The Complete Guide to AB5 for Small Businesses

If you’re a California based business who hires contractors then AB5 probably has you shook. It could mean a major change to who and how you hire help and put you at risk of losing your number one girl friday. 

Or maybe you live outside of California but your fav freelancer resides in the Golden State. Can you keep working with your contractor in shining armor without putting your business at risk? 

You can and you even have some options how to do it. But, before we get into that, it’s important that you understand what AB5 is and how it works. 

What is California 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 conduct the ABC test (more on that later) to determine a worker’s classification for California income tax, unemployment, worker’s compensation, and labor law purposes.

This test is not used by the IRS or other federal agencies. And it only applies in California to workers located there.

There are two ways to classify a worker:

Whenever you hire someone to help in your business one of the first decisions you have to make is whether the worker is your employee or an independent contractor.  This is a big deal because employees and independent contractors are treated very differently for tax and other legal purposes. 

• Employee: Employees are not running their own businesses. Instead, they work for your business under your direction and control. Employees are paid through payroll and you withhold and pay state and federal income taxes, along with Social Security and Medicare taxes.

You also pay for unemployment compensation, workers’ compensation, and state disability insurance. Employees are covered by state and federal labor laws which require they be paid a minimum wage and overtime and provide other legal protections.

• Independent contractor: Independent contractors are people who are in business for themselves. They sell their services to multiple clients or customers, and don’t work under any single hiring firm’s direction or control.Independent contractors are not paid through payroll, but instead paid directly. Contractors are responsible for their own taxes–no tax is withheld from their pay.

Because they are independent businesses, independent contractors have almost no rights under state and federal labor laws (for example, minimum wage laws don’t apply). Also, they aren’t entitled to unemployment or worker’s compensation. An independent contractor’s “rights” are limited to those spelled out in your independent contractor agreement. You have one of those, right?

So what does AB5 have to do with classifying workers? Well, under the new law it’s much more difficult to classify a worker as a contractor. And, it’s on you, the hirer, to prove that a worker is a contractor.  You know that saying, “Innocent until proven guilty”? Under AB5 it’s more like, “employee until proven contractor.”

What is the ABC test?

The ABC test provides the criteria that you use to prove that your fabulous freelancer is indeed a contractor. 

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 hire California based freelancers, 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 you can’t tell your worker how to do their job. You can hire them to provide a deliverable (like a logo design), but you can’t dictate how they go about designing the logo, the days of the week they work, or their daily activities. Your control is limited to accepting or rejecting the final results the contractor delivers.
• Financial: Contractors are supposed to have their own independent businesses. This means that they shouldn’t be solely reliant on you to earn a living and they should have more than one client or customer. They should also invest at least some money in their business–the more the better.

Usually, they pay their own expenses and provide their own tools, materials, and workplace. And their pay should be negotiable. If you give workers  everything they need to perform the service (like a laptop, software to use, and a place to work), then you’re entering into employee territory.

• Relationship: Do you allow the freelancer to work for others? If not, they’re likely an employee. Also, relationship control takes into account the permanency of the worker’s position. If you hire the worker indefinitely (rather than on a short-term project), then they 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 worker’s services aren’t an essential part of how your business operates or earns revenue. A contractor shouldn’t be doing the same work your employees ordinarily do.

Let’s go back to the logo design example. If your business is a fitness boutique, then your core function is to provide fitness classes to the public. A logo design is outside of your usual course of business. 

But what if you’re a design agency that subcontracts designers? Then there’s a good argument that a designer’s services are essential to your business’s operation and that they 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.

A contractor is supposed to have a real, stable, established business. And the business must be able to survive after you terminate the person’s services. There are many ways to show that a worker has an independent business or trade. Workers look like they’re running an independent business if they: 

• have a separate office or business location
• advertise their services
• own the equipment needed to perform the services
• employ assistants
• have a financial investment in the business and the ability to lose money (employees don’t have this)
• have their own liability or workers’ compensation insurance
• perform services for more than one unrelated hiring firm at the same time
• are paid by the job rather than by the hour
• have all required business licenses
• files business (IRS Schedule C) federal income tax returns

Not all these factors need to be present. But, the more there are the better off you’ll be.

Hiring contractors who have formed corporations or LLCs is helpful since they look more like independent businesses. Remember, the worker must pass all three of these tests to be an independent contractor. 

Workers reclassified as employees under AB5

If  your worker doesn’t pass the ABC test, you must reclassify them as an employee. You’ll be the worker’s employer for California tax, labor law, and other legal purposes. This means you’ll have to:

• provide the worker with unemployment insurance by paying California unemployment insurance taxes and the employment training tax
• provide the person with workers’ compensation insurance coverage, either from a private carrier or the State Compensation Insurance Fund
• withhold state disability insurance taxes
• withhold California personal income taxes from the worker’s pay and send the money to the California Franchise Tax Board
• provide the worker with up to six weeks of paid family leave
• pay the worker at least the minimum wage
• provide a minimum amount of annual paid sick leave
• pay employees 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 employees for out-of-pocket expenses necessarily incurred on the job, such as driving expenses
• provide meal and rest breaks
• comply with various notice, poster and wage statement requirements
• pay employees for unused vacation time when employment ends
• comply with California paycheck rules

What to do if your contractor should be an employee

So you may have just read all that and thought, “Whoa! Most of my freelancers wouldn’t pass the ABC test,” followed by, “But that’s okay because they want to be contractors and signed an independent contractor contract. So I’m protected, right?”

Not really. Just because your worker wants to be a contractor, you want them to be a contractor, and their contract that says that they’re a contractor, that doesn’t mean they ARE a contractor. The ABC test determines their classification, not what you or the worker wants. 

But before you swear off California based freelancers forever, know that not all hope is lost. Here’s what you can do if your contractor should be an employee. 

Check if the freelancer fits into one of the exemption categories

AB5 is a law, and, like all laws, nothing is black and white. There are exemption categories and your first step is to check if the freelancer falls into one of the categories. 

If they do, be sure that you read through the special criteria. Just because someone is a graphic designer, which does fall into a exemption category, doesn’t mean they meet all the criteria of a contractor. 

Also, an exemption doesn’t automatically make a worker a contractor. It means that the worker doesn’t have to pass the ABC test. You still have to prove that the worker is a contractor under the Borello test, which is another test used to classify workers. 

The Borello test isn’t as strict as the ABC test, but it doesn’t let you off the hook completely.  Under this test, a worker is an employee if the hiring firm has the right to control the work he or she does and how it’s done. This was the test that was used for all workers before AB5. 

Help the worker establish an independent business

If you haven’t noticed, there’s a lot of talk about a worker operating independently from 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 the worker falls into one of the exemption categories, they still have to show some degree of independence. 

At their core contractors are businesses. To protect that status, your contractors 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 that your freelancers act like a business. 

So what can you do to help your freelancers move out of that middle ground and into the bonafide business category? Help them incorporate their business.

When someone is a sole proprietor, they personally own their business. In short, there’s no legal separation between them and  their business. But, when they incorporate, their business becomes its own legal entity. 

When it comes to AB5, this is crucial because you’re no longer hiring the individual, you’re hiring the entity. Legally, the corporation is the worker’s employer, not you. It’s supposed to pay state and federal payroll taxes and comply with the other requirements for employers, not you.

That means two things. One, it provides very strong evidence that the worker is engaged in an independently established business. And two, it helps the worker  meet the business-to-business exemption.

So, does this mean that you have to set up and pay for every single one of your freelancers to incorporate their business?

No. Absolutely not. But it does mean that you can provide support to help them on their way. For example, you can refer workers to a lawyer to help set up their own corporations. But they should be responsible for filing the paperwork and paying all the fees and costs. Don’t ever pay a worker to set up a corporation–it makes it look like a sham to get around the law.

Many workers prefer to establish limited liability companies (LLCs) instead of corporations because they’re cheaper and easier to operate. However, unless the LLC elects to be treated as a corporation (which is an option), hiring an LLC is not as good as a corporation. LLC owners are not employees of the LLC unless they elect to have it taxed as a corporation.

Convert your contractor to an employee

You can convert your employees for legal and tax purposes. This probably isn’t the option that you want to hear, but it is an avenue you could take. After all, there are benefits of having employees. You have greater control over their work schedules, when they can take time off, and what policies they have to adhere to. 

If you do convert a contractor to an employee, be prepared for some additional costs. Some costs you may incur are:

• Federal and state payroll taxes
• Worker’s compensation insurance
• Unemployment insurance
• Employee benefits like health insurance, paid time off, and retirement contributions 
• Compliance with state and federal labor laws, such as time-and-a-half for overtime.

You might also have to pay reclassified workers for employee benefits they should have received and reimburse them for out-of-pocket expenses such as work-related mileage. 

Generally, the cost of an employee is 1.25 – 1.4 times their base salary. So, if you pay a worker $30,000 annually as a contractor, then you can expect their annual cost to increase to $37,500 – $42,000 as an employee. 

Classify workers as both employees and independent contractors

AB5 only requires that employers use the ABC test for California tax, employment and labor laws purposes. It doesn’t require you to use the ABC test to determine whether a worker is an employee or contractor for federal taxes. Instead, the more flexible Borello test (remember we talked about this earlier?) is used by the IRS. 

It’s possible for a worker to qualify as a contractor for IRS and other purposes under the less strict right of control test and be an employee under the ABC test in California. This could happen if a worker satisfies the A and C criteria of the test, but not the B outside service criterion. 

In this situation, you could treat the worker as an employee for California purposes and as contractor for IRS and other purposes. This means you would not withhold or pay federal payroll taxes for the worker, which is a substantial savings since employers are required to pay half their employees’ Social Security and Medicare taxes.

Obviously, implementing a dual classification system would be complicated and pose practical problems. But it may become increasingly common for California businesses. If you decide to go this route, we recommend you talk to a payroll specialist. 

Now that you have all the deets on AB5, it’s time to take action. The first step is to see if your contractor’s pass the ABC test. If not, then you’ll have to decide what action you’ll take to stay legal under AB5. And remember, when in doubt, consult a lawyer, who can help you navigate the law.