California state has become the epicenter of worker classification risk. What many business owners still call “AB 5” is now a dense framework of statutes and court decisions that determine whether your workers are employees or independent contractors for California Labor Code, Unemployment Insurance, wage-and-hour, and even state income tax purposes. While Assembly Bill 5 initially added Labor Code section 2750.3, those rules were repealed and re-enacted, with modifications and dozens of industry-specific exemptions, in Labor Code sections 2775 through 2787 under Assembly Bill 2257, with further tweaks in later bills.
Under this regime, most California workers are presumed to be employees unless the hiring entity can satisfy every prong of the strict “ABC test” first announced by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court and later codified. At the same time, some occupations and relationships remain under the older Borello multi-factor test, and app-based transportation and delivery drivers are subject to a ballot initiative regime under Proposition 22, which the California Supreme Court unanimously upheld in 2024. The result is a patchwork that is confusing even for sophisticated employers.
In this environment, an “independent contractor agreement” that ignores AB 5, AB 2257, and their successors is little better than a blank sheet of paper. California state regulators, plaintiff-side employment lawyers, and even competitors are scrutinizing how companies classify and document workers. Misclassification can trigger overlapping exposure: unpaid wages and overtime, meal and rest break penalties, Private Attorneys General Act (PAGA) claims, Employment Development Department (EDD) employment tax audits, Franchise Tax Board (FTB) income tax consequences, IRS payroll tax issues, and, in egregious cases, criminal employment tax exposure.
An AB 5-compliant independent contractor agreement is not a magic shield. The law is clear that you cannot manufacture independent contractor status simply by slapping that label on a contract. However, carefully structured agreements that are aligned with the ABC test, any applicable Borello-based exemptions, and the actual day-to-day working relationship are an essential part of a defensible contractor model and can materially improve your position in a worker classification audit or lawsuit.
The Legal Framework: ABC Test, Borello, and Key Exceptions
For most California workers today, Labor Code section 2775 requires that a person providing labor or services for pay is considered an employee unless the hiring entity proves all three parts of the ABC test:
- A. Freedom from control. The worker must be free from the power and direction of the hiring entity in performing the work, both under the contract and in fact.
- B. Outside the usual course of business. The worker must perform work that is outside the normal course of the hiring entity’s business.
- C. Independent business. The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
If the ABC test does not apply because of a statutory exception or a court determination, then the older Borello multi-factor test governs. Borello looks at a long list of factors, with the principal one being whether the putative employer has the right to control the manner and means of accomplishing the work, but no single factor is dispositive. Under AB 2257’s recodification, certain occupations and relationships fall into categories where the Borello test replaces the ABC test, sometimes automatically and sometimes only if additional statutory requirements are met. Those include:
- Certain licensed professionals, such as attorneys, accountants, engineers, and some medical providers.
- Certain business-to-business contracting relationships.
- Certain professional services and referral-agency relationships require detailed criteria to be satisfied for separate business locations, licenses, control over rates and schedules, and multiple clients.
Layered on top of this is Proposition 22, which governs app-based rideshare and delivery drivers for defined “network companies” and explicitly exempts them from the otherwise mandatory ABC test in favor of their own statutory framework. Even after Prop 22’s 2024 Supreme Court victory, however, state and local authorities are actively litigating whether specific platforms really qualify or are misusing contractor status in ways that violate California labor law.
Critically, California’s taxing agencies have made clear that worker classification under these Labor Code rules is directly relevant to state income tax and payroll tax obligations. The FTB’s AB 5 guidance explicitly states that the ABC test and related provisions in sections 2775 through 2787 are relevant for California income tax purposes, and that a worker might simultaneously be treated as an independent contractor for federal tax and an employee for California, creating complex reporting and withholding issues. In other words, AB 5 compliance is not just a wage-and-hour issue. It is an employment tax issue too.
What “AB 5-Compliant” Independent Contractor Agreements Should Do
No contract can override the law or cure a misclassification where the underlying facts show an employment relationship. Courts and agencies will look first to reality on the ground and treat the written agreement as one piece of evidence. That said, intelligently drafted independent contractor agreements play a central role in demonstrating compliance with the ABC test or a Borello-based exemption and are explicitly required in several of the statutory exemptions that AB 2257 introduced for professional services, referral agencies, and certain business-to-business relationships.
Note: We recommend an employment attorney be consulted and engaged to draft proper subcontractor agreements.
An AB 5-compliant contractor agreement should, at a minimum, address:
Freedom from Control (ABC Prong A)
The agreement should make clear that the contractor controls how the work is performed, subject only to outcome-oriented specifications. That typically means: the contractor chooses work methods, sequence, and tools; the contractor can set or at least negotiate schedules within broad deadlines; and the hiring entity’s quality assurance provisions are framed in terms of deliverables rather than day-to-day supervision. These contractual statements must be consistent with actual practice, since the ABC test expressly looks at both the contract and the real-world relationship.
Work Outside the Usual Course of Business (ABC Prong B)
Wherever possible, the agreement should accurately describe a scope of work that is ancillary to your core revenue-generating activities. California authorities and courts view workers performing the same functions as your employees, on an ongoing basis, as strong evidence that they are part of your “usual course of business.” By contrast, hiring a one-time outside specialist (such as a licensed IT consultant or marketing firm) to deliver a discrete project is more consistent with independent contractor status. The contract should describe services in a way that reflects this distinction.
Evidence of an Independently Established Business (ABC Prong C)
An AB 5-compliant agreement should require the contractor to maintain an independent business and should document that reality. Typical provisions include requirements that the contractor:
- Maintain a separate legal entity or trade name where appropriate.
- Hold any required business and professional licenses.
- Advertise services to the public or multiple clients.
- Maintain separate business insurance.
- Supply their own tools, equipment, and workspace except for narrow, clearly justified exceptions.
These are the same types of facts the California Supreme Court and the FTB identify as hallmarks of an independently established business under Part C of the ABC test.
Occupation-Specific AB 2257 Requirements
For professional services exemptions, referral agency relationships, and business-to-business contracts, the statutes often require a written contract that spells out rate of pay, scope of work, payment schedule, and the contractor’s right to set its own rates and hours, work offsite, and service multiple clients. Agreements that do not contain these terms, or that undercut them in practice by requiring exclusive service or tight day-to-day control, can destroy the very exemption you are trying to rely on.
Realistic Tax and Benefit Disclosures
Most contractor agreements require the worker to take responsibility for their own federal income and self-employment taxes and expressly state that no employee benefits will be provided. Those provisions are still appropriate, but they must not be drafted in a way that suggests you can contract around California’s classification rules. The agreement should not promise “independent contractor” status regardless of what AB 5 and sections 2775 through 2787 would actually require, and it should acknowledge that the parties intend to comply with all applicable classification laws.
Consistency with Your Policies and Actual Practices
A beautifully drafted contract is routinely undermined by a handbook that treats contractors like employees, a scheduling system that dictates their daily hours, or a manager who requires contractors to seek permission to take outside work. AB 5 compliance is a systems problem, not a template problem. Your independent contractor agreement should be the backbone of a larger program that includes internal training, classification checklists, periodic reviews, and, where needed, adjustments to business models.
In short, “AB 5-compliant” agreements are not generic forms. They are highly tailored documents built around the specific statutory test that applies to a given role, the industry in which you operate, and the actual way your company uses contractor services.
Misclassification Risk, Employment Tax Exposure, and The High-Risk Audit Environment
Companies that treat AB 5 and its successors as “just paperwork” are increasingly finding themselves in the crosshairs. California has already used civil enforcement actions against high-profile companies for alleged misclassification, and state and local authorities continue to sue or threaten litigation where they believe workers have been improperly treated as contractors.
On the tax side, misclassification is a classic trigger for EDD and IRS employment tax audits. If a contractor you let go files for unemployment insurance, the EDD may examine whether that worker and similarly situated individuals should have been treated as employees. If the agency concludes that workers were misclassified, it can assess back state payroll taxes, interest, and penalties. It may share information with the IRS, which can also pursue federal employment tax assessments. For patterns of intentional misclassification or failures to remit trust fund payroll taxes, the risk escalates into high-risk “eggshell” tax audits, where every statement you make can influence whether a civil case becomes a criminal employment tax investigation.
California also has separate statutory penalties for willful misclassification. Senate Bill 459 and Labor Code section 226.8 authorize civil penalties ranging from five thousand dollars to twenty-five thousand dollars per violation, on top of other remedies, when an employer is found to have intentionally misclassified workers as independent contractors. Meanwhile, wage and hour exposure can include minimum wage and overtime back pay, meal and rest break premiums, waiting time penalties, and Prive Attorneys General Act civil penalties, often multiplied across large groups of similarly situated workers.
From a benefits and federal tax perspective, simply converting everyone to employee status to “play it safe” can also create problems. Reclassifying workers as employees can affect 401(k) plan qualification, health plan eligibility, and other benefit structures if done without careful planning. Employers, therefore, need a deliberate, documented strategy, not ad hoc fixes.
Properly structured, AB 5-compliant independent contractor agreements are one of the few pieces of evidence entirely within your control before any dispute arises. They help tell a coherent story to regulators, judges, and juries about why certain relationships truly are independent, and they put you in a stronger position if you decide that specific roles must be converted to employment going forward while minimizing retroactive damage.
How the Tax Law Offices of David W. Klasing Help Design and Defend AB 5-Compliant Contractor Programs
Worker classification in California sits at the intersection of employment law, federal and state tax law, and rapidly changing statutory carveouts. Few firms are built to handle all of these dimensions at once. The Tax Law Offices of David W. Klasing is a boutique California tax law firm composed of award-winning, nationally recognized dual-licensed Tax Attorneys and CPAs who focus on precisely this type of high-risk, cross-disciplinary problem but solely from an employment tax perspective.
Our legal team stays current on AB 5, AB 2257, Dynamex, Borello-based exemptions, Proposition 22, and ongoing enforcement trends, and we routinely measure clients’ worker models against the ABC test, Borello factors, IRS common law standards, and relevant industry-specific rules. For businesses that rely on independent contractors that are under audit we can:
- Map your current risk. We review your worker populations, roles, industries, and existing agreements to identify which tests apply, where exemptions may be available, and where current practices will not withstand scrutiny.
Defend you in audits and investigations. If you have already received an IRS, EDD, FTB, or DOL worker classification audit notice, we provide comprehensive representation, including controlling communications, managing document production, negotiating with agencies, and, when necessary, litigating or appealing adverse determinations. When patterns of misclassification raise potential criminal employment tax issues, our dual-licensed Criminal Tax Defense Attorneys and CPAs step in to manage the case, keeping matters civil whenever possible.
Because the firm’s CPAs are employees of the Tax Law Offices of David W. Klasing and work as part of the legal team under the direction of our attorneys, their analytical work, consultations, and draft calculations are generally protected under the attorney-client privilege and work product doctrine, which is critical in high-risk employment tax and worker classification engagements.
Contact the Tax Law Offices of David W. Klasing if You Are Unsure Whether Your Independent Contractor Agreements Comply With AB 5
At the Tax Law Offices of David W. Klasing, our dual-licensed Employment Tax Attorneys and CPAs have decades of combined experience defending worker classification audits within California.
We offer confidential, reduced-rate initial consultations in which we review your situation, explain your risk profile in plain English, and outline practical options for moving forward. With a main office in Irvine and satellite offices throughout California and across the country, including Los Angeles, San Diego, San Francisco, Sacramento, Las Vegas, Phoenix, Manhattan, and Miami, among others, we make it convenient to get the guidance you need. To schedule a consultation, call the Tax Law Offices of David W. Klasing at (800) 681-1295 or contact us online HERE today.
