Many companies hire independent contractors for a variety of reasons. Some companies may want to take advantage of certain tax laws, while others may hire independent contractors to escape vicarious liability for a worker’s negligent actions. However, with the implementation of Assembly Bill 5 (AB 5) in California, many companies are worried about how it could affect employment taxes for their business. If you are concerned about how AB5 may impact your employment taxes, you should contact our experienced California dual-licensed Tax Attorneys and CPAs. At the Tax Law Offices of David W. Klasing, our skilled Tax Attorneys and CPAs possess decades of combined legal & tax experience, and we are prepared to use these skills to provide you with the legal and tax representation you need. Our legal team has kept close track of the intricacies of Assembly Bill 5, and we could help you remain compliant with these new regulations. The Tax Law Offices of David W. Klasing is here to discuss the ways in which AB5 has changed employment taxes in California.
How AB 5 Affects Employment Taxes in CA
Assembly Bill 5’s new test for independent contractors changes how employment taxes will be handled by a number of businesses. As a result, employees should be prepared to make changes on how they will handle federal and state taxes.
Federal Tax Implications for CA Employers Under AB 5
For federal tax purposes, an employer will still have to follow the common law test set by the Internal Revenue Service instead of the new test set under AB 5. The IRS test for independent contractors examines a worker’s behavior, financial control, and relationship with their employer. If a worker qualifies as an independent contractor under the IRS test, the employer would be permitted to resume using a Form 1099 for federal tax reporting for those workers. Additionally, the employer would not have to contribute to Social Security or Medicare fund.
Alternatively, if the IRS test determines the worker is not an independent contractor because the employer has wide discretion over their behavior, financial agreements, and relationship, this would open the employer to federal tax liability.
Employers are likely concerned about how a worker could be considered an independent contractor for federal purposes but may be required to be classified as an employee under California state law due to AB 5. As a result, a company may find it tedious to apply some taxes for the worker while ignoring others, which could cause the company to classify the contractor as an employee instead. However, if a company decides to declare a former independent contractor as an employee for all purposes, they will have to deal with the following federal regulations:
- Social Security and Medicare Taxes
- Verification of I-9 Forms for Citizenship and Immigration
- Wage and hour
- Affordable Care Act (ACA)
- Fair Labor Standards Act (FLSA)
State Tax Implications for CA Employers Under AB 5
In California, the application of the AB 5 test for independent contractors will depend upon the actions of state agencies. It would be unwise to assume that state taxing agencies will always apply the AB 5 test for workers.
Note, however, that implementation of AB 5 will require employers to retain state unemployment insurance and disability insurance contributions for workers that could be classified as employees. Additionally, after July 1, 2020, employers will need to cover their contractors under workers’ compensation insurance.
Ultimately, if an employer must classify an independent contractor as a worker, the employer would be accountable for the following tax liabilities:
- Income tax withholding for state and federal taxes
- Paying taxes for state disability, unemployment insurance, state employee training
- Withholding of employee’s portion of federal payroll taxes
- Paying taxes for employer’s portion of federal payroll taxes
If an employer neglects to pay the above taxes, they could subject to a number of state and federal tax penalties. Our skilled team of tax attorneys and accountants are prepared to help you handle your tax liability. To learn more about how to classify an employee under California’s Assembly Bill 5, you should continue reading and contact the Tax Law Offices of David W. Klasing as soon as possible.
AB 5 Tests for Independent Contractors/Employees in CA
California Assembly Bill 5 was passed into law on September 18, 2019, by Governor Gavin Newsome. The purpose of AB 5 is to change how California classifies independent contractors and employees, which is a change from classification rules implemented by the Internal Revenue Service. Before AB 5 took effect on January 1, 2020, the IRS had the following guidelines for determining whether a worker is an employee or independent contractor:
- Behavioral Control – This step of the classification process looks at the level of control the employer has over the worker. If the employer has a wide range to dictate how the worker should perform their tasks and when they should perform tasks, it is likely that the worker is an employee rather than an independent contractor.
- Financial Control – If an employer provides the worker with the equipment, they need to perform their job or finances the purchasing of materials, this will increase the likelihood that the worker is an employee. Independent contractors typically possess personal equipment that will be used to complete work and is often not reimbursed for these items.
- Relationship – It is also necessary to question the relationship between the company and the worker. If the company has an open-ended agreement with the worker to consistently perform a variety of tasks, this may be used to prove that the worker is an employee. To combat this assumption, a business owner should ensure that they have a contract with an independent contractor that highlights vital details, like the temporary nature of the work.
AB5 Three-Factor Test for Independent Contractors vs. Employees
After Governor Newsome passed AB 5, California now follows a three-pronged test to determine whether an independent contractor should be reclassified as a full-fledged employee. Under AB 5, the following three factors will determine whether a contractor is considered an employee:
- The first factor examines whether the worker is permitted to control all or most of the details of how the job in practice and in the terms of the contract for performance. For example, if a rideshare driver is only permitted to use routes assigned by the company, this may question whether they are an employee or an independent contractor.
- The second factor is whether the contractor does work that is outside the typical scope of the employer’s business. When an employer hires a contractor to perform work that is identical to that of an employee, this may signify that the contractor is not independent. For example, hiring a worker to perform a one-time project may help an employer prove that the worker should be classified as an independent contractor. Alternatively, a worker used to support routine work for certain seasons may be considered an employee.
- Finally, AB 5 analyzes whether the worker primarily operates in an “independently established trade” in the same field as the employer that hired them. If a contractor is only performing work for one business, this may call into question their independent status.
Exceptions to California’s AB5
It is important to note that there are some exceptions to AB 5, depending on the circumstances of the employer’s business. For instance, the following professions could be exempt from AB 5 if they meet certain criteria:
- The professional works at a separate business location from their employer
- Business licenses and other professional licenses (e.g., attorney)
- The professional has the discretion to set their own rate
- The professional has control over their work schedule
- Providing services to multiple clients
- Discretion over your day-to-day activities
As a result, the following professions could be exempt from AB 5:
- Accountants
- Architects
- Doctors
- Dentists
- Engineers
- Investment Advisors
- Landscapers
- Veterinarians
This is not an exhaustive list. There are other businesses and professional services that could be exempt from AB 5. If you wish to learn more about the consequences of misclassifying employees under California’s AB 5, you should continue reading and consider working with an experienced California dual-licensed Tax Attorney and CPA.
Employment Tax Penalties for Misclassifying Workers Under AB5
In response to California’s Assembly Bill 5, many companies are seeking legal action to fight the bill or claim they are not subject to the regulations of the bill. For example, rideshare companies like Uber and Lyft have stated that their drivers operate outside of the normal scope of their respective businesses. Ultimately, each company was prepared to suspend its operations in California if drivers were given the privileges of full-time employees.
Unfortunately, every company in California does not have the ability to cease operations in order to avoid complying with AB 5. As a result, companies should be focused on how they could remain compliant with the bill in order to avoid various tax penalties.
State agencies are still determining the best approach to implement penalties under AB 5. Depending on the circumstances, an employer that does not comply with AB 5 could be subject to fines, back taxes, and other penalties. Specifically, one law that applies to the misclassification of employees is California Senate Bill 459.
Under California Senate Bill 459, an employer that misclassifies an employee would be subject to fines of at least $5,000 to a maximum of $25,000 per violation from the Labor and Workforce Development Agency. It is also possible for this agency to impose other types of damages against employers that misclassify employees.
As mentioned, some companies may decide to classify a worker as an independent contractor for all purposes rather than to struggle to identify when the worker should be classified as an independent contractor. However, classifying an independent contractor as an employee could pose some risks to a company. Specifically, treating an independent contractor as an employee may affect the following matters:
- Tax Qualification Rules of 401(k) plans
- Denials of Claims for an Insured Health Plan
- Disqualification of Tax-Qualified Employee Stock Purchase Plan
- Accidental establishment of multiple employer welfare arrangement
It is also important to note that the misclassification of employees is not the only way that an employer could be assessed penalties. For instance, by misclassifying an employee, an employer affects a worker in many other ways. The worker may not be provided with necessary breaks for meals and rest or violations for paying the incorrect wages.
The Tax Law Offices of David W. Klasing could help your company remain compliant with AB 5 to avoid unnecessary tax penalties.
Consult with Our Skilled California Employment Tax Attorneys and CPAs for AB 5
If Assembly Bill 5 applies to your business, you should work with a skilled California Tax Law Attorney and CPA that could help you resolve issues regarding AB 5. The Tax Law Offices of David W. Klasing has provided a variety of legal services to many clients across the State of California, and we would welcome the opportunity to work with you. To schedule a confidential consultation to discuss the details of your case, call the Tax Law Offices of David W. Klasing at (800) 681-1295. Our firm is still operating during the COVID-19 pandemic, and clients can schedule secure virtual meetings to ensure that your sensitive information is kept confidential from others.
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