Worker Classification and the ABC Test
Due to the drastic overhaul of the California labor code, AB5 prompted the California Employment Development Department (EDD) to begin a series of state payroll audits to determine if businesses are correctly classifying a worker as an independent contractor instead of an employee under the new regime. Typically, an EDD audit is triggered when a former worker classified as an independent contractor applies for unemployment benefits or when there is a sweep of a jobsite. Independent contractors are not eligible for unemployment benefits. As such, their claim may trigger the EDD to investigate the employee classification practices of the business.
The EDD uses the “ABC Test” to determine if a worker is considered an employee (not an independent contractor). The presumption is that a worker will be classified as an employee unless the business can demonstrate that workers satisfy all three conditions of the ABC test:
Part A: The worker must be free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work and in fact.
Part B: The worker must perform work that is outside the usual course of the hiring entity’s business.
Part C: The worker must customarily be engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
If the EDD determines that the worker did not meet the requirements under AB5 and should, in fact, be classified as an employee, the business owner can be liable for “unpaid” payroll taxes, fines, and interest.
Exemptions to the ABC Test
There are several exemptions to the ABC test. If an exemption is met, the employer does not need to meet the conditions of the ABC test; however, each exemption has its own set of criteria that must be met to ensure the person is still an independent contractor.
The most common exemption to the ABC Test is the business-to-business exemption. This exemption has specific requirements under the California labor code. If a company wants to classify a worker as an independent contractor under the business-to-business exemption, the independent contractor must meet all the following requirements. The worker must:
- be free from the control and direction of the contracting business entity;
- provide services directly to the contracting business rather than to customers of the contracting business;
- have a written contract with specific provisions regarding payment;
- have a business license;
- have a separate business location;
- have an independently established business;
- not be restricted from providing the same or similar services to others;
- hold himself/herself out to the public as available to provide the services;
- provide his/her own tools, vehicles, and equipment to perform the services,
- negotiate his/her own rates;
- set his/her own hours and location of work; and
- not perform work requiring a license from the Contractors’ State License Board.
$35 Can Save Your Client Thousands
With all this in mind, one of the best decisions businesses in California can make is to ensure that the independent contractor they are engaging has a valid business license, as this is one of the most scrutinized elements that we see as tax practitioners.
A California business license is generally around $35, depending on the industry, and can be obtained online by following a series of prompts related to the type of business and its operations. This is a simple and sound investment for an independent contractor considering that, if an audit is triggered, the EDD auditor will certainly look for evidence of a business license as proof that the exemption applies. Please be aware that it is not the responsibility of the independent contractors to be correctly classified, but that of the employer. So, should an individual not have a business license or be improperly classified, all fines, penalties, and interest will only be shouldered by the employer. Always remember, payroll taxes are not dischargeable in bankruptcy, and if a business shuts down with this payroll liability, a responsible individual will be assessed. Payroll taxes will haunt the business owner like Casper the friendly ghost, except they aren’t friendly in any respect.
Thus, the next time your business client (or your law firm) engages with independent contractors in California, consider making it a prerequisite that there be a stipulation to their contract that they must have a California business license. This relatively small requirement could end up saving thousands of dollars and the pain of dealing with the EDD.