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The Anderson Files
The Anderson Files

The guest on this episode is Ernest Howard, CPA, based in Los Angeles, shares his thoughts and insight on California AB-5 and the Dymex Decision and how it will be catastrophic to many California businesses.

With AB-5, effective January 1, 2020, many independent contractors that fail the 3-part test, known as the “ABC” test, in California, will be considered W2 employees for purposes of claims for wages and benefits.

Ernest Howard, CPA, based in Los Angeles., offers a full range of accounting, tax, business consulting, bookkeeping, tax planning and tax audit defense services. Ernest is key leadership of the California CPA Society in Los Angeles and on the State level. CalCPA is your connection to your profession.

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This is The Anderson Files on PodClips.
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The Anderson Files is a look at commerce, investment, economics and retirement issues that affect each and every one of you.
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Your host is Mike Anderson, Executive Vice President, retirement services, and partner with Finestone Partners.
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Finestone Partners is an independent firm with securities offered through Four Points Capital.
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And now your host Mike Anderson. Thank you, Mark Alyn,
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Our Anderson Files co-host for this segment, and we turn to our guest, Ernest Howard, CPA.
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Ernest has been in practice as a CPA 41 years since August 5th, 1978, 9:14 a.m. Pacific Standard Time, located in the Marina Del Rey area.
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He serves the self-employed, small business, investors, the real estate sector and the tax distressed.
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He is current chair of CAL CPA Hollywood Beverly Hills Discussion group, and not only currently, but for the last 33 years, Ernest, welcome.
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Well, thank you. Welcome.
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And our subject today is an issue, a tax issue, a very important tax issue that will affect independent contractors in California.
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And most of which will become effective.
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A lot of it will become effective,
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January 1st 2020. Ernest.
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What is this big tax wave and issue that’s coming up? Well, this has been something that’s been developing over the years. Back in 2012,
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the state passed Labor Board Law number 226.8 that basically created penalties for companies that pay independent contractors when they should be treated as employees.
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And they added to that Labor Code Section 2753 which provides for up to a $,5000 to $25,000 penalty for anyone who gives advice to someone other than an employee of the company or other than an attorney, licensed attorneys are exempt from this penalty as our employees of the company.
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But for accountants and other financial advisers to give advice, they can be subject, per violation, to this penalty, and we’ll get into what the per violation means a little bit further along.
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This is part of what’s becoming what many would describe as a poisonous business environment in California, where thousands of businesses per year now are opting to leave California for more business-friendly places like Texas and Florida and other non-tax states like Washington state, and South Dakota, Nevada,
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and a few other places, but, basically this law was there and didn’t really do much. It was available, but the Labor Board with California didn’t have a lot of incentive to do much with it.
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And then last year, there was a California Supreme Court case called Dynamex, and Dynamex basically created some rules as to who should be and should not be an independent contractor, and went well beyond the previously established rules.
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And, and what’s really scary about the Dynamex decision is it’s retroactive so that they can go back to 3 to 4 years of whatever is open under the statute of limitations and, and hit businesses, and this is dangerous because obviously they can’t come after all the violators.
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But if you rub the wrong people the wrong way, you can become the focus of some selective enforcement, and I don’t, I can’t say that that’s happening, but that possibility is a great risk for small business.
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How, how did the Dynamex case gain this degree of attention for this particular issue? Was there something some part of it that was particularly unique that led to this? Well, let’s take this a step further. Dynamex was then codified just a few months ago this year, in 2019, by AB-5, a California law that basically statutorily codified the Dynamex decision.
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And it basically, functionally, has the risk of putting businesses like Uber and Lyft out of business because their entire model is surrounded, is built around using independent contractors to be drivers and to pick up people in their cars and, under the AB-5 rules, clearly, those people should be employees, and economically the money and the organization just don’t exist.
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This is of such significance that both Uber and Lyft have been raising hundreds of thousands of dollars to try and put together a California proposition to turn over this law.
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So it’s that serious.
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The initial Dynamex decision is based on what a company did?
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This was a California Supreme Court case, and there was a company called Dynamex.
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That was, I don’t remember the specific industry or details, but paying people as independent contractors that clearly, even under the old rules, probably should have been employees, but they fought it and fought it all the way to the California Supreme Court, and unfortunately, we were left with the residuals of some pretty gnarly stuff.
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Are the, as far as participation from Sacramento, the legislature, are they for the most part, have they been behind codifying Dynamex to create the AB-5? Well, look, our California State Assembly and Senate love revenue and, and basically they love revenue
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They can collect and, you know, independent contractors basically take their income, subtract their expenses and it’s the net profit that they’re supposed to pay the tax on.
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And a lot of them are very slippery, or smart, depending on your perspective.
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And, basically are hard to get the money away from.
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And of course, with employees, all of the taxes are withheld by the employer and paid in, and with humongous payroll penalties.
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If you don’t pay payroll tax penalties, if you don’t deposit them and pay them on time, employers are intimidated into, you know, paying this religiously.
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So the state would like it if everybody was an employee with withholding and, of course, that will never happen.
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But what we’ll get a little bit further into some rules that can make things happen.
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But I encourage anybody who’s interested in this to do an online search, whether you use Google or or whatever your search engine is,
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just do a search for AB-5, California AB-5, AB dash 5, and the law, the entire text will come up. Just before this meeting,
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I went online and downloaded it from one of the websites I use and it’s about 13 pages long.
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We’re not gonna be able to cover everything that’s in it, but we’ll, we’ll get into it enough that, you’ll see, that this has very serious implications for small business will cover, you know, exactly who should and should not be, or could or could not be, an independent contractor, in a few moments that I’ll cover the three tests.
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But let me go over a few other aspects first.
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So AB-5, you know, takes formally effect January 1st of 2020, but the Dynamex decision is already there and extends retroactively.
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At first, there was a strong indication that this might even overturn what’s common in the entertainment industry or the use of loan out corporations.
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And of course, in loan out corporations, somebody is paid as their corporation of fee for their services and then they are employees of their own corporation, and there is still some risk that this may come to pass.
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But the indications are that the political pressure from the richer than us, members of the entertainment industry, that there’s a good chance that loan out corporations will survive.
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But, that’s found mostly in the entertainment sector in California, primarily.
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But, well, actually in other states as well.
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But, and of course many of the other states, if you go to places like Texas and Florida, the rules are much looser and businesses are gravitating to those places in droves. In one day,
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I called two of my clients that had relocated to Texas, one in the morning and one in the afternoon, and they both said the exact same thing, is Ernest, you wouldn’t believe it.
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But everybody we meet is here is from California, and every one of them either brought a business with them or started one when they got here.
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And I remember this happened back in the early nineties.
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In the early nineties, California was reputed to have such a bad business climate that businesses were just leaving in massive numbers.
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In fact, during the early nineties, 30% of my clients, you know, more hundreds of clients, moved out of state.
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And thankfully, 90% of them continued to be clients via phone, fax, and the internet, and and express mail.
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But California basically got with the program.
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I think the economy was so bad in the early nineties, in 1993,
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California couldn’t pay its bills.
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So they were paying contractors and people doing work for the state with pink vouchers called warrants, that you had to wait until the state had some money to actually pay off on them.
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That’s scary.
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And, since California has upped the tax rate to 13% and we still have the dot com businesses here,
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they’re a little bit overly confident that that’s not gonna happen again.
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I can honestly see that as, as Google’s buildings depreciate and they find success, getting enough technical employees in other locations that a large percentage of our tech industry could leave.
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Leave California.
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Let’s talk about the entertainment industry.
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I mean, we’ve got, you know, radio, TV,
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you know, Hollywood is just down the street from where we’re recording, and there are many small production companies.
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If a company moved to Texas, but had to shoot in California, that would add to the conundrum.
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Would it not? It would complicate things? But then why would they need to shoot in California? Maybe they need the beach.
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There’s, I mean, you can go to Galveston in Texas but they need, who knows? You know, the director needs a certain shot.
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But of course, what if 90% of it shot in Texas and that beach shot is done here, you know, with technology.
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In fact, they may not even be here.
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They may just have some, somebody go there remotely who is not even formally associated with them and take the shot, and transmit it to them so that, you know, your physical existence is less significant than just having the camera in the right place at the right time through technology.
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Well, I have to ask because I think it’s important, and that is who should be 1099 and who should not be 1099?
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Well, basically, the AB-5 has three tests, and you must pass all three, failing any one of these three tests is fatal.
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The first one, is that you have to show that you are really in business.
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You, you want to be, basically, have more than one client. If you are a captive, solely doing business for one business, that probably will fail because you are too much, you know, it looks too much like an employment relationship. The second, and actually this has been the law for years in California, is that control. If the company engaging the service, whether they’re the employer or the independent contractor hirer, if they have the ability to control when, where, and how, what is done, whether or not they exercise that control, is determinative if that control exists, boom, they’re an employee, period.
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So in other words, if we were to say, Ernest, we’re going to do an interview with you at 1:30 you’re an employee.
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If you’re paying me for doing the interview, that definitely weighs in favor of that direction.
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If, that’s the only aspect of control and I have the ability to say whatever I want, maybe not.
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But, you’ve got to look at, you know, the subjective factors behind that.
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And then the last test, let’s see, we have control and we have being in business is you cannot be rendering a service that is an integral part of the business.
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So, and here’s an interesting thing, is AB-5 exempts doctors, lawyers, accountants, and certain other professionals.
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However, that’s only if they’re rendering service to other businesses unrelated to themselves. If I hire accountants to do work for me,
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And this has been an industry typical activity, or practice for forever.
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Basically, that during tax season and other busy times, accounting-wise, accountants would hire other accountants as independent contractors to come in and work with them.
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Well, now if what, what the service that the independent contractor is renting is an integral part of the business that’s engaging that service.
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Then by definition, they’re an employee under the three tests.
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And , and an example, let’s say in my case, if I hired accountants to help do tax returns, or to help prepare financial statements, clearly, they would be employees, even though accountants are supposed to be exempt.
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But in that instance, I’m engaging them to perform a service that’s part of our business.
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On the other hand, if I were a plumbing shop and I engage an accountant to come in, well, clearly, accounting is not part of plumbing.
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And on the other hand, as an accountant, if I hired a plumber to come in and fix the leaky toilet here in the office, well, clearly, that’s not part of our regular business, so we’d be ok.
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But if you look at how subtle the differentiations in services rendered can be, this is going to be a nightmare, to sa, have we crossed a line or haven’t we? And there will be court case after court case and, and that uncertainty is scaring the heck out of small businesses and, and they’re leaving California in massive numbers and I can, I can see with, with being redesignated as an employee, you then get into all the employee benefits, group, health and welfare retirement, comp packages.
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Let me give you an example, and this will take a few minutes.
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In fact, this will be a good part of our presentation here as an example, I have a client who has a restaurant that was in the South Bay area.
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And, basically, they decided to move to West LA, and in the move, the liquor board held up their liquor license for a couple of years, and imagine trying to make money in a restaurant without being able to serve beer and wine.
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So, the poor owner of this lost her life savings, keeping the business going.
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And it finally got to where she was an inch away from shutting down.
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And her previous accountant said, well, you know, to save money, , let’s just pay your waiters and waitresses as independent contractors for a few months until we get our license and we can get our cash flow going.
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So, after a few months of doing this, the labor board inspector just happened to walk in and say, show me all your payroll records, and by the way, if that ever happens, I recommend that you say you must make an appointment to meet with my accountants and my attorneys and have a chance to get your records organized.
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Do not let them intimidate you into immediately showing them everything, because you can do a little bit of damage control if you get some good professional advice.
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But at any rate she didn’t.
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And immediately the labor board inspector found that there were 41 checks written to waiters and cooks that were, should have been employees, and basically… And this was during this interim period until they, this particular establishment, had their liquor license and they were fully up to speed to run their restaurant.
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So that, you know, they were on desperation times anyway.
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And then finally their liquor license came through.
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But they were deeply in debt enough.
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At that point, they were owing a lot of sales taxes and some payroll taxes otherwise.
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So that things were desperate.
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But at any rate, when the dust settled, they found 41 checks written to people that should have been employees and were treated as independent contractors, and they could have charged a penalty anywhere from $5,000 to $25,000 per check. Because we did a self audit,
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We managed to nip the bud at $10,000 per violation.
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So we saved them from the high end of it and, but, you know, still $10,000 times 41 checks is $410,000.
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And this is all on a business that only grosses, you know, $6, $7, $800,000 a year.
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And, you know, that’s catastrophic.
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And then in addition to that, once the Labor Board said, well, OK, these people are really employees, prove that you can document that
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They took their meal breaks and their rest breaks, and they couldn’t, and prove that you paid them proper overtime if they worked overtime, meaning over eight hours a day at a time and a half and over whatever it is, 10 or 12 hours a day at double time and, they were hit with another $90,000 worth of penalties for what are called wage and hour violations.
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And of course, if they’d also had pension plans that were supposed to cover all employees, then these people would have, they would have had pension liabilities.
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And so, you know, here, a business that paid approximately $50,000 out in, in payroll via independent contractor status people, got hit with over $500,000, almost $550,000 in penalties, taxes and, and interest.
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And that’s just from California. The Labor Board then referred them to the IRS, and the IRS in a few months is going to be doing a payroll audit and, will also hit them for massive amounts of payroll.
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It would seem to me that this poor restaurant is gonna go under if it hasn’t already.
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It’s, well, if we can survive, and actually I should get you a speaker on this subject.
00:20:50.689 – 00:20:55.439
There is a new business Chapter 11, Subchapter V (Roman numeral five)’
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That’s a small business
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Chapter 11.
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That is like a Chapter 13 for a small business.
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And, and this can, this company may be a candidate to ride that and try to do it.
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I’m Mike Anderson and this is The Anderson Files.
00:21:15.13 – 00:21:22.119
Our guest is Ernest Howard. Mike.
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Have you seen this coming? Did you see this coming, you know, for corporate clients? Yes, we had this initially come up from a retirement plan and group health and welfare aspect from existing clients asking, you know, if, what’s, if we’ve got individuals that at certain times of the year they’re contracted, what are going to, what’s gonna be the, if their status changes, what’s the effect on the benefits? And we basically, they came to me posed this question and it was almost, are they really contract workers or not? And it then became, you know, a labor issue and, you know, I want to help them, but it became an employment attorney labor issue as to the status of that individual.
00:22:25.01 – 00:22:36.77
Most of the companies had a few, you know, these are manufacturers, distributors, professional firms, service companies, retail companies,
00:22:36.81 – 00:22:42.349
that there were people that would be changing status.
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And then getting an assessment of what the impact would be on their benefits, which would then be one of the cost components of the change of their status.
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So I first started getting that inquiry about a year and a half ago.
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I, I still, you know, if I were to take a job today, I’m gonna start working.
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Trust me,
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Ernest, I would not be able to do anything with numbers because I can’t add two and two.
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However, you hire me to do something for you in house and you say, look, I’m gonna give you retirement, I’m gonna give you help, but it doesn’t kick in for 90 days.
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And after seven days of working here, you say, Mark, you really can’t add two and two.
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I have to let you go.
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I’m gonna take that same analogy and say if I, if a small production company is doing a shoot and hires somebody for three days, they usually don’t have to worry about health, and retirement, and benefits because you’re only working for three days.
00:23:55.329 – 00:24:15.079
If that. Can you respond to that and how AB-5 is gonna affect that? In the case of the benefits you’re mentioning it’s not a problem, but it has long been the Employment Development Department, the payroll tax arm of California, that an employee can be an employee for two minutes.
00:24:16.089 – 00:24:37.699
It’s a rule that predates all of this, is that if a business hires anyone to perform a service that requires a contractor’s license and the person they engage does not have a contractor’s license, then basically they are by definition an employee and you are liable for any payroll taxes that should have been withheld.
00:24:38.069 – 00:25:07.13
So imagine if you paid someone, you know, let’s say you hired someone to remodel your restaurant and they came in and brought in their independent contractors and let’s say you paid them $50,000, when the dust settles and when the IRS and the Employment Development Department are done with you with payroll taxes, you may well owe that much again in payroll taxes and penalties, even though you paid contractor XYZ who says I’m a licensed contractor.
00:25:07.14 – 00:25:09.77
Well, if he’s a licensed contractor, you’re ok.
00:25:09.969 – 00:25:21.949
But if he’s not, and a lot of people love handymen because some of them are really experienced and can render good service, and, but, you know, without the contractor’s license, that’s dangerous.
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And actually on the other side of the coin from a handyman standpoint, under California have recently passed a law, that if you render a service that requires a contractor’s license and you don’t have one,
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basically the person hiring you can recover everything they’ve paid you and not have to pay you.
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They can basically just stiff you on the entire job.
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Holy moly that’s in effect now.
00:25:48.219 – 00:25:48.25
00:25:48.569 – 00:25:49.38
00:25:49.39 – 00:25:54.839
So that, you know, it’s a dangerous world and the trick is, in lots of small businesses,
00:25:54.849 – 00:26:00.969
It’s been traditional that certain people, like accounting firms hiring people during tax season per diem.
00:26:01.119 – 00:26:03.52
And, I mean, accountants know how to pay their taxes.
00:26:03.53 – 00:26:10.079
It’s very rare that people doing taxes don’t report their income and pay their tax.
00:26:10.089 – 00:26:17.89
But, unfortunately, they’re stuck, doctors, you know, frequently hospitals would hire doctors as independent contractors.
00:26:18.15 – 00:26:25.02
Clinics would bring people in for periods of time as independent contractors, nurses in some cases.
00:26:25.03 – 00:26:42.39
And of course, in the entertainment industry, you know, for years, it’s, you know, what you call production assistants, you know, would frequently be treated as independent contractors, and now, you know, there’s just no way that will fly.
00:26:42.829 – 00:26:55.38
So if I hire Jane to be a production assistant or to come in and do my accounting for a day, she can’t be an independent contractor.
00:26:55.39 – 00:26:57.13
Correct. Wow.
00:26:58.31 – 00:26:59.92
And how does Texas look to you, Mike?
00:26:59.93 – 00:27:15.709
Unfortunately, what this is gonna do is, is make the government’s problem worse, not better because for all of these little people, you know, just think about it if I hire somebody to come in for an hour and I pay them as an independent contractor and they should be an employee.
00:27:15.739 – 00:27:29.93
Well, that could be a $5,000 to $25,000 penalty just for that one check that I wrote to them, and imagine having to pay a $25,000 penalty for paying somebody $200 bucks for doing a couple of hours worth of work.
00:27:30.25 – 00:27:52.699
You know, it’s so disproportionate to reality, and to what would seem to make any sense that businesses would almost certainly start paying people like that cash, and, you know, you would basically, they would probably be taking that from their income that they wouldn’t report that that came in cash and then pay these people.
00:27:52.709 – 00:28:05.579
And you would be basically increasing the underground cash economy, not putting it to the detriment. For going into 2020 and beyond,
00:28:06.709 – 00:28:30.209
How do you see the state’s enforcement of looking at small business and those businesses that most likely do have contract workers? Interesting. You know, the IRS and the Employment Development Department, and now what’s called the Department of Tax and Fee Administration used to be called the Board of Equalization, sales tax people,
00:28:30.609 – 00:28:45.599
the recession of ’08, ’09, ’10, ’11, ’12 taught them that you get more bees with honey than you do with vinegar, that if you treat a business reasonably respectfully and you try to work with them, keep them in business so that all the employees there don’t lose their jobs, you’re OK.
00:28:45.939 – 00:29:01.79
But, bureaucratic entities like the Labor Board just don’t give a darn, and they just come in and, the bigger the numbers, you know, the better their rates, I suspect, I don’t know that for a fact but that the behavior seems to follow that pattern.
00:29:02.01 – 00:29:14.05
So that investment, or the enforcement department, do you see them doing, hiring? Not as independent contractors, but of course, basically full time employees.
00:29:14.06 – 00:29:34.52
I am sure it’s a government growth area. Ernest if employers have not addressed the impact of AB-5 on their business yet, what should they be doing? Well, you know, basically, if they’ve had independent contractors under the Dynamex decision, they’re retroactively at risk for at least three years.
00:29:34.92 – 00:29:40.42
But, I would say at the very least, starting January 1, come into compliance.
00:29:40.689 – 00:30:06.099
If the numbers aren’t too catastrophic, I would suggest maybe, you know, contemporaneously converting their independent contractors to employees and paying in the payroll taxes so that in 2019, so they can document as of when they became aware of the requirements, they complied with it back to January 1st, if possible.
00:30:06.439 – 00:30:10.88
And then, you know, once three years is down the road, you know, they’re home free.
00:30:11.18 – 00:30:21.42
My client that got stung with this with the $550,000 in penalties, basically immediately converted all of her people back to employees,
00:30:21.43 – 00:30:24.479
so that she wasn’t at least adding to the problem.
00:30:24.719 – 00:30:35.51
And, and when, once they’ve given you a determination that your people are employees, then almost certainly you’re going to be hit with the maximum penalties, the $25,000.
00:30:35.91 – 00:30:53.68
Now, if you were caught in one of these labor board audits, one thing that we did in this case, and I recommend is you can do a self audit where the Labor Board will give you an Excel spreadsheet where you plug in all of the people that you paid and the amounts that you paid them, you know, by date.
00:30:54.119 – 00:31:00.599
So each payment is in there, and you calculate whether you paid the right overtime, whether you can document that
00:31:00.609 – 00:31:03.459
they took meal breaks and that sort of thing.
00:31:03.859 – 00:31:11.51
And, we were able to cut the penalty down to the $10,000 per, from $25,000 by doing the self audit.
00:31:11.76 – 00:31:19.55
You know, we could have been on the hook for close to a million bucks if we had allowed the labor board to do the audit.
00:31:19.869 – 00:31:45.699
So, doing a self audit, at least prospectively, and in the future, you know, doing things correctly and treating people as employees, and, if possible, going back to January 1st and, you know, reclassifying your people and playing catch up with payroll taxes and getting it out there, is probably a smart move to protect yourself. Ernest.
00:31:45.709 – 00:31:46.3
Thank you.
00:31:46.31 – 00:31:52.79
This has been a very informative 30 minutes with you on a very important subject.
00:31:52.8 – 00:32:02.3
We look forward to having you back in the future on other tax issues affecting California, and the country.
00:32:02.579 – 00:32:08.43
I’m Mike Anderson with co-host Mark Alyn, and this is The Anderson Files on PodClips.