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What Is AB5 (California Assembly Bill 5) And How Will It Affect Your Work With Contractors?

Learn the basics of California Assembly Bill 5 and how it can impact the way your organization works with freelancers and contractors.

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What is AB5?

California Assembly Bill 5 (AB5) is a piece of legislation that requires businesses hiring independent contractors to reclassify them as employees. This new employment law went into effect on Jan. 1, 2020, and is being considered by other states, like New York and Illinois. 

California AB5 defines several types of independent contractors that businesses must classify as employees. As a result, the employment status of many workers, previously categorized as 1099 contractors, might change and they will now be considered as W-2 employees.

Contractors categorized as W-2 employees are entitled to employee protection and benefits, such as health and unemployment insurance, paid time off, and retirement. To reclassify W-2 employees as 1099 independent contractors, employers must use the ABC TEST, which assumes a worker is an employee unless demonstrated otherwise.

What is an ABC Test?

The California Supreme Court has ruled that companies must use a three-sided test known as the ABC test to determine the classification of workers. Independent contractor testing must prove three things:

A. Workers provide services without the control or direction of the company

This means that workers should have complete freedom in how, when and where they work. You cannot meet this requirement unless there is clear evidence that workers are not under control of the company—it is not sufficient to have an agreement saying this is the case.

B. Workers perform work that is outside normal business activities

This part of the test specifies that to be considered an independent contractor, a worker must perform work that is not related to the company’s normal activities. For example, if the company hires an online marketing specialist, it must demonstrate and document that online marketing is not part of normal business activities, otherwise that contractor will be considered an employee.

The main concern of the legislation is to ensure that employees critical to the business are respected and well treated. A specific target of this provision is the gig economy (for example, ride-sharing companies and their drivers), in which workers are treated as contractors, even though they perform the main business activity of the company.

C. Workers are engaged in an independent but established occupation of the same nature as the work being performed

This part of the test is intended to ensure that contractors cannot be hired through intermediary companies or agencies, to avoid classifying them as contractors. It is important if the contractor works under a Federal Tax Identification Number (FEIN) and not under a Social Security Number (SSN).

AB5 Exemptions

AB5 provides several exemptions. These are occupations, industries, and business relationships that are not automatically considered as independent contractors, but are by a more flexible multi-factor test. 

The main exemptions are:

  • Specific professions—including licensed insurance agents, doctors, physicians, lawyers, architects, engineers, private detectives, accountants, registered stockbrokers, direct sales agents, and commercial fisherman.
  • Commercial relationships—licensees of construction subcontractors, automobile clubs, real estate agents, and others who meet certain criteria.
  • Professional services contracts—certain business relationships that meet additional sub-criteria such as talent managers, fine artists, marketing professionals, travel agents, graphic designers, photographers, and cosmetologists.
  • True intercompany contractual relationship—a contract in which a “real business service provider” according to the law’s definition contracts with another “contract business” to provide services. To qualify for this exemption, a company must meet 12 criteria, including elements A and C of the ABC test.
  • Referral agencies—in some cases, organizations that connect service providers to clients in fields like house cleaning, graphic design, photography, dog care, small repairs, moving, gardening, might be exempt. They will then be subject to the multi-factor test instead of the ABC test, if they meet the 10 requirements of this exemption (similar to the 12 requirements of intercompany relationships).

The Potential Consequences of AB5

An unintended consequence of the new law is that it applies to everyone. So even if contractors are happy to be defined as such, due to the flexibility of contract work or the ability to improve their income, employees will be forced to define them as salaries employees.

Many workers may not be able to continue working in the status quo, which may force them to make changes or seek other employment opportunities. Other workers may choose to incorporate as a private company and then use their employees to engage with their clients. Gig workers might find themselves operating as companies instead of independent contractors.

The gig economy gives businesses additional external resources and flexibility that were impossible just a few years ago. Employers need agility and the ability to take advantage of opportunities, leveraging workers on a project-by-project or as-required basis. 

The gig economy also provided the opportunity to increase productivity, while creating an alternative career path for many workers. At a time when it’s more difficult than ever to attract full-time talent, flexible work opportunities gave employers additional possibilities to attract the best candidates. enhance the value proposition of corporate employers and significantly increase the talent pool of candidates. This is an effective way to retain high-value employees.

However, new legislation may remove this option and result in a loss of competitive advantage for employers, while restricting the flexibility of employees in the new economy.

Conclusion

In this article, I explained the basics of California Assembly Bill 5 and how it can impact the way your organization works with freelancers and contractors. In particular, I covered the following AB5 concepts:

  • The ABC Test – a three-pronged test which individuals must pass in order to be considered a contractor.
  • AB5 Exemptions – specific professions and commercial relationships that might allow your contractors to be exempt from the full ABC test (but still subject to a more flexible multi-factor test).

In the bottom line, AB5 will make it more difficult for organizations to hire contractors and for employees to work as contractors if they choose to do so. At the same time, it can serve to protect underprivileged populations against exploitation. Whatever your opinion on AB5, your organization must learn the details and prepare for this major shift in California employment legislation.

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