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Worker classification in California is no longer a gray area. Since the passage of Assembly Bill 5 (AB5) in 2019, the rules for determining whether someone is an independent contractor or employee have changed dramatically. The new standard is stricter, more enforceable, and places the burden of proof squarely on employers.
For small businesses, startups, and even well-established CPA firms with clients across industries, this shift has created confusion and risk. Misclassifying a worker is no longer just a paperwork error. It can lead to back taxes, penalties, lawsuits, and audits from multiple state agencies.
California’s AB5 builds on the state’s long-standing effort to curb worker misclassification, particularly in industries that rely heavily on contract labor. It replaces the previous flexible test with the ABC test, a three-part rule that assumes a worker is an employee unless all conditions are met.
In this article, we will break down what AB5 means, how the ABC test works, which industries are affected, and what businesses can do to remain compliant. Whether you are managing a small business yourself or advising clients through your CPA firm, understanding the nuances of AB5 is essential for minimizing risk and ensuring legal compliance.
AB5, officially known as Assembly Bill 5, was signed into law in September 2019 and took effect on January 1, 2020. It codifies the California Supreme Court’s decision in Dynamex Operations West, Inc. v. Superior Court (2018), which established a new standard for classifying workers.
The Dynamex ruling created the ABC test as the legal standard for determining whether a worker should be classified as an employee or an independent contractor under California wage orders. AB5 took this judicial standard and applied it broadly across California labor law, unemployment insurance law, and workers’ compensation law.
The bill was designed to address what lawmakers viewed as the widespread misclassification of workers, particularly in gig economy sectors like ridesharing, delivery, and freelance work. By tightening classification rules, AB5 aims to ensure workers receive employee protections such as minimum wage, unemployment insurance, paid leave, and health benefits.
The implications are wide-reaching. Businesses can no longer assume a freelancer or 1099 contractor is classified appropriately without applying the ABC test. Failure to comply can lead to substantial legal and financial consequences.
At the heart of AB5 is the ABC test, a three-pronged standard that a hiring entity must meet to classify a worker as an independent contractor.
To qualify as an independent contractor under AB5, the hiring party must demonstrate all three of the following:
This means the worker operates independently, both in terms of how they complete their work and when they do it. The company cannot dictate detailed processes, manage daily operations, or impose strict supervision. General deadlines and quality expectations are allowed, but not micromanagement.
Example: A freelance web developer working off-site, setting their own hours, and submitting completed designs without daily oversight would typically satisfy Part A.
This is often the most difficult part of the test. The work being done must be unrelated to the core services or products that the business provides.
Example: A marketing firm hiring a plumber to fix the office kitchen sink is fine. But hiring a freelance copywriter to work on client campaigns would likely not pass Part B, since content creation is central to the firm’s offerings.
The worker must be truly independent, meaning they regularly offer their services to other clients, have their own business licenses or business entity, and market themselves to the public. They should be able to operate without relying exclusively on one client for income.
Example: A certified public accountant (CPA) with multiple clients, their own business registration, and professional liability insurance would likely pass this part of the test.
If any one of these three conditions is not met, the worker must be classified as an employee under California law.
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AB5 applies broadly to all companies operating in California that hire individuals to perform services. This includes corporations, LLCs, partnerships, and sole proprietorships. The law affects industries ranging from tech and media to logistics, construction, and professional services.
However, recognizing that not all professions fit neatly into the ABC test, lawmakers included specific exemptions. These exemptions allow some workers to continue being evaluated under the more flexible Borello test, which considers multiple factors like control, skill, and the nature of the working relationship.
Here are key categories of exemptions outlined in the law:
The following licensed professions are generally exempt if certain conditions are met:
These workers must maintain professional licensing and operate independently, with the ability to set their own rates and schedules.
This includes:
There are limits, though. For example, a freelance writer must not provide more than 35 content submissions per client per year unless they meet other conditions to be considered exempt.
These individuals continue to be governed by their existing regulatory frameworks under California law and are generally exempt from AB5.
If one business contracts with another genuine business, and both meet strict requirements, the ABC test does not apply. These conditions include having a separate business location, being free from control, marketing services to other clients, and maintaining proper licenses.
This exemption is often misunderstood and must be evaluated carefully. It is not enough to just have a contract in place; the relationship must demonstrate true independence.
Platforms that connect service providers (like tutors, dog walkers, or house cleaners) with clients may qualify for exemptions if they do not control how the services are delivered and other criteria are met.
While exemptions exist, several industries have been significantly affected:
Small businesses working with freelancers in California should assume the ABC test applies unless they have clearly documented exemptions.
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Misclassifying a worker under AB5 can lead to serious legal and financial consequences. California has multiple enforcement agencies that may pursue violations, including the Labor Commissioner’s Office, the Employment Development Department (EDD), the Franchise Tax Board (FTB), and the Division of Occupational Safety and Health (Cal/OSHA).
The combined financial burden from just one misclassified worker can threaten a small business’s stability. CPA firms advising clients in California must ensure that classification policies are regularly reviewed and fully compliant.
Navigating AB5 requires more than just updating a few contracts. It demands a complete review of business practices, hiring models, and worker relationships. The steps below provide a practical roadmap for achieving and maintaining compliance with AB5.
Start with a full audit of your current workforce. Identify every person providing services and determine whether they are classified as an employee or an independent contractor. Pay close attention to contractors working in roles that support your core operations.
For each contractor:
This audit will help you catch potential misclassifications before enforcement agencies do.
Once you have a list of contractors, run each one through the ABC test. This is not a checklist you can skim over. If even one of the three criteria is not met, that contractor should be reclassified as an employee unless they fall under a valid exemption.
Create written documentation showing how each contractor meets (or does not meet) each part of the ABC test. This documentation will be critical if your classification is ever challenged.
If you believe a worker qualifies for an exemption, make sure all required conditions are met. For example, if you are using the business-to-business exemption, you must verify that the service provider:
Do not assume someone is exempt just because they have an LLC or send invoices. Compliance requires evidence.
Having a written contract with independent contractors is not enough to comply with AB5, but it still matters. Update all agreements to:
Legal review is strongly recommended. Contracts must align with the business reality and should reflect the true nature of the working relationship.
In many companies, team leaders or department heads may engage freelancers without understanding the legal risks. Provide training to ensure all hiring managers understand:
Standardizing onboarding processes and approval procedures for contractors can help reduce risk.
Worker classification should not be a one-time check. Businesses should adopt a policy of periodic review—especially when:
Set up a recurring review process, perhaps every six months, to validate that contractor roles still meet the required standards or exemptions.
Given the complexity and consequences involved, consult employment law counsel and tax professionals who understand AB5. A good advisor can:
For CPA firms, this is also an opportunity to guide clients through the same process, helping them stay compliant while adding value to your advisory services
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Reclassifying a worker from independent contractor to employee triggers significant payroll tax responsibilities. California takes employer tax compliance seriously, and failure to comply can result in audits, back taxes, penalties, and interest.
Here is what businesses need to consider:
Once a worker is classified as an employee, you are required to:
Each of these comes with filing requirements and due dates, typically on a quarterly basis.
Employers must submit:
Failure to file or pay on time can result in stiff penalties, even if the misclassification was unintentional.
California law requires that all employees be covered by workers’ compensation insurance, regardless of the business size or industry. Once a contractor is reclassified as an employee, the company must:
Working without proper workers’ compensation coverage is not only illegal but exposes businesses to liability if a worker is injured on the job.
Misclassifying employees as independent contractors can lead to significant financial and legal consequences. California has ramped up enforcement efforts, and the state works closely with federal agencies to pursue violations.
Here are the main risks:
If a misclassified worker files a claim, the business may be required to:
This can result in thousands of dollars in retroactive payments.
Failure to pay proper payroll taxes may result in:
The California Employment Development Department (EDD) aggressively investigates classification issues and may impose fines even without a worker complaint.
Misclassified workers can file lawsuits against their employers, often resulting in:
Legal defense alone can be costly, even if the business prevails.
For small businesses and startups, reputation matters. A high-profile classification lawsuit or state audit can damage client trust, slow funding opportunities, and attract unwanted attention.
AB5 compliance is not just a legal issue—it is a business continuity issue.
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Complying with AB5 does not mean the end of flexible staffing models or contractor relationships. It just requires a more thoughtful approach to worker classification, documentation, and legal structure. Here are practical strategies businesses can adopt:
Start by reviewing all existing independent contractor agreements. Ask:
If the answers suggest employee status under the ABC test, it is safer to reclassify.
For long-term contractors or those providing essential, ongoing services, consider moving them to employee status. This ensures compliance, avoids audits, and allows better integration into company culture and systems.
You can offer part-time or flexible roles to maintain autonomy while meeting legal standards.
If you need flexible help but want to avoid the burden of payroll, tax filings, and benefits management, consider using:
These services offer compliance protection and streamline administrative work.
If contractors are core to your business model, explore legal restructuring options. Some companies:
Consult with legal and tax professionals to assess whether restructuring makes strategic sense.
Misclassification often starts with a lack of internal understanding. Train hiring managers, HR teams, and finance departments on AB5 compliance rules. Use checklists and templates to ensure consistent contractor vetting and onboarding.
The more proactive your team is, the less likely you are to face penalties or legal action.
Navigating AB5 requires more than legal advice. Businesses need to track, document, and manage the financial side of reclassification. This is where CPA firms and accounting partners come in.
At Madras Accountancy, we support small and mid-sized CPA firms in the U.S. with offshore execution support for AB5 compliance, including:
By partnering with us, CPA firms expand their bandwidth and help clients reduce risk without overextending internal resources.
California’s AB5 law has changed how businesses must classify and compensate their workers. Ignoring the law or hoping it will be repealed is no longer a viable strategy.
Businesses that continue to rely on independent contractors without proper classification and documentation face serious risks—financial, legal, and operational.
The solution is not to panic but to act deliberately. Review your workforce, evaluate risks, adjust where necessary, and build a compliant staffing strategy that supports long-term growth.
And if you are a CPA firm looking to guide your clients through AB5, Madras Accountancy is here to help. Our offshore accounting and compliance team provides hands-on support so you can focus on advising, not chasing paperwork.
Get in touch to learn how we can help your clients stay compliant while protecting profitability.
FAQs
Question: What is California's AB5 law and how does it affect worker classification?
Answer: California's AB5 law, enacted in 2020, establishes the "ABC test" as the primary method for determining whether workers are employees or independent contractors. Under AB5, workers are presumed to be employees unless they meet all three criteria: (A) free from control and direction in work performance, (B) performing work outside the hiring entity's usual business, and (C) customarily engaged in independently established trades or professions. This law significantly restricts independent contractor classification compared to previous standards, requiring most workers to be classified as employees with full labor protections, benefits, and employer obligations. AB5 affects various industries but includes specific exemptions for certain professions and business relationships.
Question: What are the specific ABC test criteria under AB5 and how are they applied?
Answer: The ABC test under AB5 requires all three criteria be met for independent contractor classification: (A) Control - workers must be free from control and direction in work performance under contract and in fact, (B) Business - work performed must be outside the usual course of the hiring entity's business, and (C) Customarily - workers must be customarily engaged in independently established trades, occupations, or businesses of the same nature as work performed. All criteria must be satisfied; failing any one results in employee classification. Courts examine actual working relationships rather than contract terms, considering factors like supervision, integration with business operations, and workers' independent business activities. Professional consultation helps evaluate specific situations under these strict criteria.
Question: Which types of workers and industries are exempt from AB5 requirements?
Answer: AB5 exemptions include various professional services such as lawyers, doctors, dentists, accountants, architects, engineers, and real estate agents who meet specific criteria. Business-to-business exemptions apply when companies contract with other businesses rather than individuals, provided specific requirements are met including separate business licenses, contracts, and independence indicators. Other exemptions cover certain salespeople, referral agencies, tutors, and specific industry professionals. However, exemptions often have detailed requirements and limitations that must be carefully followed. Many gig economy workers previously classified as contractors don't qualify for exemptions and must be reclassified as employees. Regular legal review helps ensure exemption compliance and proper classification decisions.
Question: What are the penalties and consequences for AB5 non-compliance?
Answer: AB5 non-compliance penalties include back wages, overtime pay, meal and rest break premiums, and benefits owed to misclassified workers. Employers face penalties of $5,000-$25,000 per violation for willful misclassification, plus attorney fees and costs in successful worker lawsuits. Additional consequences include unemployment insurance liability, workers' compensation premiums, payroll tax obligations, and potential class action lawsuits from affected workers. The California Labor Commissioner actively investigates misclassification cases and can assess substantial penalties and back payments. Criminal penalties may apply for willful violations, while tax authorities can assess additional payroll tax liabilities with interest and penalties. Compliance costs are typically much lower than non-compliance penalties and legal risks.
Question: How should employers conduct worker classification audits for AB5 compliance?
Answer: Conduct AB5 compliance audits by reviewing all contractor relationships against ABC test criteria, documenting current working arrangements, and analyzing actual versus contractual working relationships. Evaluate control factors including supervision, training, integration with business operations, and performance standards. Assess whether contractor work falls outside normal business activities and whether contractors operate independent businesses. Review contracts, payment methods, benefit provisions, and termination procedures for classification indicators. Document findings, identify misclassification risks, and develop remediation plans for problematic relationships. Professional legal assistance helps ensure thorough evaluations and appropriate classification decisions while minimizing legal risks and penalties.
Question: What steps should employers take to properly classify workers under AB5?
Answer: Properly classify workers under AB5 by applying the ABC test consistently, documenting classification decisions, and ensuring actual working relationships match intended classifications. For independent contractors, establish contracts clearly demonstrating independence, avoid supervision and integration with regular business operations, and ensure contractors operate separate businesses. For employees, provide proper wage and hour protections, benefits, and workplace rights required by California law. Implement classification policies and procedures, train managers on proper practices, and conduct regular compliance reviews. Seek legal counsel for complex situations, maintain detailed documentation supporting classification decisions, and be prepared to reclassify relationships when circumstances change or analysis reveals misclassification risks.
Question: How does AB5 affect common business practices like freelancing and gig work?
Answer: AB5 significantly restricts traditional freelancing and gig work arrangements by requiring most workers be classified as employees rather than independent contractors. Many freelancers who previously worked as contractors now must be hired as employees or work through business-to-business arrangements if they qualify for exemptions. Gig economy companies often had to reclassify drivers and workers as employees, though some obtained ballot initiative exemptions. Businesses must restructure relationships with freelancers, potentially limiting work arrangements or changing to employee relationships. Alternative arrangements include hiring exempt professionals, working with legitimate independent businesses, or using temporary employment agencies. Creative solutions within legal parameters help maintain flexibility while ensuring compliance.
Question: What ongoing compliance requirements exist for AB5 worker classification?
Answer: Ongoing AB5 compliance requires regular review of worker relationships, monitoring for changes in working arrangements, and updating classifications when circumstances change. Maintain current documentation supporting classification decisions, conduct periodic audits of contractor relationships, and train supervisors on proper practices to avoid creating employment relationships inadvertently. Monitor legislative and regulatory changes affecting classification requirements, update contracts and policies as needed, and ensure payroll and benefits systems reflect proper classifications. Establish procedures for onboarding new workers with proper classification analysis, document business justifications for contractor relationships, and maintain legal counsel relationships for complex situations. Proactive compliance management reduces risks and ensures adherence to evolving requirements.
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