Hiring and Growth

What California’s New Labor Law Means for Small Businesses That Work With Contractors

Jon Hyman Employment lawyer 
AB5: What It Means for California Small Businesses with Independent Contractors

Thanks to Assembly Bill 5 (AB5), California just made it significantly harder for businesses operating within the state to classify their workers as independent contractors instead of employees

Simple time tracking that syncs with payroll.

On September 11, 2019, California passed AB5, an employment law that will rewrite the rules of worker classification within the Golden State. The law takes effect on January 1, 2020.

Why AB5 is a big deal for California employers

The distinction between who qualifies as an independent contractor over an employee is extremely significant. That’s because contractors aren’t entitled to the many protections that many laws provide to employees.

These protections include:

When AB5 goes into effect on January 1, 2020, many contractors who didn’t receive the protections and benefits above will now be entitled to them. 

There are also several key differences between how a company interacts with an employee compared to how it interacts with an independent contractor.

EmployeeIndependent contractor
HiringTypically fills out an employment application, meets with HR, and must complete additional requirements before hiring, such as a background check and drug testTypically interacts with the person or department needing services, and may submit a proposal; signs a contract or statement of work before starting work
TaxesCustomary withholdings are taken from wages (payroll taxes, Social Security, etc.); all money paid during the tax year is reported on a W-2No withholdings are taken from wages; all money paid during the tax year is reported on a 1099
How they're paidEarns either an hourly wage or a salaryPaid by the job, either in total when it is completed, or incrementally per a fixed schedule
When they're paidPaid from payroll per a fixed period that cannot be changed (weekly, every other week, twice per month, monthly)Paid by accounts payable whenever an invoice is submitted

For this reason, any law that reclassifies a large group of workers is pretty important for business owners who hire independent contractors.

What does the Dynamex ABC Test have to do with AB5?

Last year, in Dynamex Operations West v. Superior Court, the California Supreme Court set forth a three-part test (commonly known as the “ABC Test”) to determine whether a worker is truly an independent contractor or an employee. 

California’s Assembly Bill 5 codified the ABC Test, which says that a worker is “properly considered” an independent contractor only if they meet each of the following three criteria.

CriteriaWhat it means
(A) “The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact.”The “control and direction” test is what the IRS usually uses to define an independent contractor. It looks at three key points of control: behavioral (who controls the how, what, and when of the work), financial (does the workers have the opportunity not only to make a profit through the work, but also take a loss), and relationship (is the worker limited only to working for the one business, or are they free to work for others).
(B) “The worker performs work that is outside the usual course of the hiring entity’s business.”This factor looks at whether the work performed is outside the core function of the business. Think functions such as IT maintenance, which a business can easily outsource.
(C) “The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.”This factor examines whether the worker is traditionally engaged in their own business. For example, degreed professionals, such as lawyers and accountants, licensed service trades, such as barbers or massage therapists, and traditional freelancers, such as landscapers and artists, could all qualify as contractors under this factor.

As you can see from the ABC Test for contractors, AB5 is going to impact the gig economy hard

Before we can discuss how hard, let’s first have an understanding of this “gig economy” industry we’re talking about.

Wait, what’s the gig economy again?

The gig economy is a labor market characterized by short-term contracts or freelance work, as opposed to permanent jobs. Gig workers are independent contractors that business owners hire to help with either specialized work and/or short-term work that doesn’t require a full-time hire.

Many times, small business owners connect with gig workers through apps or other online platforms. Think Upwork, Fiverr, and other part-time job sites. 

Gusto makes payroll, benefits, and HR actually easy.

Freelancers (the gig workers) can choose jobs or projects from anywhere in the world, and employers can access a wider pool of workers for projects. Moreover, gig work allows people to change jobs with the flexibility of choosing when and where to work. Gig workers also enjoy the work-life balance afforded by a job that permits total control over work schedules. 

A recent study by Intuit predicts that by 2020, as many as 40% of American workers will be independent contractors

How should California small businesses prep for AB5?

AB5, however, will upend the entire gig economy. 

Because of how narrowly AB5 defines an “independent contractor,” there are certain steps that California gig employers, and any California business that employs independent contractors (which includes many small businesses), should be doing now before the law takes effect on January 1, 2020.

1. Lawyer up

If you currently work with independent contractors, hire an employment lawyer to analyze your team.

This will help you determine whether your workers are properly classified as independent contractors. And, if they’re not, the analysis will tell you how much your potential exposure could be for unpaid overtime, health benefits, and other compensation if you leave them misclassified after AB5 takes effect in January.

2. Reclassify your team if necessary

After reading the ABC Test above, you may realize that some of your workers are actually employees. Better late than never.

If you need to reclassify an independent contractor to an employee, you will need to make sure all employment requirements are taken care of.

Your employee will need to:

  • Complete an employment application
  • Undergo a background check and drug test (if that’s your normal practice)
  • Complete an I-9 and a W-2
  • Enroll in your employee benefits program

You will also have to register your new employee with whatever agencies your state requires (for example, for purposes of workers’ compensation and unemployment coverage), and you will have to add your employee to payroll

You will also have to ensure that your employee receives (and signs a receipt for) your employee handbook, and begins properly tracking their time for payroll and overtime purposes.

3. Figure out how you will pay for any reclassifications 

Large companies might be able to absorb the costs of increased wages and benefits that go along with the reclassification of independent contractors to employees. 

Small businesses, however, will struggle without proper planning. 

You’ll either absorb the cost or pass it on to your customers. Either could result in a steep financial loss, so make sure you review your business finances to see where you could potentially make cuts or change pricing in order to come out ahead. 

4. Limit your team’s schedules

If you need to reclassify your contractors to employees, consider assigning set work schedules. 

This will help you avoid, as best as possible, your gig employees working too many hours (and earning potentially unlimited overtime premiums as a result).

5. Account for paid rest breaks 

If you must reclassify your contractors to employees, ensure that you’re giving them sufficient time away from work. 

For example, California law requires that employees receive a 10-minute paid rest break for each four hours worked and a 30-minute paid meal break for each five hours worked. 

Failing to give this time to your new employees will result in liability under California law.


The application and impact of AB5 all comes down to flexibility. The flexibility gig workers currently enjoy (which drives them to gig jobs instead of full-time employment), and the flexibility that small business owners might take away if they have to reclassify their contractors. 

With AB5’s passing, the days of California contractors working when and where they want are likely over. And because of the loss of flexibility to workers and the added cost to businesses, both sides will pay a price.

Updated: November 1, 2019

Jon Hyman
Jon Hyman Jon Hyman is a partner in the Labor & Employment Group at Cleveland, Ohio’s Meyers, Roman, Friedberg & Lewis. He is the author of the award-winning Ohio Employer Law Blog. When he’s not helping employers proactively and cost-effectively solve workplace problems, he’s working as an unpaid roadie for his kids’ burgeoning rock ‘n’ roll careers.

Comments

  • Cooper

    If I am a New York-based small business and I do not operate in the state of California, but I employ a California-based independent contractor who does not pass the ABC test, am I liable to pay benefits? Or is this law limited to California-based businesses?

    Reply
    • Gusto Editors

      Hi Cooper, we recommend reaching out to an attorney, as they’ll be able to provide you with recommendations specific to your situation!

      Reply

*Required fields

Your email address will not be published.

Back to top