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).
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
- 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 circumstances.
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.