AB5 Worker Classification Compliance in California: What Employers Must Know

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.

What Is AB5 and Why Was It Introduced?

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.

Understanding the ABC Test

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:

A. The Worker Is Free from Control and Direction

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.

B. The Work Performed Is Outside the Usual Course of Business

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.

C. The Worker Is Customarily Engaged in an Independently Established Trade or Business

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.

Who Does AB5 Apply To and What Are the Exemptions?

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.

Common Exemptions Under AB5

Here are key categories of exemptions outlined in the law:

1. Professional Services

The following licensed professions are generally exempt if certain conditions are met:

Doctors
Dentists
Psychologists
Lawyers
Engineers
Accountants
Architects

These workers must maintain professional licensing and operate independently, with the ability to set their own rates and schedules.

2. Creative Professionals

This includes:

Graphic designers
Writers
Photographers
Editors
Illustrators

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.

3. Real Estate Licensees and Insurance Agents

These individuals continue to be governed by their existing regulatory frameworks under California law and are generally exempt from AB5.

4. Business-to-Business (B2B) Contracting

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.

5. Referral Agencies

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.

Industries Heavily Impacted

While exemptions exist, several industries have been significantly affected:

Gig Economy: Rideshare and delivery drivers were at the center of the AB5 debate. While Proposition 22 (passed in 2020) provided limited relief, legal challenges continue.
Trucking and Logistics: Owner-operator models are under scrutiny due to the control and integration involved.
Event and Entertainment: Freelance musicians, performers, and stagehands have faced challenges navigating the new law.
Construction: Independent contractors in construction must meet additional criteria under California law to be considered exempt.

Small businesses working with freelancers in California should assume the ABC test applies unless they have clearly documented exemptions.

Risks of Misclassification Under AB5

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).

Key Penalties and Liabilities

Unpaid Wages and Benefits: Employers may be required to pay back wages, unpaid overtime, missed meal and rest breaks, and health benefits that would have applied if the worker was properly classified.
Employment Taxes: The EDD can assess unpaid payroll taxes, including unemployment insurance, disability insurance, and employment training tax, plus penalties and interest.
Civil Penalties: Businesses can face fines ranging from $5,000 to $25,000 per violation if found to have willfully misclassified workers.
Personal Liability: In some cases, owners, officers, or managers may be held personally liable for unpaid wages or penalties.
Litigation Risk: Workers may bring lawsuits for misclassification, including class actions, which can be costly to defend and result in reputational damage.
Loss of Business Contracts: Some companies require vendors to certify compliance with AB5. Failure to meet those terms may result in canceled contracts.

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.

Steps to Achieve AB5 Compliance

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.

1. Conduct a Classification Audit

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:

Review their job description and actual duties
Assess their level of independence
Check whether their services relate to your primary business offering
Look at how you manage or supervise their work

This audit will help you catch potential misclassifications before enforcement agencies do.

2. Apply the ABC Test to All Contractor Relationships

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.

3. Identify and Verify Exemptions

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:

Has a separate business location
Maintains a business license or registration
Offers services to multiple clients
Exercises full control over their work

Do not assume someone is exempt just because they have an LLC or send invoices. Compliance requires evidence.

4. Update Contracts and Engagement Terms

Having a written contract with independent contractors is not enough to comply with AB5, but it still matters. Update all agreements to:

Define the scope of work and deliverables
Avoid language that suggests control or direction
Specify the independent nature of the relationship
Reference the service provider’s business registration or license

Legal review is strongly recommended. Contracts must align with the business reality and should reflect the true nature of the working relationship.

5. Train Your Management and HR Teams

In many companies, team leaders or department heads may engage freelancers without understanding the legal risks. Provide training to ensure all hiring managers understand:

The ABC test and its implications
The difference between employees and contractors
How to properly structure engagements

Standardizing onboarding processes and approval procedures for contractors can help reduce risk.

6. Establish Internal Review Protocols

Worker classification should not be a one-time check. Businesses should adopt a policy of periodic review—especially when:

Contractor roles evolve over time
Project scopes change
Long-term engagements begin to resemble employee relationships

Set up a recurring review process, perhaps every six months, to validate that contractor roles still meet the required standards or exemptions.

7. Consult Legal and Tax Advisors

Given the complexity and consequences involved, consult employment law counsel and tax professionals who understand AB5. A good advisor can:

Help apply the ABC test correctly
Identify exemptions you may have missed
Review and draft proper contracts
Assist with agency filings if needed

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

AB5 and Payroll Tax Obligations

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:

1. Withholding and Employer Contributions

Once a worker is classified as an employee, you are required to:

Withhold federal and state income tax
Withhold the employee's share of Social Security and Medicare
Pay the employer’s share of Social Security and Medicare
Pay Federal Unemployment Tax (FUTA)
Pay California Unemployment Insurance (UI)
Pay California Employment Training Tax (ETT)
Pay California State Disability Insurance (SDI)

Each of these comes with filing requirements and due dates, typically on a quarterly basis.

2. Reporting and Filing Obligations

Employers must submit:

IRS Form 941 (quarterly federal tax return)
IRS Form W-2 for each employee at year-end
California DE 9 (quarterly wage and withholding report)
California DE 4 (employee withholding certificate)
California DE 34 (new hire reporting within 20 days of hire)

Failure to file or pay on time can result in stiff penalties, even if the misclassification was unintentional.

3. Workers’ Compensation Insurance

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:

Add them to the workers’ compensation policy
Update payroll estimates to reflect the increased exposure
Ensure that class codes reflect actual job duties

Working without proper workers’ compensation coverage is not only illegal but exposes businesses to liability if a worker is injured on the job.

Risks of Non-Compliance

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:

1. Back Wages and Benefits

If a misclassified worker files a claim, the business may be required to:

Pay back wages
Provide unpaid overtime
Reimburse for unpaid meal and rest breaks
Compensate for benefits they would have received as employees

This can result in thousands of dollars in retroactive payments.

2. Tax Penalties

Failure to pay proper payroll taxes may result in:

Unpaid employer contributions
Interest on late payments
Penalties for failure to file, deposit, or report
Potential federal involvement from the IRS

The California Employment Development Department (EDD) aggressively investigates classification issues and may impose fines even without a worker complaint.

3. Legal Liability and Lawsuits

Misclassified workers can file lawsuits against their employers, often resulting in:

Wage and hour claims
Wrongful termination suits
Class action lawsuits involving other misclassified workers

Legal defense alone can be costly, even if the business prevails.

4. Reputational Damage

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.

Strategic Options for Businesses Moving Forward

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:

1. Reevaluate All Worker Contracts

Start by reviewing all existing independent contractor agreements. Ask:

Does the work fall within the core business offering?
Is the worker economically dependent on the company?
Do you control how and when the work is performed?

If the answers suggest employee status under the ABC test, it is safer to reclassify.

2. Transition Key Contractors to Employees

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.

3. Work With Staffing or Employer-of-Record Agencies

If you need flexible help but want to avoid the burden of payroll, tax filings, and benefits management, consider using:

Staffing agencies that employ the workers directly
Employer-of-record (EOR) providers that take on compliance responsibilities

These services offer compliance protection and streamline administrative work.

4. Restructure Business Models if Needed

If contractors are core to your business model, explore legal restructuring options. Some companies:

Convert into cooperatives where workers are owners
Franchise portions of the business to retain contractor freedom
Separate service offerings to allow contractors to legally qualify

Consult with legal and tax professionals to assess whether restructuring makes strategic sense.

5. Educate Internal Teams and Stakeholders

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.

How CPA Firms and Accounting Partners Can Help

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:

Payroll tax recalculations for reclassified workers
Cost impact modeling for potential employee transitions
Audit prep in case of EDD or IRS scrutiny
Integration of classification tools into onboarding processes

By partnering with us, CPA firms expand their bandwidth and help clients reduce risk without overextending internal resources.

Final Thoughts

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.

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