For founders, hiring the right talent can be an all-consuming job at times. Given your company’s financial and organizational constraints, it may seem quicker and easier to hire independent contractors rather than employees. However, there are key considerations in order to stay compliant with existing contract worker laws. In particular, a new California law, Assembly Bill (AB) 5, has changed the definition of independent contractors.With an estimated 1.6M of CA’s 19.4M workers being full-time contractors, the new law aims to expand protection for individuals in the gig economy. Click To Tweet
Given the stricter requirements and steep penalties for misclassification that went into effect on January 1, 2020, it is critical that founders take the time to understand AB 5. Here are some key takeaways for employers.
Employees vs. contractors: what is the difference?
Employees are usually full-time, regular workers whose rights and responsibilities are explicitly detailed by the nature of the employer-employee relationship. The company has control over their schedule, training, methods of performing work, and the work products created. The company must also withhold income tax, Social Security, and Medicare from wages paid.
Independent contractors, on the other hand, are non-employees who provide a certain service or work product for a specified duration under a contractor agreement. They are otherwise outside the purview of the company and do not present the same tax liability as employees.
The decision to hire employees versus engaging independent contractors has important implications for a company’s tax liability and legal obligations. The U.S. Department of Labor (DOL), the Internal Revenue Service (IRS), the National Labor Relations Board, and state agencies all have their own rules for distinguishing between employees and independent contractors and assessing the employer’s obligations.
Prior vs. current definition of employees vs. contractors
The prior definition of employees vs. independent contractors in California was established in S.G. Borello & Sons, Inc. v. Dep’t of Indus. Relations (Borello). This definition was replaced by the “ABC test,” which was codified by AB 5 and originally set forth by the 2018 California Supreme court decision in Dynamex Operations vs. Superior Court.
The ABC test has more stringent requirements to categorize workers as independent contractors. Under the new law, a person providing labor or services must meet all three of the test’s criteria to be considered an independent contractor rather than an employee. Here are the key differences between the old and new definitions.
If the worker meets all three criteria of the ABC test, then they would be considered an independent contractor and the hiring entity would provide a Form W-9 and a Form 1099-MISC to them. If the worker fails to meet any one of the criteria, then they would be considered an employee and the employer must provide a Form W-2.
Importantly, whereas the prior definition was limited to California Industrial Welfare Commission (IWC) Wage Order violations, the ABC test now also applies to Labor Code violations, California unemployment insurance, and workers’ compensation proceedings (e.g., companies are now liable for business expense reimbursement claims by anyone who qualifies as an employee under Labor Code Section 2802, something that was not covered by IWC Wage Orders). Further, it seems that the ABC test will apply retroactively to wage and hour claims, though for now it is uncertain whether it will also apply retroactively to unemployment insurance.
Exemptions from the ABC test
Certain types of workers are exempted from the ABC test. However, an individual who meets the exemption requirements does not necessarily qualify as an independent contractor. Instead, they must meet the Borello standard and/or other statutory provisions as specified in AB 5. The exemptions apply to generally seven categories, each with its own set of requirements, briefly summarized below.
- Specific occupations, such as certain investment advisers, accountants, lawyers, direct sales salespersons, engineers, securities broker-dealers, insurance agents, physicians, surgeons, dentists, podiatrists, veterinarians, architects, private investigators, and commercial fishermen
- Certain contracts for “professional services” including marketing, human resources, travel agents, graphic design, grant writers, fine artists, agents practicing before the Internal Revenue Service, payment processing agents, still photographers, photojournalists, freelance writers, editors, newspaper
- Cartoonists, estheticians, electrologists, manicurists, barbers, and cosmetologists
- Certain real estate licensees and repossession agencies licensed pursuant to the California Business and Professions Code
- Certain bona fide business-to-business contracting relationships
- Certain relationships between contractors and individuals working under a subcontract in the construction industry
- Certain relationships between referral agencies and service providers
- Certain relationships related to motor club services
What you need to do to comply
Considering the significant impact AB 5 has on hiring and HR compliance, founders should take the time to understand and comply with the new law as soon as possible. Here are some of the key actions your company can take right away:
- First, companies need to take an inventory of all the contingent workers that they have, whether through a contract, staffing agency, or another third party. Conduct the ABC test for all of your contingent workers (i.e. do they met one of the three new criteria, etc)
- To ensure a true independent contractor relationship exists for those you classify as independent contractors, the recipient of payment for the work performed must be an entity (e.g., a staffing agency) and not an individual. In other words, you must have a business-to-business relationship with your independent contractors.
- If you continue to retain any contingent worker who does not satisfy the ABC test, you can utilize a third-party payrolling service, who will become the employer of record—meaning that the service agency, instead of your company, will become the legal employer of the worker and provide them the Form W-2. Your relationship with the worker will be through the payroll service.
- You may need to pay a premium for the payrolling service you choose, and the payrolling service will be responsible for providing the worker with the necessary benefits.
- Lastly, you should work with your company’s employment counsel to ensure compliance, particularly given the complex requirements for exemptions.
Penalties for misclassification of employees vs. contractors
Given the relatively complex criteria and exemptions provided by the new law, it is easy to misunderstand or neglect its provisions. A common pitfall is that employers misunderstand the exemptions and mistakenly believe that their workers are exempt when they are in fact not. Another common mistake is believing that because your company has not faced misclassification exposure before, you will not be exposed going forward. These pitfalls, however, could lead to steep penalties.
Under the new law, employers who misclassify workers as independent contractors are liable to Labor Code violations for items such as unpaid wages, overtime, and missed meals and breaks. In addition, they are liable to civil penalties of $5,000 to $15,000 for each violation of “willful misclassification.” The penalties increase to a minimum of $10,000 to $25,000 per violation if an employer is found to have a pattern of misclassifying workers.
While the new law is being challenged on various fronts (including by large companies like Uber), employers in the meantime should closely review the classification of their independent contractors to ensure compliance and avoid steep penalties. It is crucial that you stay up to date with ongoing changes in contract worker laws and adjust your hiring practices accordingly. For more information on this topic, check out some of our founder-related resources such as
- Hiring U.S. contractors and employees with employment authorization
- Issuing stock options to employees and contractors
All information, content, and materials presented are for general informational purposes only. The information presented is not legal advice, is not to be acted on as such, may not be current and is subject to change without notice. All liability with respect to actions taken or not taken based on the information presented is hereby expressly disclaimed.