Assembly Bill 5 (AB-5)

Assembly Bill 5 (AB-5) is the new standard by which employers must classify employees. Business owners must now classify workers by using AB-5’s ABC Test.

What is Assembly Bill 5 (AB-5)?

CA Assembly Bill (AB-5), inspired by the Dynamex Case April 2018, was signed into law by Governor Gavin Newsom in September of 2019. It went into effect on January 1, 2020. This is not just another bill. The new AB-5 law directly affects the way Small Business Owners who hire Independent Contractors will operate in California. The law impacts all Small Business Owners.

In a nutshell, this new law redefines the way you as a business owner must classify your workers. The California Employment Development Department (EDD) placed the burden of proof on business to show that workers are correctly classified as 1099 contractors and that they should not be reclassified as employees under the stricter criteria set out in the new law. Business owners must now classify workers by using AB-5’s ABC Test.

What is the ABC Test?

Under the ABC test, a worker is considered an employee and not an independent contractor, unless the hiring entity satisfies all three of the following conditions:

The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
The worker performs work that is outside the usual course of the hiring entity’s business; and
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

The new, stricter legal regulations push business owners to employ workers as W-2 employees if they do not meet ABC test criteria and pay for benefits and protections (unemployment, overtime, sick leave, and worker’s comp) that employees get under California Law.

There are, however, several exceptions for specific industries and job categories. For those industries, the worker classification guidelines under the 13 Factor Borello Test remain the standard by which CA EDD will determine worker classification.

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 the project deliverables and how they are delivered.
Have your contractor submit an invoice.
Keep correspondence about project timelines clearly recorded.
Ensure you are not placing requirements on your 1099 contractors regarding how they perform their work. ie: Do not tell them what to do and do not specify reporting requirements.
Document and file Scope of Work (S.O.W.) 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 – what products or services does your company provide?

The Third Criteria

Verify if your 1099 has insurance.
Aks 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 short list of other clients the contractor has worked for.

What is the 13 Factor Borello Test?

Before AB-5 was signed into law, there were 13 criteria (the 13 Factor Borello Test) used to determine if a worker should be classified as a contractor or as an employee. The Borello test classified workers as either W-2 employees or 1099 independent contractors. This test is less straightforward than the updated AB-5 that includes clearer guidelines under its ABC test.

Even with the new AB-5 regulations, however, you can still reference the Borello test if there are exemptions, exclusions, or confusion in classifying independent contractors. Workers exempt from the ABC Test are not automatically considered independent contractors and must also meet the Borello factor’s requirements to be considered independent contractors.

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 them may indicate that a worker should be classified as an employee, no single factor is enough to determine so 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 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 Did Dynamex Ruin it for Everybody?

Dynamex, a nationwide same-day delivery, and courier service sparked the stricter AB-5 regulations for business owners. But how? Watch our video below to learn more.

When it first started, Dynamex employed their California drivers as W-2 employees who received the benefits, payroll taxes, and perks of being a W-2 employee. Then in 2004, the company reclassified all of its California drivers into 1099 independent contractors to save on employee costs.

With reclassified 1099 independent contractors, Dynamex avoided paying their portion of employee payroll taxes, medical benefit costs, or other employee benefits costs. It saved them money at the expense of their workforce.

After their reclassification, an employee filed a lawsuit against Dynamex for misclassifying him as an independent contractor and stripping him of his employee benefits. This lawsuit turned into a Supreme Court ruling that ultimately led to a completely new and stricter reclassification system than what was set in place before.

Before the ruling, worker classification was based on the unclear 13 Factor Borello Test. As a result of the ruling, the court created the California Assembly Bill 5 (AB-5) that included the new and clearer ABC test for employers to correctly classify workers.

The California Division of Labor stated that the Dynamex case misclassifications alone cost the state $7 billion each year.

The Affects of AB-5 On You

When classifying your 1099 independent contractors according to the ABC Test, gather the following information to make sure they are classified correctly.

Who Benefits from AB-5?

Beneficiaries of the stricter classifications are:

Workers in the gig economy who want to be able to unionize
Those working full time without benefits and who will, under AB-5 have to be offered benefits, protections, and earnings guarantees.

Take this scenario, for example, a 1099 independent contractor works for a large cleaning company for fewer than 40 hours but only for one company. They do not have the benefits or protections of being an employee. These workers would, under the new AB-5 law, be classified as employees and would be offered benefits, unemployment insurance, and protection under the labor laws from being fired without just cause among many other W-2 wage-earning employee benefits.

Who is at a Disadvantage with AB-5?

Small to mid-sized businesses may find that AB-5 puts them at the biggest disadvantage if they seek to hire a flexible workforce by employing workers to help when times are good and then scale back either seasonally or due to market conditions.

These small business owners will have to pass a much stricter analysis in order to be able to hire 1099 workers as opposed to W-2 employees. The burden of proof lies with the employer to prove that a worker is correctly classified as a 1099 contractor.
Moreover, honest businesses who follow the rules are at a disadvantage as they are competing with businesses who hire 1099 contractors (without benefits and are not paying the employer portion of payroll taxes) who should be W-2 wage earners. With the Dynamex decision and the three-point test of AB-5, companies that do not follow the law will have dramatically lower overhead but a high risk of an EDD Audit.

Independent contractors who wish to keep their 1099 employment status may also be at a disadvantage. Those who choose to pick up work and prefer a 1099 contractor status do not want to be managed as a W-2 wage earner. For those workers, these new AB-5 classification rules are not offering any tangible benefits, they are creating impediments.

Surveys done by Intuit in 2016, found more than 90% of contract workers prefer the flexibility and personal control they have as independent contractors. They can accept or reject a job based on the amount offered, timing, or indeed any reason – these workers work only when they want.

What Does AB-5 Mean for Uber, Lyft, and Other Rideshare Programs?

AB-5 targets gig economy workers for rideshare apps like Uber, Doordash, and Lyft. Drivers may have to choose one “employer” and thereby not be able to pick up as much work in a given period of time. The ramifications of this shift certainly affect both companies and workers.

In order to find a solution to converting rideshare workers into employees, and keep them as independent contractors, Prop 22 was created. The aforementioned companies pledged $30 million each to fund this ballot initiative to reverse AB-5
in 2020. This piece of legislation sought to sidestep AB-5 regulations so that rideshare workers can remain independent contractors instead of becoming W-2 employees. Thus, they remain eligible to work when and how they want, and for as many rideshare app companies as they wish. Learn more about why California overturned Prop 22 here.

Prop 22 was created because the benefits such as workers’ compensation, unemployment insurance, payroll taxes, and other employee benefits would be required to be offered to all W-2 employees– which rideshare workers would be then classified as.

This change from independent contractor to W-2 employee can be financially devastating to many California companies. The National Employment Law Project estimates businesses save roughly 30% in costs when they work with independent contractors instead of hiring W-2 employees.

Why is Correct Classification Important?

EDD takes classification seriously and performs thorough audits because they directly impact payroll taxes—essentially the money the government receives. The agency doesn’t receive proper taxes owed from the business owner or the hired workers when they are misclassified.

These strict regulations are also in place to protect workers. Workers misclassified as 1099 independent contractors, when they are truly W-2 employees, do not receive the same type of benefits, such as employment benefits they are entitled to.

This strips employees of their benefits such as:

Medical insurance
Paid time off
Retirement
And more

What Happens If You Misclassify Workers?

Misclassifying an employee as a 1099 independent contractor can trigger an audit by California Employment Development Department (EDD). Companies who are audited and whose 1099 contractors are reclassified as employees will be assessed for their payroll taxes on the total payments to these misclassified workers, which includes taxes, penalties, and interest.

A few of the top EDD audit triggers are:

Independent contractor filing for unemployment
Employee complaint
Late Filing of Taxes
Randomized verification audit

If your business undergoes an EDD audit, and the agency finds you misclassified employees as workers, your business will be subject to fines, penalties, and possibly jail time.

What Happens If You Misclassify Workers?

A few of the top EDD audit triggers are:

Independent contractor filing for unemployment
Employee complaint
Late Filing of Taxes
Randomized verification audit

If your business undergoes an EDD audit, and the agency finds you misclassified employees as workers, your business will be subject to fines, penalties, and possibly jail time.

How a got1099 report helps

Our got1099 report properly defends your business before EDD comes knocking at your door. How? We protect businesses by compiling a full classification report of your worker. Watch our video below for more information.

We use the new AB-5 regulations to support thorough research of your 1099 to ensure your worker is properly classified. This report includes everything an EDD auditor is looking for when searching for misclassifications:

Business license verification
Business entity status check
Tax license check
EIN confirmation
Website search
Social media search

Our mission is to save businesses from battling a months-long EDD audit that could be detrimental to the company.

If our report finds your independent contractor is missing elements that classify them as 1099, we alert you so you can make the adjustments necessary. That could mean reclassifying the worker as a W-2 employee or working with 1099 to fill in the gaps. Either way, our report sets up the safeguards to protect businesses against EDD audits.

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