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Navigating AB 5: Independent Contractors in California

by Gayle M. Athanacio and Virginia K. Young

Those who use independent contractors in California have had a lot to think about the past couple of years. In April, 2018, the California Supreme Court’s opinion in Dynamex Operations West v. Superior Court, (4 Cal. 5th 903) changed the law for determining whether workers are “employees” or “independent contractors” for claims under the California Wage Orders, making it significantly more difficult to establish a worker’s independent contractor status.  On September 18, 2019, Governor Newsom signed AB 5, which codifies Dynamex, and greatly expands its scope beyond the Wage Orders.   To make matters more complicated, while some state and federal courts have also addressed Dynamex, in particular to what extent it may apply retroactively and to joint employment analyses, the answers to those questions remain far from clear.

These recent legislative and legal developments have left many who do business in California scratching their heads about their independent contractor relationships.  AB 5 answers some, but not all, of the questions left open after Dynamex, and in the process raises many new questions of its own.  One thing is certain: the landscape for using independent contractors in California has changed dramatically, making it imperative for those using independent contractors in California to familiarize themselves with AB 5 and consider how it applies to their operations.

 

The Dynamex Decision and the “ABC Test”

In simplest terms, Dynamex replaced the decades-old “totality-of-the-factors” test (Borello) for determining independent contractor status with a much stricter “ABC test” for Wage Order claims.  Wage Orders, which are industry-specific, generally outline wage/hour, break and other working conditions for employees.

The “ABC test” requires ALL of the following three conditions for a valid independent contractor relationship.  Thus, if the recipient of services cannot establish any one of the factors, the individual providing the services will be deemed an employee.

  1. The worker is free from the control and direction of the hiring entity, both under the contract and in fact; and
  2. The worker performs work that is outside the hiring entity’s “usual course” of business; and
  3. The worker is customarily engaged in an independently established trade, business, or occupation of the same nature as the work being performed.

Dynamex left many questions unanswered, including:

    • Does the new ABC test also apply under the Unemployment Insurance Code (withholding obligations, payroll taxes, etc.), workers compensation law, and California Labor Code provisions that aren’t repeated in the Wage Orders (such as expense reimbursement)?
    • Does the ABC test apply retroactively?
    • Is the ABC test applicable to joint employment determinations (e.g., when two or more businesses are considered the employer, making all responsible for employment-related obligations)?

 

How is the ABC Test Different From the Borello Test?

Under the Borello test, whether a worker was deemed an employee focused on the hiring entity’s right to direct and control the manner and means of the work, and required consideration of numerous other factors, specifically, (1) whether the one performing services was engaged in a distinct occupation or business, (2) whether the work is a part of the principal’s regular business, (3) the ability to discharge at will, (4) length of time the services would be performed, (5) the kind of work and skill involved, (6) who supplies the tools and the place of work, (7) the method of payment (time or by the job), and (8) whether the parties believe they are creating an independent contractor relationship.  The failure to meet one of these factors was not fatal to independent contractor status.

However, under the new ABC test, unless it can be shown that the service provider is free from the control and direction of the hiring entity, both under the contract and in fact; and performs work that is outside the hiring entity’s “usual course” of business; and is customarily engaged in an independently established trade, business, or occupation of the same nature as the work being performed, the worker will be deemed an employee.  Thus, while certain conditions of the ABC test overlap with the Borello factors, the ABC test represents a significant departure from Borello.  For example, if a service provider is doing work that is in the usual course of the hiring entity’s business, they cannot be an independent contractor under the ABC test even if they are completely free from control by the hiring entity, and operate their own independent business.  Under Borello, that same service provider likely could be considered an independent contractor.  The ABC test takes away any potential weighing of factors and significantly limits any flexibility in the analysis.

Why Does It Matter Whether You Have an Employee or Independent Contractor Relationship? 

The California Supreme Court opened its Dynamex opinion by articulating the dramatic implications to treating a worker as an independent contractor instead of an employee:

Under both California and federal law, the question whether an individual worker should properly be classified as an employee or, instead, as an independent contractor has considerable significance for workers, businesses, and the public generally. On the one hand, if a worker should properly be classified as an employee, the hiring business bears the responsibility of paying federal Social Security and payroll taxes, unemployment insurance taxes and state employment taxes, providing workers’ compensation insurance, and… complying with numerous state and federal statutes and regulations governing the wages, hours, and working conditions of employees.  The worker then obtains the protection of the applicable labor laws and regulations.  On the other hand, if a worker should properly be classified as an independent contractor, the business does not bear any of those costs or responsibilities, the worker obtains none of the numerous labor law benefits, and the public may be required under applicable laws to assume additional financial burdens with respect to such workers and their families.

***

In recent years, the relevant regulatory agencies of both the federal and state governments have declared that the misclassification of workers as independent contractors rather than employees is a very serious problem, depriving federal and state governments of billions of dollars in tax revenue and millions of workers of the labor law protections to which they are entitled.

With these policy considerations underlying the attack on independent contractor status, it is not surprising that California has implemented laws giving rise to significant civil liability and potential criminal liability for the willful misclassification of independent contractors including damages, penalties and attorney’s fees.

 

What Does AB 5 Do To The Independent Contractor Analysis?

AB 5 enacts new Labor Code section 2750.3, which codifies Dynamex’s “ABC” test for purposes of the California Labor Code, Unemployment Insurance Code, and Wage Orders.  AB 5 also amends the definition of an “employee” under the Unemployment Insurance Code and Workers’ Compensation law to incorporate the test.

Additionally, AB 5 sets out numerous exceptions to the ABC test.  In most instances, if an exception applies, the Borello test will determine whether the service provider is an independent contractor or an employee.   Notable exceptions include persons or organizations licensed by the Department of Insurance, licensed accountants, architects, engineers, lawyers, physicians and surgeons, dentists, podiatrists, psychologists and veterinarians; marketing and human resources administration services performed under certain conditions; real estate licensees; subcontracts in the construction industry meeting certain requirements; and “business to business contracts” meeting specific requirements.

 

Does the Borello Test Ever Apply Anymore?

In a word, yes.  AB 5 carves out numerous exceptions to the application of the ABC test.  In most circumstances, meeting one of these exceptions means that the Borello test will apply instead of the ABC test.  Meeting an exception does not necessarily mean that the service provider is an independent contractor.  Those planning to rely on an exception should familiarize themselves with the specific detailed requirements of each.

 

Occupational Exceptions (Labor Code 2750.3(b))

            The Borello test, rather than the ABC test, will apply to the following occupations in the specified circumstances:

    • a person or organization licensed by the California Department of Insurance under certain sections of the Insurance Code (e.g., insurance agents, brokers, analysts, etc.)
    • a physician, surgeon, dentist, podiatrist, psychologist, or veterinarian licensed by State of California and performing professional or medical services to or by a health care entity
    • an attorney, architect, engineer private investigator or accountant licensed by the State of California and practicing in the profession
    • a securities broker-dealer or investment advisor or agents registered with the SEC or FINRA or licensed by state of California
    • a direct sales-person as described in section 650 of the Unemployment Insurance Code (in-person demonstration and sales of consumer products, including services or other intangibles, in the home or sales to any buyer for resale in the home or otherwise than from a retail or wholesale establishment)
    • Commercial fisherman (details omitted)
    • A newspaper distributor or publisher, or a newspaper distributor working under contract with a newspaper publisher, until January 1, 2021 (details omitted). This exception was established by AB 170, a measure related to AB 5.

Exception For Certain Professional Services (Labor Code 2750.3(c))

The Borello test will be used for professional services in the following areas if the listed conditions are also satisfied.  Services that are the types of services defined in AB 5, or arrangements that do not meet all the conditions, will be subject to the ABC test.

      Types of services that may qualify:

    • Marketing, if the work is original and creative and the result depends primarily on the invention, imagination, or talent of the service provider, including work that is an essential part of or necessarily incident to any of the contracted work
    • Administration of Human Resources, if the work is predominantly intellectual and varied in character and the output produced or the result accomplished cannot be standardized in relation to a given period of time
    • A travel agent regulated by the Attorney General under Article 2.6 (commencing with Section 17550) of the Business and Professions Code, or an individual who is a seller of travel within the meaning of subdivision (a) of Section 17550.1 of the Business and Professions Code and who is exempt from the registration under subdivision (g) of Section 17550.20 of the Business and Professions Code
    • Graphic design
    • Grant writing
    • Fine artist
    • Enrolled agent of Dept. of Treasury
    • Payment processing through independent sales organization
    • Photographer or photojournalist who does not license content to the hiring entity more than 35 times per year
    • Freelance writer, editor, or newspaper cartoonist who does not license content to the hiring entity more than 35 times per year
    • Licensed esthetician, electrologist, manicurist (until January 1, 2022), barber or cosmetologist who: set their own rates, process their own payments, are paid directly by clients, set their own hours of work, have sole discretion to decide the number of clients and which clients for whom they will provide services, have their own book of business and schedule their own appointments, maintain their own business license for the services offered to clients, and issue a form 1099 to the salon or business owner from which they rent their business space (if they perform services there).

 

While some of these services are very specifically defined (e.g., marketing, HR administration, travel agents), some are not defined at all (e.g., “graphic design”, “fine artist”).  This ambiguity may lead to uncertainty as to their application.

In addition to the service falling into one of the above categories, the service provider must meet all of the conditions below:

  • maintain a business location separate from the hiring entity, but may choose to perform at the location of the hiring entity
  • have a business license if the work is performed more than 6 months after the effective date of AB 5
  • be able to set or negotiate rates
  • have the ability to set their hours
  • be customarily engaged in same work with another hiring entity or hold themselves out to other potential customers as available to perform same type of work
  • exercise discretion and independent judgment

 

Real Estate Agents and Repossession Agencies

The ABC test will not apply to real estate licensees who are licensed pursuant to section 10000 et seq. of the California Business and Professions Code.  Instead, where Bus. & Prof. section 10032 applies, the independent contractor status shall be determined by that section, not the ABC test.  Where Section 10032 does not apply, the determination of independent contractor status is made under various sections of the Unemployment Insurance Code, Labor Code section 3200 (for workers’ compensation), or the Borello test.

Nor will the ABC test apply to repossession agencies licensed pursuant to Bus. & Prof. Code section 7500.2.  Rather, Section 7500.2 shall determine independent contractor status, as long as the repossession agency is free from the control and direction of the hiring entity/person in the performance of the work – both under the contract and in fact.

 

 “Business to Business Contracting”

Perhaps the most ambiguous, but significant, of AB 5’s exceptions allows the Borello test to apply to “business to business” contracting relationships which meet all of the following criteria:

  • Service provider must be a business entity formed as a sole proprietorship, partnership, limited liability company, limited liability partnership, or corporation
  • Service provider must be free from the control and direction of the contracting business in connection with the performance of the work, both under the contract for the performance of the work and in fact
  • Service provider must be providing services directly to the contracting business rather than to customers of the contracting business
  • The contract with the service provider must be in writing
  • If the work is performed in a jurisdiction that requires the business service provider to have a business license or tax registration, the service provider must have all required business licenses or business tax registrations
  • Service provider must maintain a business location that is separate from the business or work location of the contracting business
  • Service provider must be customarily engaged in an independently established business of the same nature as that involved in the work performed
  • Service provider must actually contract with other businesses to provide the same or similar services and maintain a clientele without restrictions from the contracting business
  • Service provider must advertise and hold itself out to the public as available to provide the same or similar services
  • Service provider must provide its own tools, vehicles, and equipment to perform the services
  • Service provider must be able to negotiate its own rates
  • Service provider must be able to set their own hours and location of work (consistent with the nature of the work)
  • Service provider cannot be performing the type of work for which a license from the Contractor’s State License Board is required

Some of these criteria are straightforward (e.g., the existence of a written contract).  Other criteria are highly fact specific but at least are recognizable hallmarks of independent contractor analysis (e.g., freedom from control and direction, providing their own tools, setting their own hours).

Yet, how certain “business to business contracting” requirements should be interpreted or applied remains unclear.  For example, the requirement that the service provider provide services “directly to contracting business rather than to customers of the contracting business” contains no explanation.  The legislative history of AB 5 offers the following comment from the bill’s sponsors: “an independent contractor and the client should have a direct relationship, communicate directly to resolve any questions or concerns, and use the structure of the contract to resolve any disputes.”  Analysis, Senate Cmte. On Labor (July 10, 2019) p. 10.

The requirement that the service provider must actually contract with other businesses to provide the same or similar services and maintain a clientele without restrictions from the contracting business, appears to mean that the exception will not apply if the services provider’s only customer is the hiring entity, even if the contract gives the service provider freedom to contract with other entities.  While a hiring entity could seek assurances relating to the status of the service provider’s business – at least at the outset of the relationship – getting “proof” that the service provider has other business and maintains other business during the course of the relationship raises numerous challenges, including a service provider not wishing to provide confidential business information.

As if there isn’t enough to think about with the business to business exception, a few more issues are worthy of consideration.  AB 5 states that the business to business exception does not apply to an individual, as opposed to a business entity, who performs services for a contracting business.  It also states that the ABC test will determine whether an individual working for a business service provider is an employee or an independent contractor.  Finally, the business to business exception expressly states that it does not relieve a hiring entity from joint liability under Labor Code section 2810.3, which establishes joint liability for wages and workers’ compensation insurance for workers under certain business relationships, (e.g., temporary staffing agencies).  Hiring entities can also face common law claims of joint employer liability (see below for further discussion).

 

Subcontracts in the Construction Industry

The ABC test does not apply to the relationship between a contractor and an individual performing services in the construction industry if all of the conditions listed below are met.

  • The subcontract is in writing
  • Subcontractor is licensed by the Contractors State License Board and the work is within the scope of that license
  • If the subcontractor is domiciled in a jurisdiction that requires the subcontractor to have a business license or tax registration, the subcontractor has all required a business licenses or business tax registrations
  • Subcontractor maintains a business location that is separate from the business or work location of the contractor
  • Subcontractor has the authority to hire and to fire other persons to provide or to assist in providing the services
  • Subcontractor assumes financial responsibility for errors or omissions in labor or services as evidenced by insurance, legally authorized indemnity obligations, performance bonds, or warranties relating to the labor or services being provided
  • Subcontractor is customarily engaged in an independently established business of the same nature as that involved in the work performed

If these conditions are satisfied, Borello and Labor Code section 2750.5 determine whether the service provider is an independent contractor or employee.  Labor Code section 2750.5 establishes a rebuttable presumption that where a worker performs services that require a license pursuant to Business and Professions Code section 7000 et seq., or performs services for a person who is required to obtain such a license, the worker is an employee and not an independent contractor.

 

Construction Trucking Services

The State Contractor’s License board license requirements above do not apply to a subcontractor providing “construction trucking services” for which a license is not required under Chapter 9, Division 3 of the Business and Professions Code provided all of the following are met:

  • The subcontractor is a business entity formed as a sole proprietorship, partnership, limited liability company, limited liability partnership, or corporation
  • For work performed after January 1, 2020, the subcontractor is registered with the Department of Industrial Relations as a public works contractor pursuant to Section 1725.5, regardless of whether the subcontract involves public work
  • The subcontractor utilizes its own employees to perform the construction trucking services, unless the subcontractor is a sole proprietor who operates their own truck to perform the entire subcontract and holds a valid motor carrier permit issued by the Department of Motor Vehicles
  • The subcontractor negotiates and contracts with, and is compensated directly by, the licensed contractor

“Construction trucking services” means “hauling and trucking services provided in the construction industry pursuant to a contract with a licensed contractor utilizing vehicles that require a commercial driver’s license to operate or have a gross vehicle weight rating of 26,001 or more pounds.”

For work performed after January 1, 2020, any business entity that provides construction trucking services to a licensed contractor utilizing more than one truck shall be deemed the employer for all drivers of those trucks.   An individual who owns their truck may work as an employee of a trucking company and utilize that truck in the scope of that employment. An individual employee providing their own truck for use by an employer trucking company must be reimbursed by the trucking company for the reasonable expense incurred for the use of the employee owned truck.

 

Referral Agencies

The Borello test will apply to the relationship between a “referral agency” and a service provider meeting certain conditions.  The definition of a “referral agency” under AB 5 is a business that connects clients with service providers that provide graphic design, photography, tutoring, event planning, minor home repair, moving, home cleaning, errands, furniture assembly, animal services, dog walking, dog grooming, web design, picture hanging, pool cleaning, or yard cleanup.  “Animal Services” and “Tutors” have further specific definitions.  Service providers not falling within these definitions would not fall within the exception.

For service providers who are business entities and meet the definition above, the following conditions must be met:

  • Service provider must be a business entity formed as a sole proprietorship, partnership, limited liability company, limited liability partnership, or corporation
  • Service provider must be free from the control and direction of the referral agency in connection with the performance of the work for the client, both as a matter of contract and in fact
  • If the work for the client is performed in a jurisdiction that requires the service provider to have a business license or business tax registration, the service provider has the required business license or business tax registration
  • If the work for the client requires the service provider to hold a state contractor’s license pursuant to Chapter 9 (commencing with Section 7000) of the Business and Professions Code, the service provider has the required contractor’s license
  • Service provider delivers services to the client under service provider’s name, rather than under the name of the referral agency
  • The service provider provides its own tools and supplies to perform the services
  • The service provider is customarily engaged in an independently established business of the same nature as that involved in the work performed for the client
  • Service provider maintains a clientele without any restrictions from the referral agency and the service provider is free to seek work elsewhere, including through a competing agency
  • Service provider sets its own hours and terms of work and is free to accept or reject clients and contracts
  • Service provider sets its own rates for services performed, without deduction by the referral agency
  • Service provider is not penalized in any form for rejecting clients or contracts. This does not apply if the service provider accepts a client or contract and then fails to fulfill any of its contractual obligations.

Like the ‘business to business” exception, the exception does not apply to an individual worker, as opposed to a business entity, who performs services for a client through a referral agency.  The determination whether such an individual is an employee of a referral agency is governed by the ABC test.

 

Motor Clubs

The ABC test will not apply to “the relationship between a motor club holding a certificate of authority issued pursuant to Chapter 2 (commencing with Section 12160) of Part 5 of Division 2 of the Insurance Code and an individual performing services pursuant to a contract between the motor club and a third party to provide motor club services utilizing the employees and vehicles of the third party.” If the motor club demonstrates that the third party is a separate and independent business from the motor club, the Borello test will apply.

 

When Do AB 5 and the ABC Test Apply?  Are Either Retroactive?

AB 5 goes into effect on January 1, 2020. The amended definition of “employee” under the workers’ compensation law, however, applies beginning July 1, 2020.

AB 5 states:

  • The ABC test is a declaration of existing law as to claims under the Wage Orders and other Labor Code claims “relating to the Wage Orders.”
  • To the extent they “would relieve an employer of liability” the exceptions to the ABC test under AB 5 shall apply retroactively.

Thus, under AB 5, the ABC test applies retroactively as to Wage Order claims and Wage-Order-related Labor Code claims.  Many wage and hour claims have statutes of limitation of 1 to 4 years. Whether retroactivity extends back to the date of Dynamex decision or earlier will likely depend on how the courts determine whether Dynamex itself applies retroactively. State and federal courts have issued decisions applying Dynamex and the ABC test retroactively.  The California Supreme Court granted review of the question of whether Dynamex applies retroactively at the request of the Ninth Circuit Federal Court of Appeals in Vasquez v. Jan-Pro Franchising Inc..  Those using independent contractors should continue to monitor that case.

 

Does The ABC Test Apply To Claims Of “Joint Employment” By Two Employers?

“Joint employment” arises when two or more businesses are considered the “employer” and responsible for employment-related obligations.  One example is Labor Code section 2810.3, mentioned above, which imposes joint liability for wages and workers’ compensation insurance where a “client employer” obtains workers from a “labor contractor” to perform labor in the client employer’s usual course of business (e.g., a staffing agency).  Joint employer issues can come up in other situations such as contactor/subcontractor arrangements and with affiliated companies.[1]  The main focus for determining joint employment in those cases is the exercise of control over the work or working conditions of the employee.

AB 5 does not address joint employment specifically (other than its mention of Labor Code 2810.3 in connection with the “business to business” contracting exception).  The author of the AB5 has stated “AB 5 is not intended to replace, alter, or change joint employer liability between two businesses.  AB 5 is focused upon the determination whether an individual is an employee or an independent contractor.”  Assemblymember Gonzalez, Letter to Assembly journal, September 13, 2019.

Courts addressing whether Dynamex’s ABC test applies to joint employment claims have come to different conclusions.  A California appellate court recently rejected application of Dynamex’s ABC test where a gas station manager claimed he was the joint employee of both the owner and the operator of the station, noting that the manager was classified as an employee of the gas station operator and was receiving the protections of the state employment laws; as such, the court concluded the policy concerns of Dynamex were therefore inapplicable.  Henderson v. Equilon Enterprises, LLC (noting a similar conclusion in a case decided in April 2018, Curry v. Equilon Enterprises).  Recently, in a case addressing joint liability of a franchisor for employees of its franchisees, the Ninth Circuit held that Dynamex “has no bearing here, because no party argues that Plaintiffs are independent contractors. Plaintiffs are [Franchisees’] employees; the relevant question is whether they are all still McDonald’s employees.”  Salazar v. McDonald’s Corp.

However, in the Vazquez decision referenced above in connection with retroactivity, the  Ninth Circuit held that the Dynamex ABC test applied to joint employment claims.  This part of the Vasquez decision is not pending before the California Supreme Court and, although the Vazquez opinion was initially withdrawn, the court subsequently issued an opinion in which it “re-established” the remaining holding of its prior decision reflecting the court’s conclusion that the Dynamex ABC test was applicable to joint employer claims.  The Vasquez decision regarding joint employment appears to be at odds with the Ninth Circuit’s McDonald’s decision and the California appellate court’s decision.

How the joint employer issue will be resolved remains to be seen.  The logical take-away from the Dynamex court’s discussion of the policy reasons for adopting the ABC test, and the Equilon and McDonald’s cases suggest that the ABC test should not apply to the joint employer question: by definition, in joint employment cases the worker is being treated as an employee by the hiring entity and is therefore receiving the protections of employment status, so there is no need to apply the expansive definition of “employee” under the ABC test.  The matter is likely to be the subject of further litigation which should be monitored.

Conclusion

AB 5 does provide certain clarity following the Dynamex decision.  With this legislation we now know that the ABC test expressly applies to claims under the Wage Orders, the Unemployment Insurance Code and all of the Labor Code provisions, subject to  a number of specific exceptions.  Yet these exceptions create their own questions for which there are not clear answers.  Consequently, anyone using independent contractors in California should review AB 5 in detail and consult with counsel now to assess whether their classifications and agreements are in order.  For some, this might a be a relatively straightforward process.  For others the process may be complex.  But whatever the case, it is an endeavor that should be undertaken without delay.

Further, anyone hiring workers in California should follow the ever-evolving developments and changes in California independent contractor law.  At minimum we can expect further legislative “refinements” to AB 5 via amendment and additional guidance and precedent from courts and administrative agencies.  Californians may also get to vote about at least some portions of AB 5, as some industry groups have vowed to pursue ballot propositions relating to AB 5 and its exceptions.

 

About Rogers Joseph O’Donnell Labor & Employment Law Practice Group

Rogers Joseph O’Donnell’s Labor and Employment Law Practice Group is comprised of experienced labor and employment attorneys with extensive experience representing and advising individuals, businesses, government contractors, and public entity employers.

The depth and breadth of our employment law experience allows us to offer the same quality of representation usually expected from much larger law firms, while our relatively small size enables us to maintain highly competitive rates and a more direct and personal relationship with our clients.

Our labor and employment practice focuses on counseling – guiding employers as to how to navigate the patchwork of employment laws and avoid litigation before it starts – while also defending against single and multiple plaintiff litigation, class and collective actions, and PAGA actions. While we believe that early case evaluation and mediation are often advantageous ways to minimize the costs and disruption of protracted litigation, we are also skilled, trial-ready attorneys with a winning record in court, administrative hearings and arbitration.

If you have questions about California labor and employment law, please contact the Rogers Joseph O’Donnell attorney with whom you regularly work, or the authors of this legal update: Gayle M. Athanacio and Virginia K. Young.

 

[1] The issue has also arisen in the franchise context, however, the California Supreme Court issued a favorable ruling that uniform marketing and operational plans cannot automatically impose liability on the franchisor for the actions of a franchisee’s employees.

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