On September 18, 2019, Governor Gavin Newsom signed Assembly Bill No. 5 (AB 5) into law, regarding the classification of workers as employees or independent contractors. The new law will have far-reaching effects with respect to employee classification, tax ramifications, and corporate structuring.
On the most basic level, the law will affect employer costs with respect to Social Security and Medicare taxes, unemployment and disability insurance, workers’ compensation costs and coverage, sick leave, minimum wage, overtime, and rest breaks and meal periods. AB 5 may impact businesses considering whether to leave California to avoid increased compliance, tax liabilities and risk.
The new law codifies the “ABC” test for determining independent contractor status, which was adopted as the default classification test by the California Supreme Court in its 2018 decision in Dynamex Operations West, Inc. v. Superior Court.
However, the law also provides for several categories of exemptions. For those occupations, the former test for classification as set forth in the 1989 case Borello & Sons, Inc. v. Dept. of Industrial Relations, which focuses on the right of control, will apply.
AB 5 will become effective on January 1, 2020.
Before Dynamex, the common law test for employee classification outlined in Borello concerned whether the hiring entity had the right to control certain aspects of the work being performed.
The following factors were considered:
- The right to discharge a worker at will, without cause
- Whether the worker is engaged in a distinct occupation or business
- The type of work, emphasizing whether it is usually done under direction or without supervision
- The skill required for the particular occupation
- Whether worker supplies her or his own tools, materials and workspace
- The length of time the work will be performed
- Method of payment (e.g., whether by the time or by the job)
- Whether or not the work is part of the regular business of the hiring entity
- Whether or not the parties believe they are creating the relationship of employer-employee
On April 30, 2018, the California Supreme Court issued its decision in Dynamex, rejecting the more flexible, multifactor standard laid out in Borello and establishing a new test for employee-classification, often referred to as the “ABC” test.
Under the ABC test, the presumption is that the individual is an employee unless the hiring entity demonstrates that all three of the following conditions have been met in order for the individual to qualify as an independent contractor:
A) The individual is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract terms and in fact;
B) The individual performs work that is outside the usual course of the hiring entity’s business; and
C) The individual is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
Impact on Existing Law
AB 5 writes the ABC test into the Labor Code, including the Industrial Welfare Commission wage order and the Unemployment Insurance Code.
Beginning in July 2020, AB 5 will also impact California workers’ compensation regulations–the only part of the bill that does not apply retroactively.
Additionally, AB 5 amends the Unemployment Insurance Code to include the ABC test, and does not reference the exempted occupations still subject to the Borello test. So, even if an independent contractor falls into one of those exemptions, the ABC test may still apply for the purposes of unemployment insurance.
Exemptions to the new ABC test include:
- Insurance agents
- Medical professionals such as physicians, dentists, podiatrists, psychologists, and veterinarians
- Licensed professionals such as attorneys, architects, engineers, private investigators, and accountants
- Financial advisers
- Direct sales salespersons
- Commercial fisherman
- Some contracts for professional services such as marketing, human resources, or grant writers
- Licensed real estate agents
- Business service providers
- Construction contractors and trucking services
- Referral service providers
- Motor club third party agents
An individual’s employee or independent contractor status in these occupations would be determined by the Borello test.
For some positions, however, the individual would need to meet certain requirements–such as operating under a business entity, maintaining the required business license, a record of additional clientele, and maintaining a business address separate from the employee’s personal address and the hiring entity’s address.
AB 5 provides that a contractual “business-to-business” relationship will be governed by the Borello test, where a substantial 12-prong test to establish a bona-fide contract between two companies is met. This section expressly does not apply to individual workers.
The new law also provides that employee and independent contractor classification between a contractor and a subcontractor in the construction industry will be subject to the Borello test–where the agreement is in writing, proper licensing is obtained, the subcontractor maintains a business location separate from the business or work location of the contractor, the subcontractor assumes financial responsibility for errors or omissions, and has a record of an independently established business for the type of work being performed.
For trucking companies providing subcontractor services, the code expressly provides that for work performed after January 1, 2020, any business entity that provides construction trucking services to a licensed contractor utilizing more than one truck shall be deemed the employer for all drivers of those trucks. Accordingly, any trucking subcontractor would become an employer of any independent-contractor truckers (owner-operator) that it may work with.
Estheticians, barbers, manicurists and cosmetologists
AB 5 includes an exemption for licensed estheticians, electrologists, manicurists, barbers, or cosmetologists. To be subject to the Borello test, the company must show that the worker sets their own rates, processes their own payments, is paid directly by the client, sets their own hours of work, determines number of clients with their own book of business, and maintains their own license. If the individual is performing services at the location of the company, then the individual must issue a Form 1099 to the salon or business owner from which they rent their business space.
Agreements between Services Providers and Referral Agencies
Agreements between a service provider and a referral agency are likewise exempt from the ABC test when the service provider can demonstrate appropriate licensing, business location, financial responsibility for errors or omissions, and proof of a bona-fide independent business.
The code expressly defines “referral agency” as a business that connects clients with service providers that provide certain services, including graphic design, photography, tutoring, event planning, minor home repair, moving, home cleaning, errands, furniture assembly, animal services, dog walking, dog grooming, web design, picture hanging, pool cleaning, or yard cleanup.
Potential liabilities and penalties for misclassification
Potential penalties for misclassification can be substantial. First, for any employee that has been misclassified, the employee can file an independent cause of action for minimum wages, overtime, meal break and rest break violations. Additionally, California provides for independent civil penalties that range between $5,000 and $25,000 per misclassification. Further, the IRS can levy its own penalties depending on the extent of misclassification. Lastly, the hiring entity will also be liable for payments and penalties due to the California EDD Department for unemployment and disability benefits as well as penalties to the Workers’ Compensation fund. Additionally, any employee who prevails on a private cause of action for misclassification would be entitled to attorneys’ fees.
Any employer or company that elects to classify a worker as an independent contractor should consult their legal counsel.