A New Law Passed Raising the Standard for Classifying Workers as Independent Contractors in California
September 30, 2019
By Erin Denniston Leach and Nancy K. Campbell
Since April 30, 2018, when the landmark California Supreme Court decision in Dynamex Operations West, Inc. v. Sup. Ct. (2018) 4 Cal.5th 903 (Dynamex) was issued, companies across the state have questioned whether the ABC independent contractor test adopted in that decision applies to them and/or their workers, how far it may apply, and whether it applies retroactively. The California Legislature has now stepped in and passed Assembly Bill 5 (“AB 5”) which has been called a landmark bill for workers. AB 5 answers some of those questions and adds some further areas of confusion.
Part 1: What Does AB 5 Say?
AB 5 to some extent codifies and expands the decision in Dynamex by adding to the California Labor Code and the California Unemployment Insurance Code that the ABC test applies for deciding who is properly classified as an independent contractor. Under that test, workers will be presumed to be employees for purposes of the Labor Code, Industrial Welfare Commission Wage Orders and Unemployment Insurance Code unless the hiring entity can prove that: (a) the person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the terms of the contract and in fact; (b) the person performs work that is outside the usual course of the hiring entity’s business; and (3) the person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed. Further, beginning on July 1, 2020, the ABC test will also apply to the determination of whether an individual is an employee for purposes of workers’ compensation requirements. This test sets a far higher standard for determining whether a worker is an independent contractor than the decades-old balancing test adopted in S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341 (Borello).
However, AB 5 has been a work in progress over the last few months with many industries and occupations fighting for exemptions from the ABC test. As a result, numerous revisions have been made along the way. A number of occupations received the exemption they wanted from the ABC test in the Labor Code provision. These exemptions include, among others, licensed insurance agents, certain licensed health care professionals, certain California licensed professionals (specifically lawyers, architects, engineers, private investigators, and accountants), registered securities broker-dealers or investment advisers, direct sales salespersons, real estate licensees, commercial fishermen, workers providing licensed barber or cosmetology services, and others performing work under a contract for “professional services” as defined in AB 5, with another business entity, or pursuant to a subcontract in the construction industry. However, even for some of these exemptions, there are certain factors that must be met for the worker to be deemed exempt from the ABC test. Further, how these exemptions will be applied and interpreted is yet to be seen.
In addition, the applicability of an exemption does not mean each of these individuals is automatically an independent contractor. Rather, for workers in most of these job categories, when evaluating whether they are an employee or independent contractor, AB 5 requires the application of the decades-old balancing test adopted in Borello. Interestingly, for some of these occupations, the exemption is short lived. For example, the exemption for commercial fishermen is applicable only until January 1, 2023, and the exemption for licensed manicurists is applicable only until January 1, 2022. Of note, while newspaper distributors did not receive an exemption from AB 5, Assembly Bill 170 also passed which gives newspaper distributors and newspaper carriers a one-year extension to comply with AB 5 – including with respect to their newspaper delivery people.
A high-profile industry that did not receive an exemption from the ABC test is the gig economy. As a result, AB 5 has been dubbed the killer of the gig economy. Uber, Lyft, and several other gig companies have publicly stated that they are committed to spending millions of dollars on coming up with a third option for gig companies.
Unfortunately, even with the legislation now in place, there are a number of questions still remaining, including how each of the exemptions will be applied, and whether AB 5 applies retroactively. The bill states that it shall apply “retroactively to existing claims and actions to the maximum extent permitted by law while other provisions apply to work performed on or after January 1, 2020.” This language is unclear. The question of whether the Dynamex decision applies retroactively has recently been certified to the California Supreme Court in Vazquez v. Jan-Pro Franchising Int’l.
Part 2: AB 5 Employees – Are They Entitled to Employee Benefits?
As employers sort through whether workers they previously treated as independent contractors are employees under AB 5, they should also consider whether AB 5 employees are entitled to employee benefits. The short answer is “it depends.”
ERISA and the Code - Common Law Employee Tests
Most employee benefit plans, such as Section 401(k) pension plans and health and welfare plans, are governed by the Internal Revenue Code (the “Code”) and the Employee Retirement Income Security Act of 1974 (“ERISA”). ERISA and the Code have their own tests for determining whether workers are employees. Accordingly, as employers reclassify workers as AB 5 employees, they should also consider whether they are employees under ERISA and the Code.
- ERISA - Under ERISA employees are identified using a multi-factor common-law test that was laid out by the Supreme Court in Nationwide Mutual Insurance Co. et al. v. Darden, 503 U.S. 318 (1992). Under Darden, the primary consideration is “the hiring party’s right to control the manner and means by which the work product is accomplished” and the following factors are considered: (1) the skill required; (2) the source of the instrumentalities and tools; (3) the location of the work; (4) the duration of the relationship between the parties; (5) whether the hiring party has the right to assign additional projects to the hired party; (6) the extent of the hired party’s discretion over when and how long to work; (7) the method of payment; (8) the hired party’s role in hiring and paying assistants; (9) whether the work is part of the regular business of the hiring party; (10) whether the hiring party is in business; (11) the provision of employee benefits; and (12) the tax treatment of the hired party.
- The Code - The Internal Revenue Service (“IRS”) and the United States Tax Court also identify employees using multi-factor common-law tests. The IRS and the Tax Court use different tests, but ultimately ask the same question: does the hiring entity have the right to control and direct the worker, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished? Straying from the 20-factor test established in Rev. Rul. 87-41, the IRS now organizes the factors to be considered into three categories: (1) behavioral control; (2) financial control; and (3) type of relationship. These factors are explained in more detail in IRS Publication 15-A.
If an employer concludes that AB 5 employees are also “employees” under ERISA and the Code, the employer next needs to decide whether to offer employee benefits to these employees. In making this decision, employers must consider whether their employee benefit plans will be able to pass applicable nondiscrimination testing if these employees are excluded. In addition, not offering qualifying health plan coverage to these employees could trigger significant penalties under Code Section 4980H for large employers. For more information on the Section 4980H penalties see our Health Care Reform’s Employer Shared Responsibility Penalties: A Checklist for Employers.
On the flip side, employers must be careful to not allow workers who are properly classified as independent contractors to participate in their employee benefit plans. Employee benefits, as the name implies, are for employees. Covering independent contractors under an employee benefit plan can create other problems. For example, covering independent contractors under a health plan will cause the plan to become a multiple employer welfare arrangement (“MEWA”). MEWAs are heavily regulated and in some states, such as California, MEWAs are illegal.
Employers should also consider if any employee benefits they offer are not subject to ERISA and the Code. For example, some employers structure short-term disability plans as payroll practices, which are exempt from ERISA. In such an instance, a state law definition of employee might apply.
Plan Documents and Employee Communications
After an employer decides whether to offer employee benefits to AB 5 employees, it should review all employee benefit plan eligibility provisions to confirm they are consistent with the employer’s intent. Plan documents, summary plan descriptions, employee handbooks, and independent contractor agreements may need to be amended. Employers should also be careful when communicating with AB 5 employees to make sure they understand for what purposes they are employees and for what purposes they are not.
The remedies for misclassifying a worker as an independent contractor include back wages, meal break penalties, rest break penalties, wage statement penalties, other steep penalties, and criminal prosecution, among others. Accordingly, now is the time for companies to consider their workforce and analyze whether their currently classified independent contractors will pass this new test under AB 5 and if they don’t, take proactive steps to re-classify them as employees at least for purposes of wage and hour requirements, unemployment insurance, and workers’ compensation. In addition, employers should evaluate whether these individuals may now be entitled to employee benefits.
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