On Sept. 18, Gov. Gavin Newsom signed AB-5 into law, drastically altering how millions of Californians are paid and vastly complicating the legal analysis involved in deciding whether workers are properly classified as "employees" or "independent contractors."

While the spotlight of AB-5 has been on the “gig economy,” including app-based ride-sharing and delivery companies, the majority of California businesses will feel the impact of this new law, even if only indirectly. This is because any business or industry that has relied on independent contractors to perform services must revisit, and likely reorganize, these business relationships. Economic sectors that are likely to be seriously impacted (and are not currently exempted) include: janitorial services, technology and engineering, entertainment, exotic dancers and transportation/trucking.

Employers should immediately evaluate their workforces to identify any independent contractors whose work or services may fall under the law's definitions of an “employee.” These workers may need to be reclassified as employees to mitigate risk and avoid noncompliance penalties.

Background on the Dynamex Ruling

The new law is largely a codification of the California Supreme Court's June 2018 decision in Dynamex Operations West, Inc. v. Superior Court. But as explained below, AB-5 significantly expands the Dynamex ruling.

The controversial ruling in Dynamex upended decades of case law that defined who is an employee and who is an independent contractor. Since Dynamex, California employers and courts have grappled with the sweeping changes (which we have been tracking and blogging about here, covering topics such as the applicability of Dynamex, the breadth and scope of Dynamex and whether the decision is retroactive).

In Dynamex, the court adopted the so-called “ABC Test” to determine, under Industrial Welfare Commission's wage orders, when “a person providing labor or services for remuneration shall be considered an employee” rather than an independent contractor.

To establish independent contractor status under this test, employers must satisfy all three of the following prongs:

A) The company must not be able to control or direct what the worker does, either by contract or in actual practice;
B) The worker must perform tasks outside of the hiring entity’s usual course of business; and
C) The worker must be engaged in an independently established trade, occupation or business.

There has been no judicial or legislative guidance on prong B of the test, which makes it challenging to assess the risk of misclassification.

Key Details of AB-5

AB-5 is sweeping legislation that promises to wreak havoc on businesses that operate in California. In addition to formally bringing the ABC Test into the canon of California employment law, AB-5 greatly expands the Dynamex ruling by applying the ABC Test to both the California Wage Orders and the California Labor Code, whereas Dynamex was applicable only to the Wage Orders. (See Lab. Code section 2750.3(a).)

AB-5 also significantly complicates the legal landscape by adding dozens of exemptions from the ABC Test for various professions, “professional services,” certain business-to-business relationships and contractor-subcontractor relationships in the construction industry. But these exemptions do not mean that these professions automatically qualify as independent contractors; rather, the effect of the exemption is just to revert an employer back to other established tests for ascertaining contractor status in California.

The new law creates more tests – in addition to the ABC Test – for certain exemptions to apply, and explicitly requires a distinct classification test, known as the Borello test, for workers that have been exempted from the ABC Test. (The Borello test derives from S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341.)

Professional exemptions include:

• Licensed insurance agents
• Certain licensed health care professionals (including veterinarians)
• Licensed lawyers, architects, engineers, private investigators, and accountants
• Registered securities broker-dealers or investment advisers
• Direct sales salespeople
• Commercial fishermen

The “professional services” exemption has its own criteria and includes the following services:

• Marketing
• Certain administrative services of human resources
• Certain travel agent services
• Graphic design
• Grant writing
• Fine art
• Services of enrolled agents licensed to practice before the IRS
• Payment processing through independent sales organizations
• Certain still photography and photojournalism
• Certain freelance writing, editing and newspaper cartoon illustration
• Certain licensed esthetician, electrologist, manicurist, barber or cosmetologist services

Additional tests, each with up to a dozen independent criteria, must be satisfied for “bona fide business-to-business contracting relationships,” certain construction contractor-subcontractor relationships, certain referral agency and service provider relationships and certain relationships between a motor club and an individual performing services pursuant to a contract between the motor club and a third party. If any of these independent tests are satisfied, the hiring entity still must show that the relationship passes muster under the Borello test.

Lastly, AB-5 provides that it is “declaratory of existing law” with regard to the wage orders, meaning it is the legislators’ intent that this test be applied retroactively, as though it had always been in effect.

Implications for California Employers

The seismic shift of AB-5 is going to require overhauls for business-employee relations. For example, independent contractors now classified as employees under AB-5 will no longer have the freedom to work when, where, and how they want. These “new” employees will be subject to the hiring entity’s policies, scheduling, and supervision. Employers will have to fold former independent contractors into their workforce as employees, and engage in the administrative burden of ensuring compliance with all of California’s employment laws, including minimum wage, overtime, meal periods and rest breaks, and anti-discrimination and retaliation laws that do not apply to independent contractors.

AB-5 is also significant in that employers are required to cover employees under Workers’ Compensation Insurance, as well as reimburse employees for “necessary expenditures or losses incurred by the employee” in carrying out job directives or employer directives. It is yet to be seen how employee breaks, reimbursements, business expenses, or other traditional employee functions can even be reliably tracked or monitored, particularly for gig-economy workers.

While AB-5 is officially on the books, we anticipate numerous challenges to the law, and it remains to be seen exactly how the test will be applied by the courts. Importantly, while the law does not technically go into effect until January 1, 2020, the legislature has drafted a clear intent that the law will apply retroactively.

Going forward, California employers have a choice. They may continue business as usual and risk being the test case on how the ABC Test is interpreted by the courts, or hope that ongoing challenges and lobbying efforts will eventually exempt their industry. A less risky and more practical strategy is to take immediate action to ensure compliance with AB-5 starting now. Employers should evaluate their workforce and identify any independent contractors that may not satisfy the ABC Test. If any independent contractors fail the ABC Test, the employer should change its business model to either eliminate the contractors all together, or reclassify them as employees (and hopefully in a way that differs from the prior contractor model to limit the risk of retroactive liability). If reclassified, these workers should be given required California onboarding forms, and set-up on payroll in accordance with the Labor Code. In addition, all policies and handbooks should be reviewed to ensure that they are in line with California law and AB-5.

These fixes are no easy task, but then again, doing business in California has always been different (and at times, more complicated) than other states. The only solace for California employers is that other states will very likely follow California’s lead.

[View source.]