In 2019, Governor Newsom signed Assembly Bill 5 (AB 5). Under AB 5, most California workers are presumed to be employees unless a hiring entity satisfies a three-factor test known as the ABC test. This means that many workers previously classified as independent contractors are now employees under California law. As a result, employers must withhold California income and payroll taxes, in addition to meeting California’s minimum wage and overtime requirements.
The ABC Test
All three conditions specified by the ABC Test must be met in order to treat a 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, commonly known as the Borello “control test” (G. Borello & Sons, Inc. v. Dept. of Ind. Rel. (1989) 48 Cal.3rd 342);
- 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 stipulates, for example, that a hospital that hires nurses to work in specialized areas, such as an anesthesia nurse or neonatal nurse, may not treat the nurse as an independent contractor if these nurses are filling in for employee-nurses and do not work for multiple hospitals. The same treatment applies to consulting services, technology companies, the entertainment industry, and rideshare/delivery service workers.
Exemptions
While applying the ABC Test to workers will result in many more workers being classified as employees, the legislation allows certain exemptions from employee classification under the ABC Test. The exemptions are complex and specific. Please note, however, that workers are not automatically deemed independent contractors if they are granted these exemptions.
If an exemption applies, taxpayers are still required to apply the traditional tests to determine if a worker is an employee or an independent contractor. Under these traditional tests, part “B” of the ABC test will still be considered, but it is not a definitive factor in assigning status.
Penalties
Be aware that California law includes severe financial penalties for willfully treating an employee as an independent contractor. These penalties, which may be added to other assessments, penalties, or fines, are as follows:
- $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.
(Labor Code §226.8)
Except for an attorney or other employee of the business, these penalties also apply to a taxpayer’s tax professional or any paid person who advises to incorrectly treat a worker as an independent contractor. This means that taxpayers may be required to obtain legal opinions if there is a question as to the classification of employees.
Key Takeaways
There are three important points that employers must understand:
- Forming or operating as a corporation or an LLC will not allow businesses to classify workers as independent contractors automatically. The corporation or LLC will be ignored if the worker does not meet the ABC Test, and the worker who owns the entity will still be an employee of the payer;
- In many cases the worker may still be considered an independent contractor for federal purposes if the “A” and “C” test criteria apply. This is an area that should be reviewed carefully; and
- The effective date of the law is January 1, 2020, but could be applied retroactively, so time is of the essence.
The law is extremely complex. The treatment of employees/contractors may also differ for Federal payroll purposes. We acknowledge that there are many unanswered questions surrounding these definitions and stipulations. We are happy to consult with your further regarding this new law and any other tax related matters.