Running a small business in California is like navigating a maze of regulations. One wrong turn, like misclassifying a worker, can lead to costly penalties or legal trouble. California AB 5, enacted in 2019, reshapes how businesses classify workers as employees or independent contractors, impacting your payroll, taxes, and compliance. This guide simplifies contractor classification for small business owners, offering a clear path to compliance. We’ll break down AB 5, who it affects, and the small business compliance steps you need—plus answer common questions to keep you ahead.
Table of Contents
- What is California AB 5?
- Who is Affected by AB 5?
- Implications for Small Businesses
- Key Compliance Needs for AB 5
- 5 Steps to Comply with AB 5
- Common Questions About AB 5 Compliance
- What’s Next?
What is California AB 5?
California AB 5, signed into law in September 2019 and effective January 1, 2020, is a landmark labor law aimed at reducing worker misclassification. It codifies the “ABC test” from the 2018 California Supreme Court case Dynamex Operations West, Inc. v. Superior Court, making it harder to classify workers as independent contractors. AB 5 applies to California’s Labor Code, Unemployment Insurance Code, and Industrial Welfare Commission wage orders, ensuring workers receive protections like minimum wage, overtime, and benefits. In 2020, AB 2257 amended AB 5, adding exemptions and clarifications, now codified in Labor Code sections 2775–2787.
The ABC test presumes workers are employees unless the hiring business proves all three criteria:
- A: The worker is free from the hirer’s control in performing the work, both in contract and practice.
- B: The work is outside the hirer’s usual business (e.g., a bakery hiring a graphic designer, not a baker).
- C: The worker is engaged in an independently established trade of the same nature (e.g., a freelancer with their own clients).
A UC Berkeley study estimated 64% of workers doing independent contracting as their main job would be reclassified as employees under the ABC test. This shift increased employee protections but reduced self-employment by 10.5% and overall employment by 4.4% in non-exempt occupations, with no significant rise in W-2 employment.
AB 5 protects workers and levels the playing field for businesses that properly classify employees, but it’s complex. Small businesses must understand its rules to avoid fines, which range from $5,000–$25,000 per violation for misclassification.
Who is Affected by AB 5?
AB 5 impacts small businesses across industries, especially those relying on freelancers or gig workers, like retail, hospitality, construction, and trucking. If you hire contractors in California or work with California-based freelancers, you’re affected, even if your business is elsewhere.
Key Impacts:
- Reclassification Costs: Reclassifying contractors as employees typically raises costs by 1.25 to 1.4 times their base pay. This increase comes from mandatory payroll taxes (such as Social Security, Medicare, and state unemployment insurance), workers’ compensation premiums, overtime pay, paid sick leave, and the administrative burden of managing payroll and employee benefits. For example, a contractor paid $30,000 annually could cost a business $37,500 to $42,000 once reclassified as an employee.
- Penalties: Misclassification can lead to back wages, missed break penalties, and fines. In 2024, staffing company Qwick Inc. paid $2.1 million for misclassifying gig workers as independent contractors.
- Industries Hit Hard: Janitors, construction workers, and truck drivers often fail the ABC test’s “B” prong, as their work aligns with the hirer’s core business.
Exemptions:
- Business-to-Business (B2B): Contractors operating as corporations/LLCs with 12 specific criteria (e.g., separate business location) revert to the Borello test, a more flexible multi-factor test.
- Professional Services: Freelance writers, photographers, and graphic designers may use the Borello test if they meet conditions (e.g., limited submissions).
- Proposition 22: App-based rideshare/delivery drivers (e.g., Uber, Lyft) are classified as contractors with some benefits, upheld in 2023.
- Others: Licensed professionals (e.g., doctors, lawyers), commercial fishermen (until 2026), and real estate agents are exempt, using Borello.
AB 2257 expanded exemptions to 109 professions, but exempt workers must still pass the Borello test, which considers factors like control, tools provided, and work duration. A U.S. Department of Labor study found 10–30% of employers misclassify workers, a persistent issue AB 5 aims to address.
Implications for Small Businesses
California AB 5 reshapes how small businesses operate, presenting challenges that can feel like dead ends in the compliance maze. Understanding its implications helps you navigate these hurdles and stay on track.
- Increased Costs: Reclassifying contractors as employees raises expenses significantly. Payroll taxes, benefits, and overtime can increase costs by 1.25–1.4 times a contractor’s base pay. For example, a $30,000 contractor could cost $37,500–$42,000 annually as an employee, straining tight budgets.
- Operational Adjustments: AB 5 may force you to rethink staffing. Hiring employees instead of contractors reduces flexibility, as you’ll need to manage schedules, provide breaks, and comply with labor laws. This can limit your ability to scale quickly during busy periods.
- Legal Risks: Misclassifying workers carries steep penalties, from $5,000–$25,000 per violation, plus back taxes and potential lawsuits. Recent lawsuits underscore the high costs of non-compliance, with businesses facing substantial financial and legal consequences.
To avoid these pitfalls, assess your current contractor classification practices now. Review worker roles, check for exemptions, and consult legal experts to ensure compliance. Taking these steps protects your business and keeps you competitive.
Key Compliance Needs for AB 5
Complying with California AB 5 means understanding the ABC test, exemptions, and your workers’ roles. Small businesses face legal and financial risks if they misclassify workers, so proactive small business compliance is critical.
Core Compliance Needs:
- Worker Audits: Review contractor relationships to ensure they pass the ABC test or qualify for exemptions. Document autonomy, work type, and independent business status.
- Contracts and Documentation: Use detailed contracts specifying contractor independence (e.g., set own hours, work for others). Keep records of invoices and work agreements.
- Payroll Adjustments: If reclassifying contractors as employees, register them for workers’ compensation, unemployment insurance, and payroll taxes. Provide breaks and overtime.
- Legal Consultation: Work with an employment attorney to navigate exemptions (e.g., B2B, professional services) and avoid misclassification penalties.
Why It Matters: California loses over $7 billion annually to misclassified workers, missing out on taxes and benefits contributions. Proper classification ensures compliance and fair competition.
5 Steps to Comply with AB 5
Follow these five steps to ensure your small business complies with California AB 5 and avoids costly mistakes. Each step is designed for small business compliance with practical examples.
Step 1: Audit Your Workers
Review all contractors to determine if they pass the ABC test. For example, if your café hires a freelancer to redesign your website, they likely pass “B” (outside your core business of serving food). A barista, however, fails “B” and must be an employee. Use a checklist for A, B, and C criteria.
Step 2: Check for Exemptions
Identify if your contractors fall under exemptions (e.g., B2B, freelance writers). For B2B, ensure the contractor has a separate business entity, sets their own rates, and doesn’t work directly for your customers. For exempt workers, classification is assessed using the Borello test, a multi-factor standard; consult an attorney to verify eligibility.
Step 3: Update Contracts
Draft AB 5-compliant contracts emphasizing contractor independence. Specify they control their work, use their own tools, and serve other clients. For example, a photographer’s contract should note they set their schedule and provide their camera. Keep invoices and agreements for audits.
Step 4: Reclassify if Needed
If a contractor fails the ABC test and isn’t exempt, reclassify them as an employee. Register them with California’s Employment Development Department for taxes and workers’ compensation. Provide benefits like 10-minute rest breaks per four hours and 30-minute meal breaks per five hours.
Step 5: Monitor and Consult
Regularly review worker classifications as your business or laws change (e.g., AB 2257 updates). Engage an employment attorney to stay compliant, especially for complex cases like trucking or healthcare. Schedule annual audits to catch errors early.
Common Questions About AB 5 Compliance
Small business owners often have questions about navigating California AB 5. Below, we answer common concerns to help you understand contractor classification and stay compliant.
How Can I Use B2B Exemptions?
Many small businesses hire contractors for tasks like marketing or IT and wonder if they qualify for the B2B exemption. To use it, your contractor must meet 12 criteria, such as operating as a corporation or LLC, having a separate business location, and signing a written contract. These rules allow flexibility while ensuring compliance.
What Documentation Protects Me During Audits?
You might worry about proving contractor status if audited. Clear contracts that specify a worker’s independence—such as setting their own hours and serving other clients—are essential. Keep invoices, work agreements, and proof of their independent business (e.g., business license). These records can prevent costly misclassification claims.
How Does Proposition 22 Affect My Business?
Proposition 22, passed in 2020 and upheld in 2023, classifies app-based transportation and delivery drivers as independent contractors, exempting them from AB 5. However, it mandates certain benefits, such as minimum earnings guarantees and health insurance stipends for qualifying drivers.
How Can I Avoid Misclassification Penalties?
Penalties for misclassification—$5,000–$25,000 per violation—concern many owners. Regular audits, updated contracts, and legal advice help you avoid fines and lawsuits, which have surged since AB 5’s passage.
What’s Next
California AB 5 is a complex but manageable part of small business compliance. By understanding the ABC test, checking exemptions, and following our five-step guide, you can navigate contractor classification with confidence. Proper classification saves you from penalties, ensures fair competition, and protects workers. With fines as high as $25,000 per violation and 10–30% of employers historically misclassifying workers, proactive compliance is essential.
Ready to streamline your compliance? Our small business compliance solutions offer expert guidance, audit tools, and tailored advice to keep your business on track. Contact our team for a consultation.
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