The AB5, California Assembly Bill 5, is a bill that was passed into legislation in California in September of 2019 and went into effect January 1st, 2020. Its purpose is to provide workers with greater opportunity to shift from being independent contractors to becoming employees. This change will allow workers to benefit from all of the perks of being an employee (i.e. earning minimum wage, access to medical insurance, ability to form a union, and additional advantages). It also places the onus on the employer to make sure his or her workers are classified correctly. In addition to paying all applicable taxes, Social Security fees…etc. in relation to the company’s employees, all of which are not something a company is responsible for with its independent contractors. The way in which a worker is classified greatly effects the way in which payroll is processed. In order to delineate the changes that may occur in payroll, one must first understand how to classify a worker as an independent contractor or as an employee.
In order to create a universal understanding of what worker qualifies as an independent contractor, the California Supreme Court developed a three-pronged test, known as the ABC Test.
Any employer that attempts to classify a worker as an independent contractor must meet all of the following qualifications:
- Work unencumbered from the control and/ or direction of the company
- Provide a service and/ or perform a job that is outside the regular scope of the organization’s work
- Work in an independently established occupation, trade, and/ or business
Any worker hired by an organization will be assumed to be an employee unless the company is able to prove he or she meets all three of the above criteria. If a company is able to successfully prove the worker meets the above requirements he or she can be classified, by the employer, as an independent contractor.
The first and foremost way payroll will shift as a result of AB5 is that companies and/ or their respective customers will have to absorb the additional costs of increased wages and benefits that are required to be offered to employees. AB5 requires employers to make state unemployment insurance and disability insurance contributions for all of their employees, which is an added cost as this is not the case with employing an independent contractor.
Payroll practices will likely be affected by AB5 as an increase in responsibility due to an increased number of contracted employees (W4s) versus independent contractors (1099s). Payroll and the proper classification of workers must be handled meticulously as, misclassification or incorrect reporting can result in unnecessary penalties under the ACA (Affordable Care Act). Additionally, as per AB5, misclassifying workers as independent contractors when they should be classified as employees denies them of their owed benefits.
There is no way to avoid the reclassification of workers as employees under this new law. It is, therefore, best to follow through with the reclassification of your workers as soon as possible, in order to get a handle on the financial implications that will be incurred by your company. If a worker does qualify as an independent contractor, a California employer would report the income for the worker on a 1099 Form for federal reporting purposes, and would have no responsibility to make any contributions to Social Security or Medicare.
For Further Information
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- Baker Botts. “Impact of California AB 5 on Payroll Taxes and Benefits: Ideas: Insights.” Baker Botts, www.bakerbotts.com/insights/publications/2019/september/impact-of-california-ab-5.
- Chidyausiku, Catherine. “What Are the Tax Implications of AB5?” TalentWave, 7 Nov. 2019, www.talentwave.com/what-are-the-tax-implications-of-ab5/.
- Kundu, Mohini, and Joshua Reeves. “California’s New Labor Law Was Just Passed-And It Might Mean Your Contractors Are Actually Employees.” Gusto, 27 Jan. 2020, www.gusto.com/blog/hiring/ab5-small-businesses.
- Team, Wrapbook. “Is Your Business AB5 Ready? The Essential Guide.” Wrapbook, The Wrapbook Team, 7 Jan. 2020, www.wrapbook.com/ab5-business-essential-guide/.