In 2020, the hot topic is California’s Assembly Bill 5, often called the “Gig Economy Bill.” This is because AB 5 makes it difficult to be an independent contractor in California.
Before we examine AB 5 in detail, let’s understand why California legislators passed the bill in their own words:
THE PEOPLE OF THE STATE OF CALIFORNIA DO ENACT AS FOLLOWS:
SECTION 1.
The Legislature finds and declares all of the following:
(a) On April 30, 2018, the California Supreme Court issued a unanimous decision in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (2018) 4 Cal.5th 903 (Dynamex).
(b) In its decision, the Court cited the harm to misclassified workers who lose significant workplace protections, the unfairness to employers who must compete with companies that misclassify, and the loss to the state of needed revenue from companies that use misclassification to avoid obligations such as payment of payroll taxes, payment of premiums for workers’ compensation, Social Security, unemployment, and disability insurance.
(c) The misclassification of workers as independent contractors has been a significant factor in the erosion of the middle class and the rise in income inequality.
Source: https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200AB5
Yikes!
This certainly promotes a world view that is very pro-government regulation and pro-union; and arguably anti-business.
Just for fun, let’s take the liberty of editing out a few words from the above act:
“Obligations such as payment of payroll taxes, payment of premiums for worker’s compensation, Social Security, unemployment, and disability insurance…[have] been a significant factor in the erosion of the middle class and the rise of income inequality.”
Pretty interesting, eh?
I would hate to suggest that onerous employment laws and high taxes could possibly hurt businesses and squeeze out the middle-class.
Alas, as an Enrolled Agent, licensed by the Internal Revenue Service, my job is to understand the rules, and help my clients stay compliant…regardless of my personal opinions.
Thus said, let’s dive into AB 5, and evaluate how to navigate the road ahead.
The Root of the Controversy – Taxes & Misclassification
For every $1,000 you earn as an employee, you’ll notice $62 withheld for Social Security and $14.50 withheld for Medicare taxes. Total is $76.50, or 7.65% of wages. The Social Security portion falls off after $137,700, but the Medicare portion has no limit.
As an employee, you’ll never see that your employer has to match your Social Security and Medicare Tax withholdings – your $1,000 wages cost your employer $1,076.50, another 7.65%.
Source: https://www.ssa.gov/news/press/factsheets/colafacts2020.pdf
In addition to payroll taxes, employers incur additional costs – including worker’s compensation, employee benefits – (health insurance, retirement, etc.), and compliance expenses.
According to the Boston Business Journal, actual employee costs can range from 125% to 140% of actual compensation.
Source: https://web.mit.edu/e-club/hadzima/how-much-does-an-employee-cost.html
As a result, there is a large temptation for a business to contract with independent contractors, as opposed to having employees.
When you pay someone as an independent contractor, they take on the burden of the 15.3% self-employment tax (7.65% employee plus 7.65% employer payroll taxes).
However, they then get to deduct reasonable business expenses.
The net result is less total payroll taxes paid, no worker’s comp premiums, and usually less overall income taxes paid.
AB 5 & the Dynamex decision focus on “misclassification: – paying someone that would ordinarily be an employee as an independent contractor.
The reason the business community is up in arms is that there were already well-established rules for determining whether someone was an employee or an independent contractor.
The general consensus among employers is that AB 5 reaches too far and makes employees out of legitimate independent contractors.
Old Rules
Since 1989, the Borello test has been used to determine if services provided are in the realm of employee duties or that of an independent contractor. The “control of work” test is of primary importance, where an evaluation is made of how much control is exerted over your time, tasks, techniques & training. In other words, does the hiring agency control what you do, when you do it, and how you do it, and have they shown you how to do it?
The easiest example of this is an independent insurance agent.
Independent Insurance Agents contract with multiple insurance carriers, and are responsible for generating their own leads, paying their expenses – i.e. office space, staffing, software, computers, and state licensing, and most importantly, they are free from quotas from insurance carriers.
If you present a qualified, willing and able consumer to the carrier, you’ll then earn a commission.
If not, well, keep prospecting.
The insurance carrier exerts very little control over the agent, aside from mandated minimum training standards and compliance guidelines set forth by the Department of Insurance. Thus said, the independent insurance agent maintains a high degree of freedom and control over their business, and is considered an independent contractor using the Borello test.
Please note, that insurance agents can also be employees. For example, if instead of being an independent agent, if a given licensed agent works for an insurance agency that controls their activities, handles the marketing, and generally treats the agent as an employee, then even under Borello, this agent would be an employee.
The key take-away from Borello is control – the more control a hiring entity exerts on time, task(s), and technique(s), the more likely it is that an independent contractor is actually an employee.
New Rules
In addition to the Borello control tests, AB 5 changes Section 2750.3 of California’s Labor Code to read:
(a) (1) For purposes of the provisions of this code and the Unemployment Insurance Code, and for the wage orders of the Industrial Welfare Commission, a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all of the following conditions are satisfied:
(A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
(B) The person performs work that is outside the usual course of the hiring entity’s business.
(C) The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
What does this mean in plain English? It means that in order to be considered an independent contractor, one must satisfy the “A-B-C Test,” which has the following 3 components:
- Control of Time, Tasks, and Techniques
- Separate Industry
- Established Business Operations
Tests 1 and 3 are fairly easy to satisfy, but the Separate Industry component will bedevil a lot of small businesses.
Thus said, AB 5 does reward licensed professionals – including:
- Insurance Agents
- Real Estate Agents
- Investment Advisors and Broker-Dealer Representatives
- Medical Professionals – Physicians, Dentists, Surgeons, etc.
- Specified Professionals – Lawyers, Accountants, Engineers, Private Investigators and Architects
- Sub-Contractors in Construction Industry (assuming licensed with own E&O insurance)
The above professionals are exempted from the more restrictive AB 5 requirements and continue to fall under the Borello test.
AB 5 also has exceptions for “Professional Services,” where a laundry list of professions must comply with the “A-B-C Test,” industry-specific licenses and/or requirements, and an additional 6 point filter, summarized as follows:
- Separate Business Location
- Business License and Professional Licenses
- Can Negotiate Own Rates for Services
- Can Set Own Hours and/or Schedule
- Have Multiple Clients (or could have)
- Control of Time, Tasks, and Techniques (Borello test)
There are also exceptions for Business to Business relationships, Direct Sales Organizations, and Referral Agencies.
Additionally, the California Trucking Association received a temporary restraining order to stop AB 5 from applying to the trucking industry (which means they are currently covered under Borello).
Options for Staying Compliant and Independent
Instead of dwelling on these exceptions, I am going to discuss what existing independent contractors can do to stay compliant – and independent.
Strategy #1 – Setup a Corporation
If you just set up a corporation, will you be automatically exempted? No.
The Separate Industry aspect of AB 5 will apply regardless of whether the performer of the work is incorporated or not.
However, incorporating may be part of the solution – here’s how:
- An S-Corporation allows you to take control of the amount of Social Security and Medicare taxes that you pay.
- You pay yourself a reasonable salary, and remaining profits are not subject to payroll taxes.
- An LLC taxed as a Partnership can be owned by multiple S-Corporations.***
***This is the key to beating AB 5 – Strategy 2.
Strategy #2 – Form a Partnership
Partners in a Partnership do not receive salaries, but rather share in profits, and can be either individuals or entities (C-Corp, S-Corp, etc.).
If you find yourself as an independent contractor that provides a substantial amount of services to another business, you may want to approach them about forming a partnership.
The partnership will allow you to retain your independence while keeping the other business from incurring the additional costs of hiring you as an employee.
Further, partnerships split profits based on ownership percentages (i.e. 50/50 or 70/30) and can provide for guaranteed payments for either partner.
Here’s a real-world example:
A California engineering firm (unincorporated) uses an unlicensed but very experienced independent consultant for project review work. Let’s assume that this arrangement is acceptable under Borello.
Even though the independent consultant is incorporated, she will fail at least one of the 6 professional services filters.
In lieu of hiring an independent consultant as an employee, the engineering firm could set up a partnership with the contractor’s corporation, and use guaranteed payments in lieu of salaries.
The consultant would still pay themselves a salary (from their own company), and the owner of the engineering firm would have the option of owning the partnership individually, or by setting up their own entity.
The key to this strategy is the ability to legitimately partner with another entity and/or person.
It won’t work if you find yourself in an abusive employer and/or employee relationship, where you are being paid as an independent contractor simply because your employer is trying to reduce costs to the bone or avoid taxes.
This is a potential win-win strategy for two small business owners looking to retain their independence while working with other professionals on a regular basis.
AB 5 Summary
AB 5 is far-reaching, and unless you are a licensed professional (insurance agent, CPA, etc.), it is very likely that you will find it difficult to be an independent contractor in California. The law is often referred to as the “Gig Economy Bill,” because there is a belief that independent contractors representing Lyft and Uber are being exploited. Sadly, there are many independent professionals – including barbers, travel agents, and graphic designers that may soon find themselves as employees, instead of independent contractors.
Compliance testing will undoubtedly lead to additional costs to those businesses that continue to use independent contractors, as penalties for misclassification can range from $5,000 to $25,000 per violation.
If you find yourself as an independent contractor in a professional relationship with another business, you may want to pursue the opportunity to partner with them…or get ready to call them “boss.”
If you need to establish a corporation or form a partnership, CorpNet can help. You can call the CorpNet team at 888.449.2638 or form your new company right online via the following links:
CorpNet’s formation experts can help you do what you love while still remaining your own boss.
