INSIGHT: Thinking Through the Dynamex Decision

Most Americans prefer things that are simple. That’s probably why most prefer sporting events between two contestants, like baseball, football and basketball: there’s always a winner and a loser at the end of each contest. But most things are not simple. And nothing relationship-based is ever simple. It’s complicated—more like cross-country or golf, where improvement is a more rational (and attainable) goal than “winning.” Ask anyone who is married.

Work relationships are just that: they are relationships. They, too, are complicated. Nonetheless, most Americans resolutely try to define work relationships in binomial terms. For most, a worker either is an employee or an independent contractor. That is unrealistic. One can qualify as an employee for wage and hour purposes, but not for employee benefits (and benefit plan) purposes. One can even qualify as an “employee” for certain federal income and employment tax purposes, but not for any other purpose. And of course, one can qualify as an “employee” for purposes of one state statute or another (e.g., workers’ compensation, etc.), yet not qualify as an “employee” under any relevant federal laws. It has been that way for more than 50 years; countless state court and federal court decisions, and regulatory pronouncements, confirm that to be the case. Why? The legal standards are different. So are the consequences.

The April 30 decision by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court of Los Angeles County (2018), Case No. 222732, just adds another layer of complexity for organizations that contract with workers in California that they do not formally “employ.” In Dynamex the California high court adopted a simplified—and burden-shifting—three-factor test to determine whether a worker qualifies as an “employee” of the party that has hired him (or her)—but only for the express—and expressly limited—purpose of extending California’s wage order rules to such workers.

That has not stopped some from casting the Dynamex ruling, and its implications, in—you guessed it—binomial terms. One management-side attorney described Dynamex as “definitely a game-changer,” and the New York Times went so far as to report that the gig economy’s business model has just been dealt a serious blow capable of adding 20% to 30% to some gig economy business’s labor costs, by referencing a 2015 New York Times article about grocery delivery companies that had decided to reclassify their workers as full-blown employees for all purposes.

So what is the reality, here? Does Dynamex constitute a wholesale attack on the gig economy’s primary business model—to this point, the ability to extensively use free lancers without having to add another 30% or more to the cost of labor to provide them with “employee” benefits—thus posing an existential threat to companies ranging from Uber and Lyft to every Domino’s franchisee that sends a 17-year old out to deliver pizzas in his dad’s car in California? Or is Dynamex a California-centric complication—just another irritating wrinkle—which needs to be effectively and practically managed?

A considered review of the facts and the law indicates that Dynamex may not be the End of the World for gig economy businesses, but complying with the decision will require thought—particularly when it comes to deciding whether (or not) to provide newly-minted “Dynamex employees” with employee benefits. For those businesses that don’t want to add 20% to 30% (or more) to their existing labor costs by providing Dynamex employees with benefits, the good news is that in many cases, they won’t have to—and may not even be able to lawfully do so.

What Actually Got Decided in Dynamex

It is important to understand what the California Supreme Court decided in Dynamex—and what it did not decide. In Dynamex the California high court held that an individual, compensated for providing personal services as an independent contractor in California, is presumed to be the employee of the party that hired that worker for California state wage order purposes, unless the hiring party can show that all three of the following conditions exist:

(A) the worker is free from the hiring party’s direction and control over how the work is to be performed (both in fact and as a matter of contract),

(B) the work to be performed is outside the usual course of the hiring party’s business, and

(C) the worker customarily engages in an independently established trade, occupation or business of the same nature as the personal services the worker is providing.

By embracing this so-called “ABC” test to determine who is subject to California’s state wage order pronouncements (which govern working conditions ranging from minimum wage rates and maximum hours, to meal and work breaks), and by putting the burden on the hiring party to make those showings, the California Supreme Court ceased to rely on S.G. Borello & Sons, Inc. v. Dept. of Indust. Rel. (1989) 48 Cal.3d 341, a decades-old, multi-factor test used to determine who qualifies for workers’ compensation protection, and joined a handful of other states such as Massachusetts and New Jersey that have taken a similar approach for certain select purposes.

That is all that got decided in Dynamex. And there can be no question that the new ABC test embraced in Dynamex only applies to California’s wage order rules, and not for other purposes – not even for purposes of California’s workers’ compensation laws, which remain subject to the multi-factor test adopted in Borello. That’s why the court in Dynamex felt compelled to explain its ruling in a daunting 82-page opinion: the opinion discusses, in detail, most of the federal and state tests that have come to be used to determine whether a worker qualifies as an “employee” rather than an “independent contractor” for one purpose or another. Most relevant here, the court in Dynamex described and expressly rejected each one in favor of adopting the “ABC” test for purposes of construing and enforcing California wage orders--while making plain that it was only addressing those state laws.

Of particular relevance to this discussion, the Dynamex court discussed and explicitly rejected the 13-factor common law-based test the U.S. Supreme Court adopted in Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318 (1992) (“Darden”) to determine whether a worker is an “employee” for Employee Retirement Income Security Act (“ERISA”) purposes. The California Supreme Court in Dynamex also explicitly dismissed the common law-based test the Internal Revenue Service (“IRS”) and the United States Tax Court use to determine whether a worker constitutes an “employee” for federal income and employment tax purposes (in the absence of certain special statutory rules) – a test that generally consists of seven common law factors, according to a review of relevant Tax Court decisions ranging from Simpson v. Comm’r, 64 T.C. 974, 984-85 (1975), Matthews v. Comm’r, 92 T.C. 351, 360 (1989), aff’d, 907 F.2d 1173 (DC Cir. 1990) and Gierek v. Comm’r, 66 T.C.M. 1866, 1868 (1993).

Very Different Tests = Very Different Results

One thing the California Supreme Court did not do in Dynamex was to acknowledge how dramatically different both the Darden common law factor test, and the common law factor test used to identify employees for federal tax purposes, are from the ABC test that it did adopt. Does this matter? In a word, yes.

The Relevant Benefit Plan Tests

A variety of federal and state law tests have been formulated to determine whether a worker is an “employee” for one purpose or another. However, when it comes to determining what pension, health insurance and other benefits a private sector business can provide to its employees (or, in the case of Affordable Care Act (“ACA”)-mandated health insurance, must at least offer to its full-time employees), the tests that matter are the 13-factor common law test used in Darden to determine “employee” status for ERISA purposes, and the 7-factor common law test used by the Tax Court to determine “employee” status for federal tax purposes under the Internal Revenue Code (“IRC”).

NOTE: For a public sector employer, such as a state or a political subdivision like a regional authority or public school system, ERISA (and the Darden test) won’t have any relevance. But the IRS/Tax Court standard will still have relevance, because even public sector employees have a vital personal interest in accruing and receiving pensions and other benefits on a tax-favored and tax-deferred basis.

As any employee benefits professional will tell you, those two standards--and the two regulatory regimes--are heavily intertwined. Private sector employers cannot realistically sponsor and maintain an employee benefit plan, and through that plan provide (or offer to provide) deferred compensation or other valuable benefits to their current and former employees (and dependents) without substantively complying with both regimes.

For instance, a private sector employer can sponsor and maintain a 401(k) plan for some or all of its employees and thereby provide them with an economically-favorable way to save for retirement and other life events. If it chooses to do so though, it must comply with ERISA (which imposes numerous substantive and procedural requirements on the plan, on the employer, and on those appointed to serve as plan fiduciaries while providing protection from, e.g., a variety of state laws). But that is only part of the story. In order for the employer’s 401(k) plan to function effectively, and deliver the promised economic benefits, the 401(k) plan also has to satisfy a number of independently-imposed “qualified plan” requirements set forth in the IRC.

One of the more important qualified plan requirements is the “exclusive benefit” rule, which provides that a tax-qualified plan can only benefit current and former employees of the plan sponsor (and/or its commonly-owned subsidiary and affiliated companies). Extending an employer’s 401(k) plan to non-employees will bring about the disqualification of the 401(k) plan under the IRC, triggering a series of disastrous economic and regulatory consequences--including the possible violation of federal securities laws.

NOTE: For years, practitioners failed to appreciate this calamitous result; then, the IRS showed in Professional & Executive Leasing Co. v. Comm’r, 89 T.C. 225 (1987), aff’d, 862 F.2d 751 (9th Cir. 1989) that it was willing and able to enforce the exclusive benefit rule when non-employees were included in an employer’s qualified plan(s). That then prompted the IRS, first in Rev. Proc. 2002-21, 2002-1 C.B. 911 and then in Rev. Proc. 2003-86, 2003-1 C.B. 285, to outline how a qualified plan could cover at least workers provided by staffing companies or professional employer organizations, where the identity of the “employer” was uncertain. The IRS has not (yet) provided comparable guidance and comfort for independent contractors, although it is conceptually possible for those who take the position that they are self-employed.

Comparing the Standards

So just how different are those two federal law-based tests from the ABC test? A careful examination of the tests reveals just how different they are.

For instance, the Darden and Dynamex tests have just two factors in common:

• whether the hiring party has the right (or, no right) to control the means of performing the work (the “A” factor); and
• whether the work to be performed is part of the hiring party’s regular (business) activities (the “B” factor).

The eleven (11) other Darden factors, including whether the worker has (and provides) the skill and training required to perform the work, who supplies the tools and instruments, location of the work, duration of the relationship, control over scheduling and hours, and the method of payment (just to name 6 of the 11), have no relevance to the ABC test, but have substantial individual and collective significance in Darden. See Darden, 503 U.S. 318, at 323-324 (listing all 13 factors).

Perhaps most important, the ABC test adopted in Dynamex includes a presumption which forces the hiring party to not only show that the factors do not exist, but that none of them exist. That means that a worker could qualify as a Dynamex employee without being able to satisfy any of the 13 Darden factors, just because the worker hasn’t been customarily engaged in an independent business that does that very kind of work (the “C” factor)--or more precisely, just because the hiring party can’t show that the worker hasn’t taken those steps.

A worker also could qualify as a Dynamex employee just because the services to be performed cannot be shown to fall outside the hiring party’s regular business operations (the “B” factor)--a situation where, again, the worker might not satisfy any of the 12 remaining Darden factors. Indeed, a number of different mismatches are possible, where a worker would qualify as a Dynamex employee but pretty clearly would not qualify as an employee for ERISA purposes--particularly when the Dynamex presumption (and its run-the-table requirement) are added in.

Similarly stark differences exist between Dynamex’s ABC test and the Tax Court’s seven-factor, common law-based test. A close examination of those two tests shows that (similar to the comparison between the ABC test and the Darden test), the Tax Court’s seven factor list and Dynamex’s ABC test have just two factors in common:

• whether the hiring party has the right (or, no right) to control the means of performing the work (the “A” factor); and
• whether the work to be performed is part of the hiring party’s regular (business) activities (the “B” factor).

That of course means that the “C” factor in the ABC test--that the worker is customarily and independently engaged in the business of providing the type of service(s) being provided to the hiring party--plays no role in the Tax Court test.

Again, it bears remembering that under the ABC test adopted in Dynamex, a presumption forces the hiring party to not only show that the factors do not exist, but that none of them exist. So just like the ERISA comparison, a worker could qualify as a Dynamex employee without being able to satisfy any of the seven Tax Court factors, simply because the worker is not customarily engaged in that sort of activity as part of an independent business (or at least cannot be shown to be formally doing so). Here, too, a worker also could qualify as a Dynamex employee just because the services to be performed could not be shown to fall outside the hiring party’s regular business operations (the “B” factor) even if the worker does not satisfy any of the six other Tax Court factors, including the ever-important “right to control” factor.

Dynamex Employees vs. All-Round Employees

By now it should be obvious that there are potentially hundreds of thousands of workers presently providing services in California who qualify as Dynamex employees (e.g., because they are moonlighting, because they provide services that just happen to be integral to the business being operated by the party that hired them such as those pizza delivery kids, etc.) but who cannot possibly qualify as “employees” either for ERISA purposes or for federal tax purposes.

There no doubt also are hundreds of thousands of other workers in California who not only qualify as Dynamex employees but also stand a much better chance of qualifying as “employees” under the Darden test and/or the Tax Court test(s). However, that simply reinforces the broader point: attaining Dynamex employee status has virtually no relevance to determining whether one will – or, won’t – qualify as an “employee” under Darden or under the Tax Court test(s).

Where This Leaves the “Benefits” Question

The broader point? An organization that utilizes independent contractors in California does not have any sort of legal obligation to provide employee benefits (e.g., access to health insurance, a 401(k) plan, disability benefits, etc.) to every worker who might now be able to qualify as a Dynamex employee. Indeed, in many cases it may not even be able to do so without violating relevant federal law.

But that does not mean that an organization that utilizes such workers in California, and thus finds itself having to deal with the Dynamex decision, can ignore the employee benefits implications generated by Dynamex – including the distorted ones that have surfaced in the media. Rather, such organizations would do well to put together a thoughtful and deliberate strategy to deal with the employee benefits fallout. This is no time to make sweeping decisions; the stakes are too high.

Excluding All Workers, Including Dynamex Employees

Certainly, if an organization wanted to make a sweeping decision, the easiest and safest one would be for it to exclude from its benefit plans all workers that it classifies as independent contractors, while so classified (without regard to their status under relevant California law, pertaining to, e.g., its wage order provisions). One of the more durable takeaways from Vizcaino, et al. v. Microsoft Corp., 173 F.3d 1006 (9th Cir. 1997) (“Vizcaino”), the famous worker misclassification/benefits case from the 1990s, occurred while Vizcaino was making its way through the courts in 1996 and 1997. Vizcaino, and the publicity it attracted, set off a series of generally unsuccessful class action lawsuits which were brought by workers who attempted to sue their way into several large corporations’ benefit plans.

In a series of decisions, including three federal appeals court decisions (Abraham v. Exxon Corp., 85 F.3d 1126 (5th Cir. 1996); Clark v. E.I. DuPont De Nemours Co., 105 F.3d 646 (4th Cir. 1997); and Trombetta v. Cragin Federal Bank, 102 F.3d 1435 (7th Cir. 1996)), courts across the country held that a plan sponsor had the unilateral right to set its plan’s terms, and (if it chose to do so) could exclude non-employee workers (or those that it classified as non-employee workers or as leased employees) from its benefit plans, by explicitly making them ineligible. For employers paying attention to those rulings, and to the IRS’s attack on qualified plans that were permitting non-employees to participate (note the above discussion of Professional & Executive Leasing Co. and the exclusive benefit rule), the choice was a pretty clear one: when in doubt, exclude from one’s qualified plans any worker whose employment status is open to question (or second-guessing by the IRS) if one wanted to avoid having one’s tax-qualified plans (such as one’s 401(k) plan) be disqualified.

But such a sweeping decision can have substantial fallout. Any organization that pursues a strict exclusion strategy risks excluding from its benefit plans large numbers of Dynamex employees who also can qualify as “employees” under the Darden and Tax Court tests. That can have potentially adverse regulatory consequences. One of the requirements imposed upon tax-qualified plans by the IRC, such as 401(k) plans and profit-sharing or money purchase pension plans, is that such plans must benefit a comparatively large percentage of the sponsoring employer’s non-highly compensated employee population. For example, IRC Section 410(b)(1) requires tax-qualified plans to generally benefit 70% or more of an employer’s non-highly compensated employees, or at least 70% of the percentage of its highly compensated employees who benefit). If the plan(s) don’t, they can be partially disqualified as to the highly compensated employees who benefit. And while Section 410(b) contains a number of alternative ways to satisfy this qualified plan requirement, including the use of economically non-discriminatory job classifications, those alternatives are very facts-intensive, and do not lend themselves to the sort of sweeping decision(s) under discussion here.

Any organization that pursues a strict exclusion strategy also tempts fate under the ACA, which – even now – requires any employer with 50 or more full-time employees (known as an “applicable large employer”) to offer minimum essential health insurance coverage to at least 95% of its full-time employees – and uses an IRC-based common law test to determine who qualifies as an “employee” for that purpose. (The standard is set forth in Treasury Regulations Section 54.4980H-1(a)(15), which can be found at 26 C.F.R. 54.4980H-1(a)(15).)

NOTE: Organizations that routinely use independent contractors in California, like Lyft and Uber, may want to prepare themselves to respond to an increase in IRS-issued ACA forms (Letter 226-J), where workers (who now consider themselves to be Dynamex employees) will start to contend that they are “employees” who have not received an appropriate offer of health insurance coverage from them. However, just because an organization receives a Letter 226-J from the IRS, due to a mistaken belief by a worker that he or she now qualifies as an “employee” as a result of Dynamex, that does not mean that the organization is now exposed to a risk of tax penalties – so long as the worker is only a Dynamex employee and nothing more. But it may make it more important for the organization to respond timely (and precisely) to such a Letter (i.e., by denying that the worker is not one of its common law employees) to avoid having that record later be treated as some sort of admission.

Safer Bet: Exclude Just Non-Employee Workers and Dynamex Employees

A less sweeping, more considered and likely less risk-laden approach for an organization to take would be to embark on a systemic review of its California-based independent contractors and separate out, into three separate groups, (a) those workers who do not qualify as “employees” of the organization for any purpose (including Dynamex’s ABC test), (b) those workers who now qualify as Dynamex employees, but nothing further, and (c) those workers who colorably (if not definitively) qualify as “employees” of the organization not only under Dynamex but also under a reasonable application of the Darden and Tax Court tests.

The organization could then categorically exclude from its benefit plans those workers in categories (a) and (b) (while taking care to protect the wage order rights of the Dynamex employees), and simply formalize the findings of the review by making the workers in category (c) regular employees, subject to whatever benefit plan offerings might then be available. An organization following this path would also then be in a position to seek appropriate relief from prior misclassification penalties under the IRS’s Voluntary Classification Settlement Program (“VCSP”), if then eligible for the category (c) workers being reclassified. (The most recent IRS version of the VCSP can be found in Announcement 2012-45, 2012-51, I.R.B. 724.) More forward-thinking organizations that find themselves in such a position might even consider formulating benefit plans specially designed to attract and retain gig workers, such as benefit plans that make it easy for such workers to function as temporary or occasional employees of the organization, in between (or, concurrent with) periods of unrelated self-employment, and/or that provide increasingly generous benefits for those that leave--but later return. For skilled or semi-skilled itinerant workers, this could be a helpful strategy.

Inevitably, some organizations will want to make a sweeping decision in the other direction, and provide at least some level of employee benefits – or, access to such benefits – to all their independent contractors following the Dynamex decision and without regard to how those independent contractors might fare under the Darden and Tax Court tests. Such organizations would face considerable risks by doing so, for that is where potentially huge legal problems lurk.

Risks from Providing ‘Employee’ Benefits to Non-Employees

No doubt, somewhere, some gig economy client will ask their legal counsel the following: “Why can’t we just offer health insurance and 401(k) plan enrollment to all our workers, or at least to the ones we now have to treat as employees as a result of Dynamex?” An appropriate answer would be this: If those workers are not the organization’s “employees” (or are only “employees” under the new Dynamex formulation but do not colorably qualify as “employees” at least under Darden’s common law test or under the Tax Court’s common law test (perhaps not a slam dunk, but at least arguable), those workers are no different than any other member of the general public. A sophisticated financial organization may be in a position to sell its non-employee workers financial and insurance products which parallel those being promoted and sold to their employees, but few organizations are in that position.

In simplest terms, an organization cannot lawfully sell insurance products or unregistered securities (the right to invest in a 401(k) plan is, after all, the purchase of an investment contract) to members of the general public. Such products need to be registered or otherwise approved by relevant federal and state regulatory authorities, and those soliciting their purchase need to be appropriately licensed and qualified. Why? Because ERISA-regulated employee benefit plans get--in effect--an “easy pass” from a wide variety of federal and state law-based regulation, even though such plans increasingly are nothing more than a platform for purchasing and selling different investment and insurance products. And there can be no doubt that, in the overwhelming majority of instances, purchase and sale activity occurs.

The U.S. Supreme Court confirmed more than 35 years ago, in International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979), that investing in a benefit plan which is both voluntary and contributory (401(k) plan, anyone?) constitutes the purchase of a security. That also helps explain why such plans (and interests in such plans) are exempted by statute from registration under the Securities Act, the Securities Exchange Act and the Investment Company Act – so long as the plan satisfies the “qualified plan” requirements imposed on such plans by IRC §401(a) – and why such plans rely on ERISA’s broad preemption statute (found at Section 514(a) and codified at 29 U.S.C. §1144) to displace a variety of consumer protection and financial regulation laws. The catch for the employer? ERISA imposes substantial stewardship responsibilities upon the employer and its appointees under ERISA’s fiduciary duty rules, to fairly disclose the opportunity, put in place appropriate safeguards to ensure whatever is being promised (subject to whatever limitations exist) is delivered, and that those the employer has chosen to involve are properly supervised. That helps explain why ERISA’s fiduciary duty rules are so reticulated, and so onerous.

Making what are intended to be close-ended, non-public opportunities available to members of the general public is not within ERISA’s contemplation. That is why an organization’s employee benefit plan, to become subject to Title I of ERISA, must cover some or all of the organization’s employees – and why a plan that covers no employees is not covered by ERISA at all. For example, there is a U.S. Department of Labor regulation (found at 29 C.F.R. §2510.3-3(b)) which provides that ERISA Title I does not cover a plan that has no employees, such as a Keogh plan, that just covers a self-employed individual. And if Title I of ERISA does not apply, neither does ERISA’s preemption statute which protects such plans (and its promoters) from a wide variety of state securities, insurance, consumer protection and similar laws.

As such, an organization that blindly offers health insurance coverage and 401(k) plan access to its independent contractors could easily run afoul of several federal and state securities and insurance laws and regulations, and prompt the sort of governmental intervention that could eclipse the enforcement actions taken by the Securities and Exchange Commission and various states (including California) in 2016 and 2017 against YourPeople, Inc. (also known as Zenefits). See, e.g., Securities Act Rel. 10429 (Oct. 26, 2017) (In re YourPeople, Inc. dba Zenefits FTW Insurance Services).

Conclusion

It is both easy and understandable that many were caught by surprise by the California Supreme Court’s decision in Dynamex. Worker classification is complicated, and a potential minefield for those that persist in seeing the field as just a binomial (red car/blue car) issue, but it is far from imponderable. So what should an organization with substantial California operations do in the wake of Dynamex? There is of course the obvious (i.e., apply the ABC test to every independent contractor working for the organization in California, and implement work-related policies and practices to make sure one doesn’t violate California’s wage order rules when utilizing anyone who qualifies as a Dynamex employee), but what else?

Certainly, an organization could make the sweeping decision to simply exclude all of its independent contractors from its benefit plans, without regard to whether they are entitled to wage order protection as a result of the Dynamex decision, but that decision carries with it certain risks, some of which may well be unacceptable.

The more prudent approach would be for the organization to determine whether any of its independent contractors qualify as Dynamex employees, and if they do, whether they also qualify as “employees” under the Darden and Tax Court common law-based tests – and offer benefits to just those workers (while taking steps to systematically exclude the others). Why? Because the cost(s) associated with providing employment-based benefits to an entirely new wave of workers no doubt would impose a substantial burden on any organization--perhaps adding 30% or more to the organization’s labor costs. For many organizations, that would be crippling.

Could an organization just take a simplified “lowest common denominator” approach, and avoid complications by just employing for all purposes every worker who provides personal services? Sure. But that “easy way out” is also the most expensive way out. And most organizations’ business models aren’t that resilient: many would not survive if compelled to provide employee benefits, and other employment-based perquisites, to anyone and everyone capable of qualifying as an “employee” under one federal or state standard or another.

John J. McGowan, Jr. (jmcgowan@bakerlaw.com) is a partner in the employee benefits practice of Baker & Hostetler LLP, where he has practiced since 1986. He collaborates regularly with members of the firm’s general tax, employment and labor, and business practices on a variety of matters (including workforce management matters as part of the firm’s interdisciplinary contingent workforce team, which has a national footprint).