penalty for unintentionally failing to withhold the employee's share of Social Security and Medicare taxes is 20% of the employee's share of the tax. The penalty is doubled to 40% if the employer did not file a Form 1099-MISC for the worker with the IRS.

If the misclassification was intentional, or if statutory employees are misclassified, the employer is liable for the full amount of both the federal income tax that should have been withheld as well as the employee's and employer's share of Social Security and Medicare taxes.

The majority of classifications of workers are not challenged by the IRS. However, when IRS reclassifications are made, it can result in the assessment of significant employment tax liabilities. In 1978, in order to ameliorate the effect of such assessments, Congress enacted Section 530 of the Revenue Act
of 1978. Section 530 provides businesses with relief from federal employment tax obligations if certain specific requirements are met, including the requirement that the business had a ‘reasonable basis’ for its action. If the requirement are met, it terminates the business’, but not the worker’s, liability for the following employment taxes: federal income tax withholding, Social Security and Medicare taxes (FICA), and Federal Unemployment Tax (FUTA). It also means the business is not required to pay any interest or penalties resulting from the liability for employment taxes. Information on Section 530 relief can be found in Publication 1976, Section 530 Relief Requirements. This publication is on the IRS Web site.

Conclusion

It is unlikely that a receiver who assumes control of a business that has misclassified employees as independent contractors will incur any liability for such misclassification. However, it is important that the receiver determine whether, going forward, the independent contractors are properly classified. The receiver must remain aware of his or her obligation to report and collect withholding taxes and other amounts if employees are being paid, and must also remain aware if other taxes, such as excise taxes, are involved in the business in receivership. If they are in fact employees, their compensation
is includable in payroll. Failure to report and pay these taxes (or to pay state payroll taxes) after the receiver has determined that the workers are misclassified could result in personal liability for the receiver. Both the federal and California tax statutes make a ‘responsible person’ potentially liable for taxes that have not been withheld or collected by the business while the responsible person was in sole or shared control. The definition of a 'responsible person' is broad enough to include a receiver in the proper circumstances. Being aware of the potential for liability is the first line of defense. If the receiver has any concerns about his or her obligations, he or she should consult with his or her tax advisor.

1 These tests are generally found in the U.S. Fair Labor Standards Act, the Internal Revenue Code and the Regulations promulgated thereunder, and in
the California Revenue and Taxation and Unemployment Insurance Codes. This article is not intended to be exhaustive on the subject of a receiver’s
obligations to file tax returns on behalf of the business in receivership; the reader’s attention is directed to the article by Charles Rosen, Intimate Affairs
with the IRS: How to Handle Those Delicate Relationship Issues, Receivership News (Summer 2004), Issue 14, page 7 for additional information on this
point.

2 Section 4304-1 goes on to provide that if it cannot be determined whether the principal has the right to control the manner and means of accomplishing a desired result, the following factors will be taken into consideration:

(1) Whether or not the one performing the services is engaged in a separately established occupation or business; (2) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of a principal without supervision; (3) the skill required in performing the services and accomplishing the desired result; (4) whether the principal or the person providing the services supplies the instrumentalities, tools, and the place of work for the person doing the work; (5) the length of time for which the services are performed to determine whether the performance is an isolated event or continuous in nature; (6) the method of payment, whether by the time, a piece rate, or by the job; (7) whether or not the work is part of the regular business of the principal, or whether the work is not within the regular business of the principal; (8) whether or not the parties believe they are creating the relationship of employer and employee; (9) the extent of actual control exercised by the principal over the manner and means of performing the services; and (10) whether the principal is or is not engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual.

3 See CUIC sections 621(a) and (c). The question of classification of employees and independent contractors is complicated by the fact that some
workers who would normally qualify as independent contractors under the common law test are classified under California law as employees for specific
taxes only. For example, someone hired as an author of a commissioned work pursuant to a written contract designating the work as a "work for hire" is subject to the provisions of CUIC sections 621(d) and 686, dealing with withholding for unemployment insurance and state disability insurance, but not to personal income tax withholding. The payments to the author would be reported on Form 1099-MISC.

4 See EDD publication DE 231SE, Information Sheet: Statutory Employees, for a fuller discussion of the classification of these employees for unemployment insurance, employment training tax, and state disability insurance purposes.

5 See, for example, Stewart v. California, .272 Cal. App. 2d 346 (1969), and the cases cited therein. California statutes impose specific duties upon a
receiver to pay outstanding sales tax and state disability unemployment insurance taxes as expenses of administration (Rev. & Tax. Code § 6756;
Unemployment Ins. Code §§ 986, 1701). Likewise, in Kirk v. Kirk, 243 Cal. App. 2d 580, 582 (1966), the court stated that under federal law a receiver
is personally liable to the United States to the extent he pays other creditors when there are debts owing to the United States or fails to give priority to
federal tax liens (citing 31 U.S.C. §§ 191, 192).

6 A ‘responsible person’ is any person or group of persons who is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and who willfully fails to collect or pay them. He or they must have the duty to perform and the power to direct the collecting, accounting, and paying of trust fund taxes. This person may be an officer or an employee of a corporation, a member or employee of a
partnership, a corporate director or shareholder, or a third party with authority and control over funds to direct their disbursement. For willfulness
to exist, the responsible person must have been, or should have been, aware of the outstanding taxes and either intentionally disregarded the law or was
plainly indifferent to its requirements (no evil intent or bad motive is required). (See the IRS website: https://www.irs.gov/Businesses/Small- Businesses-&-Self-Employed/Employment-Taxes-and-the-Trust-Fund- Recovery-Penalty-TFRP.)

*Robert C. Norton is a principal with Rodi Pollock Pettker Christian & Pramov, A Law Corporation, Los Angeles. This article is intended as a source of general information, and should not be construed or relied upon as specific legal advice without further inquiry and/or consultation with a qualified professional.