Recently enacted California Assembly Bill 5 (“AB-5”) is a game changer for businesses that use independent contractors in California — and a warning shot for employers nationwide.  Subject to exemptions for certain occupations and professions, AB-5 imposes a strict “ABC” test that appears to put a thumb on the scale of classifying workers as employees rather than independent contractors.

The ABC test was adopted last year by the California Supreme Court in its Dynamex decision to determine classification of workers for purposes of the state’s Industrial Welfare Commission Wage Orders.  For 20 years before Dynamex, worker classification was governed by the more relaxed “Borello” multi-factor test, which focuses on the hirer’s right to control an individual’s work and other secondary factors.  AB-5 now makes the ABC test the default standard for determining worker classification — not just under the Wage Orders, but also for all California Labor Code, unemployment insurance, and workers’ compensation claims.

As a result of the passage of AB-5, companies that hire consultants or contractors based in California should take a hard look at those relationships and determine whether they need to reclassify any such individuals as employees.  For other companies, this legislation should be monitored as the potential tip of an iceberg of a trend in many states, and potentially nationwide, toward imposing additional hurdles in classifying workers as independent contractors.The ABC Test Under AB-5

Under the ABC test codified in AB-5, a person providing labor or services for remuneration must be treated as an employee, rather than an independent contractor unless the hirer can demonstrate that all three of the following conditions are satisfied:

1. The person is free from the control and direction of the hiring entity in connection with the performance of the work. This prong must be satisfied both under the terms of the contract and in operation.  If the contract gives power to the hiring entity to control the individual’s work or the hiring entity insists on exercising such power even without such contractual authority, the worker will be deemed to be an employee under the ABC test.
2. The person performs work that is outside the usual course of the hiring entity’s business. This prong requires a fact-based inquiry that at times (but certainly not always) will produce clear-cut answers. For example, a plumber hired by an accounting firm to fix a toilet is performing work (plumbing) that is outside the entity’s usual business (accounting).
3. The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed. Performing work for multiple clients, or at least the ability to do so (g., a worker owning a business in a similar field or generally representing himself or herself as being available to perform similar work), helps demonstrate satisfaction of this prong.

The AB-5 test purports to be a mere declaration of existing law with respect to violations of the Wage Orders of the Industrial Welfare Commission and violations of the Labor Code relating to Wage Orders.  For all other purposes, the AB-5’s test’s application to the Labor Code take effect in 2020.

Who’s Exempt?

AB-5 exempts a number of occupations and professions from the strict ABC test and specifies that the Borello factors (with some exceptions) apply to the determination of whether these individuals should be classified as employees or independent contractors.  Notably, AB-5 applies the enumerated exemptions retroactively to the extent that they would relieve an employer of liability.  The exemptions include:

1. Occupational Exemptions. Occupational exemptions cover certain licensed doctors, veterinarians, attorneys, architects, accountants, engineers, persons licensed by the California Department of Insurance, securities broker-dealers or investment advisors, direct salespeople, and commercial fishermen. (For the full list of occupational exemptions, see Labor Code § 2750.3(b).)
2. Professional Services Exemption. Enumerated professional services are eligible for exemption from the ABC test, including, marketing, human resource administrators, travel agents, graphic designers, grant writers, fine artists, still photographers, payment processing agents, and licensed estheticians and manicurists, among others. (For the full list, see Cal. Labor Code § 2750.3(c).) To qualify for this exemption, the hiring entity must demonstrate that that several conditions are satisfied, including that the individual (A) has the ability to set his or her own business hours and rates and maintains a business location separate from the hirer, (B) is customarily engaged in the same type of work with other hiring entities, and (C) customarily and regularly exercises discretion and independent judgment in performing the services.  In addition, for any work performed more than six months after January 1, 2020, the individual must have a business license.  (For full details on this exemption, see Cal. Labor Code § 2750.3(c).)
3. Other Exemptions. AB-5 provides a number of additional exemptions, including for business-to-business contracts, real estate licensees, and repossession agencies subject to the California Business and Professions Code (which, notably, may default to the rules of the California Business and Professions Code, Unemployment Insurance Code, or Section 3200 of the Labor Code rather than the Borello test, depending on the circumstances), construction subcontractors, and “service providers” that provide, for example, minor home repair, moving, tutoring, event planning, home cleaning, pool and yard cleanup, web design, and dog grooming and walking. (For a full list of these exemptions, see Labor Code § 2750.3(d) through § 2750.3(h).)

Business Impact of AB-5

Businesses impacted by AB-5 will face complicated, and potentially costly, decisions as to whether and how they should make changes to the classification of their workers as independent contractors.   Impacted business should determine if they can rely on an exemption, and if not, whether they can satisfy the ABC test, which in many cases may involve fact patterns that present close calls.   Whether or not to reclassify in such situations may come down to a business’s risk tolerance.

Consequences of this determination can be expensive.  Employers of individuals formerly classified as contractors have to pick up normal employment costs, such as the employer’s portion of federal and state withholding taxes, workers’ compensation insurance, sick leave, business expenses, unemployment insurance, and, to the extent applicable, the cost of coverage under employee benefit plans and programs.  Balanced against these costs of reclassification is the risk of maintaining a consulting arrangement with workers that arguably could be treated as employees under AB-5.  Failure to comply with AB-5 can lead to expensive legal claims, such as for failure to pay minimum wages and overtime, meal and rest period violations, waiting time penalties, and unemployment insurance violations, to name just a few.

These risks are compounded by existing and new enforcement mechanisms that empower workers and government entities to bring claims against employers for misclassification.  Under the existing Private Attorneys General Act, workers may bring claims to recover civil penalties for Labor Code violations stemming from worker misclassification.  And, under a new enforcement mechanism in AB-5, the California Attorney General and certain city attorneys and prosecutors may bring claims for injunctive relief against companies they believe to be misclassifying workers — adding a new level of risk for employers that typically faced risk of misclassification lawsuits brought by workers only.

What’s Next

Although businesses that operate in California need to grapple with AB-5 now, the topic of worker classification in California is likely not settled. In his signing message, Governor Newsom indicated he would continue discussions with business and labor groups.

In addition, companies around the country should pay close attention to similar pending legislation, such as in New York, Oregon and Washington. Worker classification is also on the national agenda, as multiple Democratic presidential candidates have indicated their support for AB-5 and similar measures.