A new California law aimed at worker classification may have a significant tax impact for companies. Understanding the difference between an employee and independent contractor and the tax consequences that flow from each designation should be top of mind for business owners and those within the payroll and tax departments at companies with a traditionally independent contractor workforce.
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A.B. 5 in a Nutshell
Assembly Bill 5 was aimed at businesses in the “gig economy”, like Uber, Lyft, and the like. Gig economy workers were generally considered independent contractors and not employees of the companies for which they worked. Companies like Uber viewed their platform as merely a service that connects riders with drivers, instead of playing the role of employer to their thousands of ride-providing resources.
Proponents of A.B. 5 view the gig economy as potentially abusive to workers. They generally cite the lack of benefits or a minimum wage guarantee. Because independent contractors are not considered employees, they do not receive sick leave, vacation time, medical benefits, or workers compensation protection. Gig economy companies insist that changing the law to classify the workforce that utilize their applications as employees would cripple the business model. Nonetheless, California lawmakers decided that a rewrite of the worker classification rules was in order.
The ABC Test Under A.B. 5
Effective January 1, 2020, A.B. 5 lays out a three-part test in determining whether a worker is an employee or an independent contractor. The goal of the test is to analyze the control and supervision a company exerts over a worker, as well as the type of work that is being performed. A worker will be considered an employee (and not an independent contractor) unless all of the following three tests are met:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Effectively, the three-pronged test of A.B. 5 requires a company to look at its relationship with the resource and determine whether it is of the type that is typically seen between an employer and employee. The first prong of the test involves control, which has been a long-standing element of worker classification. But the second and third prongs of A.B. 5 look to the core functions of the business and the independent business activity of the worker.
If an IC does not meet these three requirements, and they are not included under “carve-out” exclusions to the law, the IC may need to be reclassified as an employee. It important to understand that carved out professions are not truly exempt from all IC requirements. They are simply exempt from the ABC Test, which means that contractors must still be qualified under the previous multi-factor Borello Test as well as the new factor tests detailed below that apply to each exception category.
The factors of the Borello test are as follows:
- Whether the person performing work is engaged in an occupation or business that is distinct from that of the company;
- Whether the work is part of the company’s regular business;
- Whether the company or the worker supplies the equipment, tools, and the place for the person doing the work;
- The worker’s financial investment in the equipment or materials required to perform the work;
- The skill required in the particular occupation;
- The kind of occupation, with reference to whether, in the locality, the work is usually done under the company’s direction or by a specialist without supervision;
- The worker’s opportunity for profit or loss depending on his or her own managerial skill (a potential for profit does not include bonuses);
- How long the services are to be performed;
- The degree of permanence of the working relationship;
- The payment method, whether by time or by the job; and
- Whether the parties believe they are creating an employer/employee relationship.
Exceptions to the A.B. 5 Test
The Carve Outs land in three different buckets:
1. Recognized or Specifically Named Professions,
Physicians and surgeons, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, accountants, broker-dealers, investment advisers, direct salespersons, private investigators and commercial fisherman.
2. Professional Services
To be exempt under this bucket, the professional service providers named below must meet six specific service requirements:
- Have a business location
- Have a business license (beginning in June 2020)
- Negotiate their rate
- Work hours they designate
- Have other clients or makes themselves available to other clients
- Exercises independent judgment in performance of services
Professional Service Providers include: marketing contractors, human resources administrators, travel agents, graphic designers, grant writers, fine artists, enrolled tax agents, payment processing agents, still photographers or photojournalists, freelance writers, publication editors and newspaper cartoonists.
Generally, the exceptions apply to companies with professionals who are independently credentialed and maintain licensure. For instance, doctors, dentists, and psychologists (among others) are excepted from the A.B. 5 test. This is likely because the professionals subject to the exception, by the nature of their position, exert the requisite independent judgement and control needed to establish their contractor status. Additionally, A.B. 5 was enacted to prevent the perceived abuse of workers in the gig economy who were traditionally independent contractors.
Professional service providers are likely not the type of individual that lawmakers had in mind when they crafted the protections resulting from A.B. 5.
It is also important to note that several bills are currently being floated around the California Legislature that are intended to further modify A.B. 5 so this area of law is at present a moving target.
3. Business-to-Business
Business-to-business contractors are carved out if they meet the following specific criteria:
- Contractor is free from the control and direction of the contracting entity, both under the contract and in fact.
- Contractor is providing services directly to the contracting business rather than to customers of the contracting business.
- Contractor has a written contract.
- Contractor has a business license or business tax registration, if required.
- Contractor maintains a business location that is separate from the business or work location of the contracting business.
- Contractor is customarily engaged in an independently established business of the same nature as that involved in the work performed.
- Contractor actually contracts with other businesses to provide the same or similar services and maintains a clientele without restrictions from the hiring entity.
- Contractor advertises and holds itself out to the public as available to provide the same or similar services.
- Contractor uses its own tools, vehicles, and equipment to perform the services.
- Contractor can negotiate its own rates.
- Contractor can set its own hours and location of work.
- Contractor is not performing the type of work for which a license from the Contractor’s State License Board is required.
- Selected construction subcontractors and motor club service providers are also exempt from the ABC Test.
This exception is quite lengthy and chock full of factors to satisfy. Businesses would be wise to see how well they can compose or adjust their IC engagements to fit within this exception, if possible.
What A.B. 5 Means for Taxpayers
A.B. 5 will require businesses who utilize those who would have been traditionally considered independent contractors to reassess worker classification statuses. If a company is deemed to have employees instead of independent contractors, that company will be required to pay employment taxes on the wages paid to employees. Companies deemed to have employees under A.B. 5 will also be required to withhold, account for, and pay over payroll taxes. A myriad of non-tax repercussions are also at play, including minimum wage requirements, workers compensation insurance, and any required medical coverage, among many other considerations
When to Seek Tax Advice Regarding A.B. 5
Although the A.B. 5 test seems simple enough, there is plenty of opportunity for planning and business structuring to help mitigate impact of A.B. 5. Additionally, the exceptions and exemptions of the new legislation oftentimes require detailed analysis and advocacy. If you are a business owner who may be affected by A.B. 5, it is in your best interest to consult with an experienced employment attorney to determine the full impact of the new law and determine whether you qualify for an exemption or exception.
The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience representing a diverse group of taxpayers. From individuals to middle market businesses and beyond, our team of zealous advocates will assist in the development of a strategy to help you reach your specific goals and objectives. Whether you are under a tax examination or are in need of tax planning advice, contact the Tax Law Offices of David W. Klasing today, online or by phone at (800) 681-1295, for a reduced-rate consultation.
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