What Does California's AB5 Mean For My Business?
From Josh: This question is a melding of questions my business-owner clients have had regarding California’s new AB5 law, which changes how workers are classified as independent contractors or W2 employees.
I’ve spent a lot of time with clients helping them to understand and manage how the law may impact them. Hopefully the following can help you too.
Joshua Escalante Troesh, CFP | MBA
In January 2020, California’s Assembly Bill 5 (AB5) went into effect which alters how businesses can classify workers in their employ. The short version is many independent contractors (IC) you have had in the past will now need to be classified as W2 employees - but many business can still classify many workers as independent contractors.
If after reading this article you believe your business can classify a worker as an IC, you should contact an employment attorney for a legal opinion specific to your situation. If you need to reclassify employees, I can help with planning the transition and minimizing financial impacts on your business and your employees.
What the Law Says
AB5 marks a massive change in California employment law, even though the bill itself just clarified the law already established in 2018 by the California Supreme court Dynamex decision. For most workers, the law makes it harder to classify them as independent contractors. Specifically, the law changes the standard for classifying employees as independent contractors from the old Borello test to a more difficult 3-part test.
Under Borello, the main factor for classifying the worker as an independent contractor is whether the worker is free from control and direction. Now, an employee must meet all three of the following tests to be classified as an independent contractor.
Free from control and direction
Work is outside the usual course of business
Engaged in independent work
Free from control and direction
This test determines if you treat the worker as an employee or more like an outside business you’ve hired to accomplish work. AB5 didn’t change this particular test very much, and employees who were correctly independent contractors in the past will likely still pass this test. Factors that determine this test include how much control you have over how the employee does the work, when the employee does the work, and where the employee does the work.
Work is outside the usual course of business
This test determines if the actual work is integral to the running of the business or if it is just something the business ‘needs.’ This is the test that will likely cause the most confusion, for both business owners and advisors. The legislative intent seems to be to make sure employees who are integral to the normal function of the business are classified as employees, specifically targeting companies like Uber and Lyft. As an example, Uber and Lyft drivers could not be classified as independent contractors because without the drivers there is no business.
The confusion I’ve seen, both with clients and commentators, is the idea that if the business needs the work to be done, then the work is inside the usual course of business. But all work hired by a company is necessary otherwise a business wouldn’t pay to have it done. So this interpretation would make the law irrelevant and independent contractor status would just be done away with. Unfortunately, there is no clear line for when work falls into the usual course of business.
While you would want a legal opinion for your specific situation, an example may help. Assume you had an independent contractor who cleaned offices. For all businesses, overnight cleanings are important to keep the workplace safe and presentable - but for a janitorial business, these workers are their business. So the janitorial business would likely fail this test while an auto body shop may pass it.
Engaged in Independent Work
The third test determines if the worker is acting like a business owner - working for you as well as others - or are they truly earning their income primarily from you more like an employee. An ‘independent contractor’ having another job or moonlighting at night would likely still fail this test. Your business must be able to demonstrate the IC is engaged independently with other clients and providing them the same services as the IC is providing for your business.
Why AB5 Classification Matters
The classification of a worker as a W2 statutory employee brings with it a number of additional costs for the business. Mandatory costs include FICA taxes (commonly called payroll taxes), workers compensation and unemployment insurance, the accrual of sick days, and health insurance if required. You may also have additional costs for optional benefits you provide employees, such as the newly classified workers being eligible for a company retirement plan.
Fortunately, these costs don’t necessarily mean a significant impact to your business’ cash flow or profitability. The costs of retirement plans can be mitigating by shifting from a cookie-cutter retirement plan to a customized retirement plan for your specific business. With most of my clients, we were able to develop a strategy to mitigate the additional costs and minimize the impact on the business owners.
Example of Mitigating Costs: Payroll Taxes
One of the first concerns business owners have regarding the law is the additional cost of adding the payroll taxes that fund Social Security. Fortunately, your business is only responsible for paying for 1/2 of the payroll taxes, which makes the financial planning a little easier.
To address the half many of my clients do have to pay for, we simply lowered the employees’ wage by the amount of the taxes - leaving the business at even. We then crafted a communication strategy for discussing the transition and helping employees understand that the business is now paying for 50% of the payroll tax while before the employee was paying for 100% through self-employment taxes. Including a financial wellness clinic to help employees with tax planning and setting their withholdings also allowed employees to end up with the same net take-home pay.
Exemptions to AB5
Like any good law, there are a number of (sometimes confusing) exemptions. Additionally, many of the exemptions have limitations based on other factors including the amount of work provided to the business.
Below are examples of exempted professions which may not have to be tested according to the above 3-part test. Instead, exempted workers would default to the previous Borello test (more below) for determining their classification as employees or independent contractors. Realize that the exact nature of the work and your relationship with them will determine if these exemptions apply. You would want a legal opinion on your exact situation before classifying a workers as an IC.
Healthcare Professionals including psychologists, doctors, dentists and veterinarians
Financial Professionals including insurance agents, stock brokers, accountants, and enrolled agents
Sales Agents including real estate agents, direct sellers, and travel agents
Marketing Professionals including graphic designers and grant writers
Other Professionals including lawyers, engineers, and human resources administrators
Random Professions including fine artists, payment processing agents, repossession agents, and commercial fisherman.
There are also limited exceptions for photographers, photojournalists, freelance writers, editors, as well as for some types of business-to-business dealings.
The Borello Test
The Borello test is based on another California Supreme Court decision and generally mirrors the IRS’ right of control test. Here, the thing the law looks for is whether you have the right to control the worker in the performance of the work. Except for specifically exempt professions, whether the work is the actual product or service the business provides is also a key factor. There is no clear single determinant for passing the Borello test, and under AB5 many of the exempted professions above require additional factors to qualify.
Best Practices with Independent Contractors
If your attorney’s opinion is your workers do qualify as independent contractors under AB5, you want to make sure your actions support that opinion rather than undermine it. Below are some practices you should consider which may help to support the worker being correctly classified as an independent contractor.
Ensure and document that the IC is treating their work as a business including:
Maintaining a business location separate from your business
Negotiating or setting their rates
Maintaining a business license and other relevant permits
Is actively marketing to and seeking other clients
Have the IC provide the equipment and tools for the work
Try to work with ICs in higher-skilled occupations
Limit the scope and length of the ICs work
Avoid managing how the IC does the work or having performance reviews
Avoid scheduling when the work is to be performed (deadlines are fine but setting work hours should be done only if absolutely necessary)
Be clear in the relationship between you and the IC, ideally in a contract
Check and document that the IC has professional or occupational licenses where ones exist
Ask your attorney for additional practices to keep for your specific situation