California Assembly Bill 5 (AB-5) took effect on January 1, 2020, and is the new standard by which employers must classify employees. Small business owners (SBOs) should familiarize themselves with AB-5 and the ABC test to avoid employee misclassification and potential penalties from the Internal Revenue Service (IRS).
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What is Assembly Bill 5 (AB-5)?
Assembly Bill 5, commonly referred to as AB-5, is a piece of legislation that extends employee classification status to some independent contractors, requiring that hiring entities reclassify these workers as employees based on the strict criteria outlined in the ABC Test.
What Caused Assembly Bill 5?
Assembly Bill 5 was inspired by the April 2018 Dynamex Case—when Dynamex reclassified all employees (previously classified as W-2s with all the associated perks) as independent contractors to save employee costs– before being signed into law by Governor Gavin Newsom in September 2019.
Read on to learn how Dynamex ruined it for everyone.
What Businesses Does AB-5 Affect?
AB-5 affects all small businesses and small business owners. Most prominently, AB-5 impacts SBOs who hire 1099 independent contractors and their operations in California.
How Does AB-5 Affect Businesses?
Through AB-5, the California Employment Development Department (EDD) places the burden of proof on businesses to show that workers are correctly classified as 1099 contractors.
The misclassification of employees can lead to:
- High fines
- Penalties
- And back tax payments
How Do I Correctly Classify 1099 Independent Contractors?
AB-5 introduced the ABC test as a stricter guideline to determine how to classify a worker as a 1099 independent contractor.
What is ABC Test?
Check out our video below for an in-depth explanation of the ABC Test.
The ABC test is a set of requirements that the worker must meet to be classified as a 1099 independent contractor instead of a W-2 employee. The worker must meet all three criteria of the ABC test to be correctly classified as an independent contractor:
- The worker is free from the control and direction of the hiring entity in connection to the performance of the work.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
If the contractor fails to meet any of the criteria in the ABC test, they are automatically classified as a W-2 employee instead.
How To Meet The ABC Test Criteria
When classifying your 1099 independent contractors according to the ABC Test, gather the following information to make sure they are classified correctly.
The First Criteria
- Gather information on project deliverables and how they are delivered.
- Have your contractor submit an invoice.
- Keep correspondence about project timelines recorded in a clear and accurate manner.
- Ensure you’re not placing requirements on your 1099 contractors regarding how they perform their work. For instance, do not tell the workers what to do or specify reporting requirements.
- Document and file scope of work (SOW) from your contractor.
The Second Criteria
- Compose a definition of your contractors’ line of work.
- Compose your definition of your business’s line of work (i.e. what products or services does your company provide?)
The Third Criteria
- Verify if your 1099 has insurance.
- Ask if they have a legal entity.
- Check if they have associations, unions, or other affiliations.
- Review their professional certifications.
- Gather their business card, website, and a list of other clients the contractor has worked for.
What is the Borello Test?
Before AB-5 was signed into law, the Borello test was used to determine if an employee should be classified as a 1099 independent contractor or a W-2 employee. The Borello test was established by the Supreme Court in S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989). The test relies on 13 factors to determine employee classification.
Even with new AB-5 regulations, the Borello test can still be a useful resource to help classify employees.
EDD provides the full Borello test worksheet with the following questions to help guide classification:
- Do you instruct or supervise the person while he or she is working?
- Can the worker quit or be discharged (fired) at any time?
- Is the work being performed part of your regular business?
- Does the worker have a separately established business?
- Is the worker free to make business decisions that affect his or her ability to profit from the work?
- Does the individual have a substantial investment in their job which would subject him or her to the financial risk of loss?
- Do you have employees who do the same type of work?
- Do you furnish the tools, equipment, or supplies used to perform the work?
- Is the work considered unskilled or semi-skilled labor?
- Do you provide training for the worker?
- Is the worker paid a fixed salary, an hourly wage, or based on a piece-rate basis?
- Did the worker previously perform the same or similar services for you as an employee?
- Does the worker believe that he or she is an employee?
Answering “yes” to questions 1-3 would provide a strong indication that the worker is an employee. Answering “no” to questions 4-6 would indicate that a worker is not in business for themselves and would likely classify as an employee. Questions 7-13 indicate important factors to be considered.
While answering “yes” to any one of the questions may indicate that a worker should be classified as an employee, no single factor is enough to determine classification independently.
The full worksheet provided by EDD provides further clarification on certain factors and circ*mstances.
If completing the provided worksheet does not provide sufficient clarification for employers, EDD also offers the ability to request a written ruling by completing a seven-page form called Determination of Employment Work Status. The form supports any business entity looking to determine if a worker is an employee or an independent contractor.
How Do I Avoid Misclassification?
You can avoid misclassification by carefully analyzing the arrangement you have with your worker in relation to the guidelines described in the ABC test and regulations set forth by AB-5.
To learn more, read on about how to hire an independent contractor.
As an expert in employment law and small business operations, I bring firsthand experience and in-depth knowledge to guide you through the complexities of California Assembly Bill 5 (AB-5) and its implications for small business owners (SBOs). AB-5, which came into effect on January 1, 2020, represents a significant shift in how employers classify their workers, particularly independent contractors.
AB-5 was catalyzed by the Dynamex Case of April 2018, where Dynamex, a company, reclassified its employees as independent contractors, prompting legislative action to address widespread misclassification issues. Signed into law by Governor Gavin Newsom in September 2019, AB-5 imposes stringent criteria, notably the ABC test, for determining whether a worker should be classified as an employee or an independent contractor.
The ABC test comprises three criteria:
- Control and Direction: The worker must operate free from the control and direction of the hiring entity concerning the performance of the work.
- Nature of Work: The work performed by the contractor must be outside the usual course of the hiring entity’s business.
- Independently Established Business: The worker should be engaged in an independently established trade, occupation, or business of the same nature as the work performed.
Failure to meet any of these criteria results in automatic classification as a W-2 employee. To meet the ABC test, businesses must meticulously gather evidence demonstrating adherence to these criteria.
Before AB-5, the Borello test was employed to determine worker classification. Originating from the Supreme Court case S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989), this test considers 13 factors, including supervision, investment, and perception of the worker's employment status. While AB-5 supersedes the Borello test, it remains relevant for classification purposes and can offer additional insights into worker status.
Small business owners affected by AB-5 face substantial penalties for misclassification, including fines, penalties, and back tax payments. To mitigate these risks, SBOs must diligently assess their relationships with workers, ensuring compliance with AB-5 guidelines and avoiding misclassification.
In conclusion, understanding the intricacies of AB-5, including its ABC test and the legacy of the Borello test, is paramount for small business owners navigating California's evolving labor landscape. By adhering to legal standards and fostering transparent working relationships, businesses can mitigate risks and uphold compliance with AB-5 regulations.
