What California’s New Labor Law Means for Small Businesses That Work With Contractors
Update on July 8, 2022: You may be reading about AB5 in the news. Wondering what’s going on?
At the end of June 2022, the Supreme Court declined to review two cases challenging the statute’s constitutionality. While the Supreme Court’s dismissal does not
preclude future lawsuits (the trucking industry has expressed it will continue to
challenge the law) it is likely to chill future litigation.
Several other organizations that rely on contractors, including Postmates, Uber, and the International Franchise Association, have already been unsuccessful in California
district courts.
The bottom line: for now, AB5 is here to stay.
Nonetheless, public disapproval has not gone unnoticed. AB5 included exemptions, which received immediate backlash for lack of clarity.
Thanks to Assembly Bill 5 (AB5), California made it significantly harder for businesses operating within the state to classify their workers as independent contractors instead of employees. The law took 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:
- Coverage by workplace discrimination laws
- Eligibility for overtime pay
- Coverage by workers’ compensation statutes
- Collection of post-termination unemployment
- Eligibility for health insurance and other employee benefits
When AB5 went into effect on January 1, 2020, many contractors who didn’t receive the protections and benefits above became 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.
| Employee | Independent contractor | |
|---|---|---|
| Hiring | Typically fills out an employment application, meets with HR, and must complete additional requirements before hiring, such as a background check and drug test | Typically interacts with the person or department needing services, and may submit a proposal; signs a contract or statement of work before starting work |
| Taxes | Customary withholdings are taken from wages (payroll taxes, Social Security, etc.); all money paid during the tax year is reported on a W-2 | No withholdings are taken from wages; all money paid during the tax year is reported on a 1099 |
| How they're paid | Earns either an hourly wage or a salary | Paid by the job, either in total when it is completed, or incrementally per a fixed schedule |
| When they're paid | Paid 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?
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.
| Criteria | What 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 impacts the gig economy.
Before getting into that, 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.
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.
How should California small businesses prep for AB5?
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.
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.
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Finances and TaxesIf 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-4
- 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.
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Hiring and GrowthFailing to give this time to your new employees will result in liability under California law.
With AB5’s passing, the days of California contractors working when and where they want are over. And because of the loss of flexibility to workers and the added cost to businesses, both sides pay a price.
