The first time I heard of AB5, I thought it was a fresh new droid from Star Wars. C-3PO, R2-D2, BB8, and AB5. Sounds like an intergalactic dream team, doesn’t it?
AB5 might seem like it’s from a galaxy far far away, but it’s actually from somewhere much closer: California. And it has nothing to do with droids but everything to do with freelancers and gig workers. AB5 is a new law that makes classifying workers as independent contractors much more difficult.
While the law only applies in California, other states may create their own versions of AB5–New Jersey, New York, and Illinois are already thinking about it.
So, even if you’re not living in California, it’s essential to understand AB5 and how it affects freelancers like you.
What is AB5?
California Assembly Bill 5 (AB5) is a law that went into effect on January 1, 2020, and it provides new rules for how businesses classify workers. It requires that employers use the ABC test (more on that later) to determine a worker’s classification.
Employers classify workers in one of two ways:
Whenever a business hires you to perform your services it must decide whether you are an employee or independent contractor. These are the only two choices, there’s nothing in between.
This is a big deal because employees and independent contractors are treated very differently for tax, labor law, and other legal purposes.
- Employee: You’re an employee if you’re not running your own independent business. Instead, you work for someone else’s business under its direction and control. Employees are paid through payroll and an employer withholds and pays payroll taxes.
Employees have many legal rights under state and federal labor laws–for example, employees must be paid at least the minimum wage and many must be paid time-and-a-half for overtime.
- Independent contractor: You’re an independent contractor if you’re running your own independent trade or business. You sell your services to multiple clients or customers and don’t work under any hiring firm’s direction or control. Independent contractors are not paid through payroll but instead paid directly. Contractors are responsible for their own taxes and no tax is withheld from their pay. They pay taxes on their net self-employment income, which is their revenue less their tax deductions. Employees don’t have business tax deductions.
Because they’re independent businesses, independent contractors have almost no rights under state and federal labor laws (for example, minimum wage laws don’t apply). An independent contractor’s “rights” against a client or customer are limited to those spelled out in the contractor agreement. You have one of those, right?
While worker classification is nothing new, AB5 makes it much harder to classify a worker as a contractor than in the past. It’s California’s way of protecting workers in the gig economy who operate as employees but don’t receive the rights or benefits of employees.
The ABC test explained
The ABC test is like the sorting hat of the freelancing world. But instead of sorting you into fun, whimsical wizarding houses, it sorts you into your worker classification.
Basically, this test is how employers are required, by law, to classify their workers. The ABC test is partially based on how the IRS classifies workers, so even if you don’t live in California, listen up.
The ABC test has three criteria (get it- A, B, and C?), and a worker must meet all three to be considered a contractor.
Let’s break them down.
A) The worker is free from the control and direction of the hirer (both under contract and in fact).
Three types of control fall under this: behavioral, financial, and relationship control.
- Behavioral: This means that the hirer can’t tell you how to do your job. They can hire you to provide a deliverable (like a website), but they can’t dictate how you develop the website, the days of the week you work, or your daily activities. The hiring firm’s control is limited to accepting or rejecting your work.
- Financial: The hirer can’t make all the decisions about the financial aspect of your relationship. That includes how much they pay you, when, and how and if expenses are reimbursed or not. Another point of financial control is whose supplies or equipment you use for the job. If you only use the hirer’s tools and materials, you’re likely an employee.
- Relationship: Does the hirer allow you to work for others? If not, you’re likely an employee. Also, this control takes into account the permanency of your position. If the hirer is working with you indefinitely (rather than on a short-term project), then you may be an employee.
B) The worker performs work that is outside the usual course of the hiring entity’s business.
In other words, the work you perform isn’t an essential part of how the business operates or earns revenue. You shouldn’t be doing the same work the hiring firm’s employees ordinarily do. Let’s go back to the website example. If your client is an ice cream shop, then designing a website is outside of their core function, which is to sell ice cream.
But what if your client is a design agency that subcontracts you for projects? Then there is a strong argument that your work is essential to the business’s operation and that you should be an employee.
C) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
It’s not enough to say, “Sure, I’ll build a website for anyone who asks.” You must have a real, stable, established business. There are many ways to show this. For example, you:
- have a separate office or business location
- advertise, like having a business listing on an online directory
- own the equipment you need to perform your services
- employ assistants
- have a financial investment in the business and the ability to incur a loss
- have your own liability or workers’ compensation insurance
- work for more than one unrelated hiring firm at the same time
- get paid by the job rather than by the hour
- have all required business licenses
- file business (IRS Schedule C) federal income tax returns.
You don’t have to do all of these things. But the more you do, the more you’ll look like an independent contractor.
Incorporating your business or forming an LLC also helps to show that you have an independent business (we’ll get more into this later).
Remember, you must pass all three of these tests to be an independent contractor.
What happens if you’re an employee under AB5?
If a hiring firm determines that you should be classified as an employee under AB5, it must:
- provide you with unemployment insurance by paying California unemployment insurance taxes and the employment training tax
- provide you with workers’ compensation insurance coverage
- withhold state disability insurance taxes from your pay
- withhold California personal income taxes from your pay and send the money to the California Franchise Tax Board
- provide you with up to six weeks of paid family leave
- pay you at least the minimum wage
- provide you a minimum amount of annual paid sick leave
- pay you time-and-a-half for overtime over eight hours per day or 40 hours per week (but administrative, executive, or professional employees are exempt)
- reimburse you for out-of-pocket expenses necessarily incurred on the job, such as driving expenses
- provide you with meal and rest breaks
- pay you for unused vacation time when employment ends
- comply with California paycheck rules
Lots of this might sound good, except for the withholding part. But many hiring firms don’t want to pay these extra expenses. So they might not hire you and hire someone outside of California instead.
How to protect your status as an independent contractor
For some, AB5 is a welcome change to the gig economy. But for others, AB5 threatens their status as freelancers and the perks that come along with it. Real talk- one of the best parts of working for yourself is the freedom you have over your work and schedule. As an employee, you lose that freedom.
And you should know that just because you want to be a contractor, your client wants you to be a contractor, and you sign a contract that says you’re a contractor, that doesn’t mean you ARE a contractor. The ABC test determines your classification, not what you or your client wants.
The other bummer about AB5? Many businesses are now wary of hiring California based freelancers for fear of misclassifying their workers.
But before you put on a pantsuit and give up on freelance life forever, you should know that not all hope is lost. There are a few things you can do to protect your status as a freelancer and maintain your work-from-home-in-your-underpants lifestyle.
Check to see if you fall into one of the exemption categories
AB5 is a law, and, like all laws, there’s a bunch of fine print. There are exemption categories, and you should check to see if you fall into one of these categories.
If you do fit into one of the exemption categories, the next step is to review the special criteria. An exemption doesn’t mean you’re automatically an independent contractor. It means you’re exempt from the ABC test. Your client still has to prove that you’re a contractor, but the requirements are less strict.
Workers in all the exempt categories must pass California’s control test (also called the Borello test) to be independent contractors. Under this test, you’re an employee if the hiring firm has the right to control the work you do and how it’s done. This was the test that was used for all workers before AB5.
California AB5 Exemption Categories
Establish an independent business
If you haven’t noticed, there’s a lot of talk about operating independently from whoever hires you. Test C from the ABC test specifically states that the worker must be engaged in “an independently established trade, occupation, or business.” And even if you fall into one of the exemption categories, you still have to show some degree of independence.
So how do you show the world (and California) that you are your own boss? By legally establishing a business.
At their core contractors are businesses. To protect that status, you have to BEHAVE like a business. The REAL impact of AB5 is going to be to eliminate the “middle ground” in freelancing. Either people are employees or they’re Businesses and behave as such.
The middle ground is where most of the abuse of gig workers has taken place, which is why it’s important to establish yourself as a business.
Five steps you can take to stay independent
1. Form a business entity
Most freelancers are sole proprietors. When you’re a sole proprietor, you and your business are one. Instead, you should form a business entity to own and run the business. This way, your business becomes legally separate from you. When it comes to AB5, this is crucial because people are no longer hiring YOU, they’re hiring the entity.
Forming a separate business entity helps show you have an independent business. And it will help you qualify for the business-to-business exemption.
The most common business entity for freelancers is a single-member limited liability company (LLC). But you can also form a corporation. When you incorporate, you can choose to be taxed as an S Corp or C Corp. To form an LLC or corporation, , you register with your state’s Secretary of State and be on record with the state as a business. You can learn more about forming an LLC in California here.
While forming an LLC or corporation does come with additional costs, it will pay off over time. You’ll be more attractive to potential clients and have an edge on sole proprietor freelancers.
2. Get a business license
Regardless of if you incorporate or not, you should still get a business license. Many of the exemption criteria require that you have a business license.
The burden to prove that you’re a contractor is on the hirer. The more proof that you give them, like having a business license, the more willing they’ll be to hire you.
Learn more about getting a business license in California here.
3. Obtain an EIN
A federal employer identification number, or EIN, is a number that the IRS uses to identify your business. Even though it has the word employer in it, anyone can apply for an EIN (yes, even a sole proprietor).
The advantage of using an EIN as a sole proprietor is that it protects your social security number. Plus, it further establishes you as an independent business.
Obtaining an EIN is free and easy to do online. You can learn more about EINs here.
4. Have your own business location
Have you noticed that every exemption criteria mentions having a separate business location? Both the IRS and California take into account where you work when deciding if you’re an employee or a contractor. Basically, they want to see that you’re not dependent on the hirer for a place to work.
But you don’t have to go out and rent a fancy office to have your own business location. Your home counts as a business location, as long as you actually work there. The key is to show that you consistently perform services for your clients at a place that’s not their office.
5. Use Written Independent Contractor Agreements
Having a client sign an independent contractor agreement won’t by itself make you an independent contractor. But you should use written agreements anyway. They can only help, particularly in close cases.
Now that you know the ins and outs of AB5, it’s time to decide what actions you’ll take to protect your freelancer status. Remember, AB5 is relatively new, and many freelancers and potential clients still don’t know that much about the law.
By taking steps now to maintain your contractor status, and assuring clients that it’s safe to hire you, you’re setting your business up for years of success, in this galaxy and beyond.
Andi Smiles, small business financial consultant and coach, teaches rad business owners to take control of their finances so they can step into their personal power.
She’s helped hundreds of self-employed folx organize and understand their business finances, while also uncovering their emotional relationship with money. Andi’s core belief is that when business owners are engaged with their finances, their personal awareness around money deepens, creating more sustainable and authentic businesses. She loves helping business owners connect with and feel good about their finances- no matter how many dollars are in their bank account.