California Tightens Classification Standard for Independent Contractors

As expected, California Governor Gavin Newsom signed Assembly Bill 5 (AB 5) into law. AB 5, which adds Section 2750.3 to the California Labor Code, makes it significantly riskier for all companies doing business in California — not just gig economy companies — to classify workers as independent contractors. Companies making use of independent contractors should take immediate steps to comply with the requirements of AB 5 and develop strategies to minimize exposure to claims arising from independent contractor misclassification.

Summary

AB 5 codifies the so-called “ABC test” for determining whether a worker should be classified as an independent contractor or as an employee, which the California Supreme Court adopted late last year for purposes of California’s Wage Orders in Dynamex Operations West, Inc. v. Superior Court. Under the ABC test, an independent contractor is deemed to have been misclassified unless the company can prove that the worker is free from the company’s control, performs work outside the company’s usual business, and is regularly and independently engaged in the trade he or she was hired for.

In addition to codifying the ABC test, AB 5 expands application of the test to the Unemployment Insurance Code and to the entire California Labor Code. The test will thus be used to determine employment status in a wider variety of contexts than required by the Dynamex decision, which applied only with respect to claims arising under California’s Wage Orders. Going forward, the ABC test will also apply when courts consider claims relating to wage statements, payment of final wages, paid sick leave, paid family leave, unemployment insurance, and expense reimbursement issues.

Although AB 5 does exempt certain categories of workers from the test (subject to various conditions), it will generally be more difficult to establish that a worker in California is properly providing services as an independent contractor and not as an employee. To reduce exposure to significant damages, penalties, and attorney’s fees, companies should consult legal counsel for advice regarding reclassification of contractors who may be misclassified under the new test and other strategies to mitigate risk.

Background: The California Supreme Court’s Dynamex Decision

In Dynamex, the California Supreme Court unanimously adopted the three-prong “ABC test” for determining whether a worker provides services as an independent contractor or as an employee. Among the harms of misclassification cited by the Supreme Court in reaching its decision were misclassified workers’ loss of workplace protections, the unfair competitive advantage to companies that improperly make use of independent contractors, and the State of California’s loss of revenue from payroll taxes and premiums made on behalf of employees but not independent contractors.

Under the ABC test, employment status is the default presumption, and the hiring entity bears the burden of proving that a worker is appropriately classified as an independent contractor by satisfying all three of the following elements:

1. The worker is free from the company’s control and direction in performing his or her work;
2. The worker performs work that is outside the usual course of the company’s business; and
3. The worker is engaged in an independently established trade, occupation, or business of the same nature as the work he or she performs for the company.

If a hiring entity fails to satisfy any one of these elements, the worker is deemed to be an employee and not an independent contractor. In Dynamex, the California Supreme Court limited application of the ABC test to claims arising under California’s Wage Orders (which set forth requirements relating to minimum wages, overtime, meal periods, rest breaks, and various other matters). For other purposes, the less rigid multi-factor balancing test set forth in the California Supreme Court’s 1989 opinion in S.G. Borello & Sons, Inc. v. Department of Industrial Relations (the “Borello” test) has continued to apply.

The Impact of AB 5

AB 5 extends application of the ABC test beyond California’s Wage Orders such that the test will now also be used to determine whether a worker is an employee or an independent contractor for purposes of the Unemployment Insurance Code and the entire Labor Code (i.e. not just those Labor Code provisions that are also addressed under the Wage Orders). The test thus applies to claims not previously covered by the Dynamex holding, including claims relating to wage statement violations, untimely payment of final wages, paid sick leave, paid family leave, unemployment insurance, and expense reimbursement. (Notably, however, AB 5 does not extend the ABC test to claims of harassment and discrimination, which arise not under the Unemployment Code or the Labor Code but under the California Government Code.)

New Enforcement Mechanism

In addition to expanding the ABC test to cover a broader range of statutes, AB 5 also empowers the California Attorney General and specified local agencies, including city attorneys in cities whose populations exceed 750,000, to bring actions for injunctive relief “to prevent the continued misclassification of employees as independent contractors.

Exemptions

Not all categories of workers are included under the new law. AB 5 explicitly carves out a number of occupations that will not be subject to the ABC test but will instead remain subject to the multi-factor Borello test. The Borello test will still apply, for example, when determining whether a worker in one of the following exempted occupations or industries is properly classified:

• State-licensed or registered occupations, including physicians, surgeons, dentists, psychologists, veterinarians, lawyers, architects, engineers, private investigators, accountants, securities brokers, and investment advisors;
• Other “professional services,” such as marketing, human resources administration, certain travel agent work, graphic design, and grant writing;
• Referral agencies connecting clients with providers of the following services: 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; and
• Bona fide business-to-business contracting.

These exemptions are likely to be construed narrowly, and some can apply only if a variety of strict conditions are satisfied. Because various conditions must be satisfied before they can apply at all, legal counsel should be consulted before relying on an exemption.

Effective Dates and Retroactivity

AB 5 provides that it is declarative of existing law — and thus potentially retroactive— for purposes of claims arising under Wage Orders and Labor Code provisions relating to Wage Orders. Since the start of 2020, the ABC test applies for purposes of the Unemployment Insurance Code (including its paid family leave requirements) and the provisions of the Labor Code that are not addressed by Wage Orders (including claims relating to wage statement violations, untimely payment of final wages, paid sick leave, and expense reimbursement). The test will apply for purposes of workers’ compensation on July 1, 2020.

Next Steps for Companies Making Use of Independent Contractors

Although the ABC test is arguably simpler to apply than Borello’s multi-factor balancing test, it is not mechanical. Much remains to be seen, for example, about how courts will interpret what it means to perform work within “the usual course” of a hiring entity’s business and how broadly or narrowly the exemptions will apply. Still, it is critical that companies making use of independent contractors in California take prompt steps in consultation with counsel to re-evaluate their independent contractor relationships, reclassify potentially misclassified workers in a way that avoids stirring up claims, educate hiring managers and other personnel about appropriate use of contractors, and otherwise adjust practices to comply with AB 5. Given the law’s retroactive application, companies may also wish to work with counsel to evaluate potential exposure from past practices and to consider other strategies to mitigate risk, including evaluation of the pros and cons of mandatory arbitration programs and class action waivers. Consultation with counsel is further recommended because the new law has been challenged in various specific contexts, and those challenges may result in additional exemptions or delays in implementation. If you have any questions about how AB5 will affect your company’s usage of independent contractors, including how existing practices may need to be modified, please contact a member of Goodwin’s California Employment team.