UPDATE — The California Assembly is currently drafting Assembly Bill 1850 that seeks to clarify the rules and modify the exceptions for employee classification created by Assembly Bill 5 discussed below. Check back for further updates.
In 2018, the California Supreme Court rendered its decision in the Dynamex case that significantly altered the rules used to classify workers as employees or independent contractors. In an attempt to “simplify the rules” and “help” workers in the gig economy the California legislature passed, and the Governor signed, Assembly Bill 5 (AB 5) in 2019. The bill codified the worker classification tests used by the California Supreme Court. Prior to the passage of AB 5 many industry lobbyists were busy in Sacramento getting exceptions and special rules included in AB 5. As a result, the worker classification rules are now very complex, have many exceptions and come with significant penalties for noncompliance.
Under AB 5, many workers previously treated as independent contractors must now be treated as employees, subject to payroll taxes, minimum wage and overtime requirements, and are entitled to paid sick leave and family leave.
AB 5, which uses the “ABC” test to determine worker classification, went into effect January 1, 2020. If your business utilizes independent contractors, it is extremely important that you understand the impact of this new law and the application of the ABC test to your company, and to take the necessary steps to ensure appropriate compliance in accordance with this new law.
The ABC test
Under the ABC test, all three of these conditions must be met in order to treat the worker as an independent contractor:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact. Under prior law this was commonly known as the Borello “control test”; and
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
The ABC test means, for example, if a software developer hires a plumber to fix a leaky faucet, the plumber is an independent contractor. If the developer hires a freelance programmer to work developing their new app, they are likely to be classified as an employee.
Exemptions
While applying the ABC test to workers will result in many more workers being classified as employees, the legislation provides for numerous exemptions to the application of the ABC test. The exemptions are complicated and very industry-specific. However, the exemptions do not mean workers are automatically independent contractors.
If an exemption applies, employers are still required to apply the traditional tests to determine if a worker is an employee or an independent contractor. Under these traditional tests, the “B” part of the ABC test will still be considered, but it is not itself a disqualifying factor.
Penalties could apply
Be aware that California law includes severe financial penalties for willfully treating an employee as an independent contractor.
The penalties, which are in addition to other assessments, penalties, or fines, are:
- $5,000 to $15,000 for each violation (a single misclassified individual); and
- $10,000 to $25,000 for each violation if the Labor Commissioner, or a court, determines there is a “pattern and practice” of these violations.
With the exception of an attorney or other employee of the business, these penalties also apply to a tax professional or any paid person who advises an employer to incorrectly treat a worker as an independent contractor. This means that employers may be required to obtain a legal opinion if there is a question as to the classification of employees.
Complicating Factors
There are three other important issues:
- If your worker forms or operates their business as a corporation or an LLC (so you are hiring an entity, not an individual) the rules of AB 5 will still apply. The corporation or LLC will be ignored if the worker does not meet the ABC test, and the worker who owns the entity will be treated as an employee of the payor.
- In many cases, the worker may still be an independent contractor for federal purposes if the “A” and “C” tests apply, as the federal worker classification rules do not rely on the ABC test. As a result, workers could be treated as independent contractors receiving a 1099 for federal tax reporting and treated as employees receiving a W-2 for California tax reporting.
- The effective date of the law is January 1, 2020, but could be applied retroactively. A California Supreme Court ruling is expected in a currently pending case that will determine if retroactive application will be allowed.
This new law is extremely complex with many unanswered questions, several lawsuits and a possible ballot measure in process to modify or potentially nullify AB 5. Due to the ambiguity and evolving nature of the new California worker classification rules, we strongly encourage you to consult with legal counsel experienced in employment practice matters to review your independent contractor relationships to determine the appropriateness of these classifications and to assist you, if necessary, to determine if reclassifications may be required to mitigate potential exposures to your business. If you do not have an employment attorney, please contact us and we can provide a referral.