Worker classification has always been somewhat difficult to navigate. Classification criteria established by the IRS is ambiguous at best. Unfortunately, things have been made worse in California. Implementation of AB 5 at the start of the year have further muddied the already murky worker classification waters.
Critics say that AB 5 was created specifically to target the gig economy and its most prominent players. Companies like Uber and Postmates' have been fighting the law since it was passed in 2019. They recently failed to convince a California court to implement a preliminary injunction while the law makes its way through the courts.
Employers are required under federal law to classify their workers as either employees or independent contractors. Employees are guaranteed certain rights under the Fair Labor Standards Act (FLSA), including eligibility to receive overtime pay and eligibility for mandated health insurance. Independent contractors are not covered by the FLSA.
As previously mentioned, the IRS has developed criteria for determining worker classification at the federal level. California has now implemented additional criteria for state classification. The problem is that we now have competing tests that make determining classification nearly impossible in some cases.
California's ABC test was implemented in 2018 following a prominent court case. That test requires a worker to meet three specific criteria in order to be classified as an independent contractor. Because the three criteria are so stringent, millions of workers previously classified as independent contractors under federal law are considered employees by California standards.
In addition to the ABC test, California has the Borello test. It was first introduced in 1989 as the result of a court case ultimately decided by the state Supreme Court. This test lists no fewer than 13 criteria defining whether a worker is an employee or independent contractor.
As you can see, combining IRS criteria with the criteria under California's ABC and Borello tests creates a very confusing scenario. California employees using independent contractors prior to January 1 now find themselves in a position of not knowing where their workers stand.
In case you were wondering, it is possible for a worker to be classified as an employee in California but an independent contractor for federal tax purposes. Such a scenario creates even more confusion at tax time. It can create nightmares for payroll departments.
A worker in this position would receive a W-2 for state tax purposes but a 1099-MISC or 1099-K for federal tax purposes. Interestingly enough, the numbers on the state and federal forms will probably not match. Why? Because income is reported differently for state and federal purposes.
The worker is left to figure out how to report income on state and federal tax returns. Meanwhile, the employer must keep multiple sets of records to account for different ways of reporting. The whole thing creates a messy situation that can be difficult to stay ahead of.
Time to Outsource Payroll
Here at BenefitMall, we obviously recommending outsourcing payroll to an experienced provider. Employers in California have all the more reason to do so now that AB 5 is the law of the land. Implementation of the law has added a new layer of complexity to payroll that even experienced bookkeepers and accountants might have trouble with.
It is our business to understand such laws and how they apply to our clients. We have made every attempt – and continue to do so – to stay abreast of all the legal obligations relating to AB 5. If your company is struggling with compliance at this point, give us a shout.