California Assembly Bill 5, simply abbreviated as "AB5", is a California law that tightens the classification of workers as contractors, rather than employees, for California-based companies. It was signed into law by Governor Gavin Newsom on September 18, 2019.
Why is it important to differentiate between independent contractors and employee status?
The distinction between employees and independent contractors is an important one. The status of someone who works in your business makes a difference in how you pay them and in how you and they pay taxes.
Employees (sometimes called common law employees) are paid as salaried or hourly, on commission, or a combination, and may be subject to overtime. Employees are taxed on their income (they receive a W-2 form showing their annual income), and you must also withhold federal and state income taxes and FICA taxes (Social Security and Medicare) from them. Your business must also make FICA tax payments.
Employees are entitled to benefits such as minimum wage, workers’ compensation, unemployment insurance, expense reimbursement, paid sick leave and paid family leave. Employers pay half of employees’ Social Security tax. The cost of these customary and legally-required benefits add up quickly. Some estimates claim that the real cost to an employer of an employee is 30% higher than the cost of a contract worker at the same hourly rate.
If someone is working for your business as an independent contractor, you don't withhold federal or state income taxes and FICA taxes from the amounts you pay them. Your business also isn't required to make matching payments for FICA taxes. The independent contractor must pay his or her own FICA taxes (called self-employment taxes), along with income tax on earnings. Independent contractors are not entitled to employee benefits.
Who determines whether a worker is a contractor or has employment status?
Until recently, in California as in other states, the employer had great leeway in determining employee status versus independent contractor status. Scrupulous employees attempted to make the most accurate possible classification, based on existing guidelines from the state and from the IRS. Less scrupulous employees made every effort to move workers from employee status to independent contractor status to save money.
One thing that AB5 does is shift the burden of proof by making the rebuttable presumption that a worker “shall be considered” an employee unless all three of the conditions in the law are met.
Precipitating these changes is a recent California Supreme Court ruling (Dynamex Operations West, Inc. v. Superior Court). Dynamex is a nationwide package and document delivery company that was sued by its drivers, alleging that Dynamex had misclassified its delivery drivers as independent contractors rather than employees.
In its simplest lay terms, the Dynamex ruling is to the effect that the State of California has been enforcing an inadequate method to determine whether a worker was an employee or an independent contractor. That ruling replaces what the State has been doing by saying that a worker is an employee unless all three factors of their new so-called “ABC test” are met. (See below.)
This ruling replaced a former eleven-factor test that had it been in use for some time in California, as well as at least partially overriding the more complicated IRS twenty-factor test. Both the Dynamex ruling and AB5 make it harder for companies to label workers as independent contractors.
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