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Does California's AB 5 Turn Your Contractors into Employees?

The new California AB 5 law is upsetting to both (a) employers and (b) independent contractors for the following reasons:

  • Employers who hire independent contractors save on Social Security taxes, Medicare taxes, employment taxes, unemployment taxes, and paid vacation and other time off, and can avoid a host of workplace rules.
  • Independent contractors enjoy workplace freedom, can deduct their business expenses, can set their own hours, and can generally put away as much as they desire into their solo 401(k) accounts.

AB 5, by law, simply makes many independent contractors W-2 employees. Employers lose their advantages. Independent contractors lose their advantages.

Now, don’t think this AB 5 independent-contractor-to-employee displacement affects only businesses located in California.

Think of the company that had 45 independent contractor sales reps, three of whom were in California. So that all sales reps would be treated the same, the company converted all the traveling sales reps to employees, who now suffer.

And then there’s the problem of the camel’s nose. (Remember, after the nose, the entire camel gets into the tent.) Other states may enact AB 5 or their versions of AB 5. Currently, both New York and New Jersey are considering adopting an AB 5 law of some sort.

Does This Apply to Me?

If your business has workers based in California who perform services in California, they are subject to AB 5, and you need to know how AB 5 impacts both your workers and your business.

What Federal Law Says

Federal law looks to common-law principles for worker classification, which over the years have proven difficult to apply. But there’s the Section 530 rule that protects most businesses.

The IRS, in its efforts to make 1099 independent contractors W-2 employees, relied for years on a 20-factor test. This test proved cumbersome, and today the IRS has broken the 20 factors into three broad factors as described below:[1]

  1. Behavioral control. You look more like an employee if the company you work for has a lot of control over the day-to-day details of your work, such as through specific instructions in your contract or through a supervisor. On the other hand, you look more like an independent contractor if you primarily decide how to perform your work.
  2. Financial control. You look more like an independent contractor if you have invested significantly in your business, if you have unreimbursed expenses, and if you run the possibility of incurring a loss.
  3. Type of relationship. You look more like an employee if you work exclusively for the company; plan to work there indefinitely; and get benefits such as retirement plans, sick days, and medical benefits.

General Thoughts

First, this is a mess. Imagine treating your California worker as a W-2 employee for California purposes and then as an independent contractor for federal purposes. You could likely do this, but there would be complications.

If you don’t have California workers but you have independent contractors in other states, make sure you have Section 530 status or other leverage that avoids federal penalties for wrong classifications.

We don’t have any precedent yet on how workers can avoid the AB 5 W-2 classification, but you have to think that forming an S corporation or a C corporation would help meet the ABC test. Many workers who pay their own expenses have a vested interest in avoiding the W-2 classification because employee business expenses are not deductible for years 2018-2025.

I can help you with your worker classifications.

Source: Bradford Tax Institute

[1] IRS Publication 15-A, Employer’s Supplemental Tax Guide, Dated Dec. 23, 2019, ps.7-8.

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