On Sept. 11, 2019, the California Senate passed legislation under AB-5 to codify the California Supreme Court decision in Dynamex and clarify application of the ruling. On Sept. 18, 2019, Governor Newsom signed the bill into law.

This bill affects all industries that regularly engage independent contractors. The ruling and new state law puts pressure on companies that otherwise might rely on freelance or contract work to classify workers employees. For example, in Los Angeles, this law significantly impacts the gig economy and entertainment industry.

New Rules under AB-5

In 2018, the California Supreme Court (Court) issued a ruling in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (Dynamex) that revised California’s standard for distinguishing employees and independent contractors under the wage orders of the Industrial Welfare Commission, which governs basic aspects of wages and working conditions in California.

AB-5 expanded the application of Dynamex to the unemployment insurance code in addition to the wage orders. As a result, a company bears the burden of meeting a three-part test to establish independent contractor status (i.e., ABC test) under AB-5.

Under the three-factor ABC test, a worker providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all the following conditions are satisfied:

  • (A) 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.
  • (B) The worker performs work that is outside the usual course of the hiring entity’s business.
  • (C) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Specific Occupations are Exempt from the ABC test

Some occupations would be exempt from the application of the ABC test and would instead be subject to the older standard for worker classification (i.e., Borello). The exempt occupations include, but are not limited to:

  • Licensed insurance agents
  • Certain licensed healthcare professionals
  • Registered securities broker-dealers or investment advisers
  • Licensed lawyers and accountants
  • Direct sales salespersons
  • Real estate licensees
  • Commercial fishermen
  • Workers providing licensed barber or cosmetology services
  • Others performing work under a contract for professional services (e.g., marketing, travel agent, artist, etc.) with another business entity
  • Work pursuant to a subcontract in the construction industry

Reverts to Borello Standard in Certain Cases

If a court of law rules that the new standard (i.e., ABC test) cannot be applied to a particular case, the determination of employee or independent contractor status shall instead be governed by the old standard (i.e., Borello).

Effective date under AB-5

California AB-5 provides that the codification of the ABC Test is not a change in law but rather declaratory of existing law and should apply retroactively to existing claims to the extent permitted by law. The other provisions (i.e., outside of labor claims) including worker’s compensation requirements of AB-5 are effective with work performed on or after Jan. 1, 2020.

What This Means for California Businesses

A reclassification of workers as employees could result in increased wages and benefits guaranteed to California workers and, therefore, could increase the company’s operating expenses and its California payroll tax liabilities. California’s bill is perhaps the strongest of its kind in the United States because the state and cities have the right to file suit against companies over misclassification and override the arbitration agreements that many businesses use to shield themselves from worker complaints.

The businesses, particularly those operating in the gig or freelance economy, are fundamentally based on the use of independent contractors. This change in the worker classification standard may result in providing healthcare and retirement benefits, employment taxes, workers’ compensation and other employee benefits for their companies’ workforce, especially if the businesses are largely reliant on a contract labor workforce. For example, it is estimated that Uber and Lyft’s labor costs could increase up to 30 percentdue to enactment of AB-5.

Companies should evaluate their relationships and contractual agreements with their current independent contractors to determine if adjustments should be considered to either their classification or scope of services provided to the business.

GHJ recommends maintaining contemporary documentation that a company’s independent contractors satisfy the ABC test unless otherwise exempt under AB-5.

Finally, and in light of this law, any businesses operating in California that treat workers as independent contractors should confer with their legal and tax advisors to review the relationship under the ABC test and determine whether such workers should be reclassified.

For more information or to see if your business is at risk, please contact Frances Ellington or Akash Sehgal from GHJ’ Tax Team.