Rules for Being an Independent Contractor in California
Self-employed taxes in California just got a lot more complicated. As independent contractors in California were getting a handle on how earning Form 1099 income could affect their employment status under Assembly Bill 5 (AB 5), the state enacted a new law to further revise the state laws governing independent contractors. The new statute, Assembly Bill 2257, was enacted on September 4, 2020, to clarify the state of the law under AB 5 and provide additional exemptions to the test for determining whether an independent contractor has been misclassified as an employee.
California just voted on Proposition 22, which would determine whether gig economy workers would stay classified as independent contractors or shift employees. The goal of the legislation was to set minimum wage, safety and employee benefit standards for app based independent contractors. Californians voted to pass Prop 22, which kept gig economy workers as independent contractors, because many prefer the 1099 employee rights like flexibility, and freedom of being a non-employee. Not to mention voting against it would have eliminated many of independent contracting jobs. However, we could see other states shift towards classifying app based gig economy workers as employees in favor of more rights in the near future.
Are independent contractors being misclassified as employees?
When a company hires an employee, they have to pay for extra costs like sick leave, minimum wage, overtime pay, rest breaks, etc. When a company contracts a 1099 worker, they don't have to worry about any of that.
Approximately $1.5 billion of taxes paid on 1099 income, self-employment tax revenue and Social Security withholdings is lost annually due to misclassification of as many as 3.5 million workers.
AB 5--also known as the “Gig Worker Law”--was signed into law by Governor Newsom 2019 and took effect January 1, 2020, over the strenuous opposition of companies that use large numbers of independent contractors to provide their services. Lyft, FedEx and Uber 1099 workers fall into this category. The law requires many businesses who had been using California-based independent contractors and freelancers or the gig economy to reclassify them as employees for the purposes of California tax and employment law.
Despite the enactment of AB 5, the federal government has not changed its test governing whether a worker is an employee or an independent contractor. Since the federal test for determining whether an individual is an independent contractor is more lenient than California’s, it is possible that a worker will be treated as an employee under California employment law, but an independent contractor for federal tax purposes. This means that some workers will receive both a W-2 and Form 1099 from a single employer.
AB 2257 retains the basic framework of AB 5, but provides a number of new statutory exemptions to the test for determining who is an independent contractor and who is an employee. It also alters some of the exemptions to the test for determining who is an independent contractor that were included in AB 5.
Most notably, AB 2257 did not provide additional exemptions for the industries that voiced the strongest opposition to AB 5, such as ridesharing services and various trucking and delivery companies.
If a worker is found to be an employee under AB 5 or AB 2257, California’s employment laws will apply to that individual and the worker will be subject to the following:
- California income tax and income tax withholding
- The state’s Workers’ Compensation Law
- California’s Unemployment Insurance Tax
- The State Disability Insurance Tax
- The Employment Training Tax
- Wage and hour rules that are enforced by the Department of Labor
- California laws regarding benefits, including sick leave and overtime
What is Form 1099 Income?
As a general rule, when businesses pay freelancers or independent contractors more than $600 in a calendar year for work related to their trade or business they must issue the worker either a federal Form 1099-NEC or a Form 1099-MISC. The workers who receive these forms do not receive any employee benefits from the business and are responsible for reporting and paying any state or federal tax due on the payments. Those 1099 workers who are employees under California law will only be responsible for the federal portion of their tax.
While businesses have traditionally reported their payments to independent contractors on a Form 1099-MISC, beginning in 2020 those businesses must report more than $600 in payments to most nonemployees for business services on the new Form 1099-NEC. Businesses are also required to issue the Form 1099-NEC to report payments for legal services and such items as taxable fringe benefits that are provided to nonemployees.
The IRS still uses an amended version of the Form 1099-MISC for businesses to report most other types of payment to nonemployees, which remains the IRS’s default form for nonemployee payments not covered by the Form 1099-NEC. Generally, a Form 1099-MISC is issued when a trade or business makes payments of more than $600 in a year to a nonemployee for such things as rent, machine rentals, medical and health care, payments to health insurers, and other similar types of payments.
A breakdown of California contractor law
While California legislation has changed the test for determining whether someone is an employee for the purposes of California law, the federal rules for determining whether a worker is an independent contractor have not changed. For the purposes of determining whether a worker is an independent contractor whose income should be reported on a Form 1099, the IRS will apply common law principles to assess the degree of control the hiring business holds over the worker based on the answers to the following questions:
- Does the business have control over the worker and how he or she does the job?
- Does the hiring business control the business aspects of the worker’s job?
- Are there written contracts or employee benefits?
No one question is controlling and the IRS will look at the overall relationship between the worker and hiring entity before making a determination as to independent contractor status. So, even if you work an independent contractor job in another state, it may not classify as 1099 work in California.
AB 5 changes California’s independent contractor law
In enacting AB 5, California incorporated the “ABC test” for employee status laid out in 2018 by the California Supreme Court in its decision in Dynamex Operations West, inc. v. Superior Court of Los Angeles into state law. The ABC test is a California Labor Code that is used to determine whether a worker is covered by California wage orders and Unemployment Insurance Code. Under the ABC test, a worker may only be classified as an independent contractor if he or she meets the following conditions:
Operates without the control or guidance of the hiring company. Basically, the hiring business must either accept or reject the work of the independent contractor without having a say in how it is performed. The worker is free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work. They basically set their own hours, drive their own cars and are not supervised on the job. You are most likely an employee if you get paid an hourly wage and you work full-time for a company.
Performs services unrelated to the hiring company’s core business. The independent contractor’s work cannot be that which would normally be performed by the hiring company’s employees. The work performed is outside the usual course of the hiring entity's business.
Works independently in an established trade, occupation, or business that exists separately from the hiring business. The independent contractor’s business must be one that will continue to exist after the hiring company has terminated the contract.
Any workers who do not satisfy all three conditions laid out in the ABC test must be classified as employees for California employment law purposes, even if that worker would still qualify as an independent contractor under federal tax law or the Affordable Care Act.
A business’s decision to classify a worker as an independent contractor is not final and the classification may be reviewed by any state agency, including the California’s Franchise Tax Board, Labor Commissioner, or Employment Development Department. Additionally, under AB 5, a business’s decision to classify a worker as an independent contractor may be challenged in court by California’s attorney general, some city attorneys, and local prosecutors. Workers may also file a class-action lawsuit against their hiring company if they believe it has violated AB 5.
Exemptions to the ABC Test
AB 5 provides that workers in some job categories were exempt from the ABC test and uses an alternative method for determining whether workers in those categories qualified as independent contractors. Under California Labor Law, workers in the following fields are exempt:
- Doctors, surgeons, dentists, psychologists, podiatrists, and veterinarians
- Insurance brokers
- Salespeople not paid by the hour
- Investment advisors and securities brokers
- Engineers and architects
- Private investigators
While workers in the above fields are exempt from the ABC test, they still must qualify as independent contractors under a test the California Supreme Court laid out in its 1989 decision on Borello vs. Dept. of Industrial Relations.
Borello is still used to determine employment status in some fields
The California Supreme Court’s decision in the S. G. Borello & Sons, Inc. v.s Department of Industrial Relations was the standard the state used for determining a worker's status prior to its Dynamex decision. It is often referred to as the “right to control test” because it bases its determination on whether the hiring business controlled the means and manner of the work.
Unfortunately, the Borello test is more difficult to apply than the ABC test and the answers to a number of different questions are weighed in making the determination of whether a worker is an employer or independent contractor, with no factor being definitive. The questions include the following:
- Was the work performed integral to the employer’s business?
- Did the worker utilize any specialized training or skills?
- Was the worker engaged in a business or occupation that is separate from the employer?
- Did the worker purchase the tools and equipment necessary to complete his or her work or were they supplied by the employer?
- Was the work performed of a type that is usually done under the employer’s direction?
- Did the worker have the potential to make a profit or register a loss from his or her work?
- How long did it take to finish the work?
- How long did the business relationship between the worker and employer last?
- Was the worker hired by the hour, or by the job?
- Did the worker hire additional employees to do the job?
- Would firing the worker constitute a breach of contract?
- Did both the worker and the employer believe they had an employer-employee relationship?
Since no single factor, or set of factors, is controlling under the Borello test its application often led to confusion because different courts would place an emphasis on different factors when applying it.
The business-to-business exemption from the ABC Test
AB 5 provided a exemption from the ABC test for business-to-business contractors. This exemption applies for business contracting relationships where the contractor is either a sole proprietor or a business entity that has been formed as a partnership, limited liability company (LLC), limited liability partnership, or corporation and contracts to provide services to another business. AB 2257 expanded the exemption so that it now applies when a public agency or a “quasi-public corporation” has been hired as a contractor.
AB 2257 also added a business-to-business exemption for individual business persons who enter into a contract to provide services at the location of a “single-engagement event” so long as other criteria for independent contractor status are met.
Some professional services receive special treatment
Workers that provide certain professional services that are exempt from the ABC test must meet additional conditions under AB 5, to qualify as independent contractors, even if they are able to qualify as independent contractors under the Borello test. To be eligible for the professional services exemption an independent contractor must meet all of the following criteria:
- Maintains a separate business location;
- Possess a business license;
- Has the ability to negotiate his or her own rates;
- Can set his or her own work hours;
- Offer similar services to other customers or engage in the same type of work for another business under contract; and
- Regularly exercise independent judgement when performing services.
AB 5 extended the exemption from the ABC test to include freelance writers, editors, photographers, translators and newspaper cartoonists that provide the hiring entity with content or submissions no more than 35 times a year. AB 2257 eliminated the limit on the number of times a year these professionals may submit content to a business while maintaining the exemption from the ABC test. Essentially, they can now produce an unlimited amount of content for a single business, so long as they do not displace any current employees performing the same duties.
The following occupations must meet the additional conditions laid out in AB 5:
- Marketing professionals who produce creative, original work
- Graphic designers
- Fine artists
- Travel agents
- Human resources administrators when their work is “predominantly intellectual and varies in character”
- Grant writers
- Payment processing agents who operate through independent sales organizations
- Enrolled agents
Real estate brokers and salespersons licensed under those brokers are allowed under the California Business and Professions Code to negotiate contracts that designate the salesperson as either an independent contractor or an employee. That provision was not amended by AB 5, but the new statute does stipule that if the Business and Professions Code does not apply to the relationship between the broker and salesperson, the Broello test will be used when determining whether the Labor Code will be applied to the salesperson.
Finally, AB 5 does not alter the process for determining whether a licensed repossession agency should be treated as an independent contractor under the Business and Professions Code when the agency is operating outside of the direct control of the hiring business.
AB 2257 Expanded the Professional Services Exemption
The list of professional services exempt from the ABC test that was provided in AB 5 was expanded upon by AB 2257. The new legislation exempts the following occupations:
- Content contributor
- Cartographers for certain publications
- Specialized performers who teach a class no more than once a week
- Home inspectors
- Registered professional foresters
Remember, if you work in one of the above occupations, you will not be found to be an independent contractor simply because you are exempt from the ABC test. You will still need to satisfy the Borello test to show your independence.
AB 2257 Added Exemptions for Performers and the Music Industry
AB 2257 created several exemptions from the ABC test for the entertainment industry, primarily for independent contractors working in the music industry. Workers in the following occupations who are involved in creating, marketing, promoting, or distributing audio recordings or musical compositions are exempt from the test:
- Recording artists who receive royalties
- Managers of recording artists
- Record producers and directors
- Musical engineers and mixers
- Independent radio promoters and some types of publicists
Musicians and musical groups who perform in a single-engagement concert are exempt from the ABC test unless they perform:
- As a symphony orchestra, musical theater production, or amusement park
- As an event headliner in a venue with more than 1,500 attendees
- At a festival selling more than 18,000 tickets per day
Musicians or vocalists must be paid the minimum wage if they do not receive royalties from a sound recording or musical composition and are treated as employees entitled to overtime pay.
Finally, individual performers who perform original works will qualify for an exemption so long as the worker is free from the control of the hiring entity, retain the intellectual property rights to their performance, set the terms for their work, and negotiate the rates paid. These performers include:
- Magicians and illusionists
- Spoken word performers and storytellers
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At Keeper Tax, we’re on a mission to help freelancers overcome the complexity of their taxes. That sometimes leads us to generalize tax advice. Please email firstname.lastname@example.org if you have questions.