Employee or Independent Contractor? The ABC Test Explained for California Business Owners

Giving someone a 1099 and calling them an independent contractor isn’t enough in California. Courts look beyond the labels and use a three-prong test to determine the true worker/employer relationship. For employers, this is crucial information because it's different from the more flexible tests that the IRS and other states use. Not knowing or understanding the distinction can result in your business ending up in hot water. If you have 1099 workers in California, it’s time to reevaluate your worker classifications under the California ABC test for independent contractors to ensure your business complies with California laws.

Key Takeaways

• There’s a presumption that workers are employees unless the business can prove it satisfies the California ABC test for independent contractors.
• The ABC test is a three-part test, where the worker: is free from control, works outside the usual course of business, and is customarily engaged in an independently established trade.
• The test originated from Dynamex Operations West, Inc. v. Superior Court.
• Certain professions and industries are exempt from the ABC test but may be required to meet alternative tests.
• Misclassification can bring heavy penalties and exposure to representative and class action liability.

The Default Classification in California Is Employee

It’s not up to the worker to prove that they are an employee. It’s up to the business to prove that they classified the worker correctly as an independent contractor. To do that, the employer has to show that all three prongs of the California ABC Test for independent contractors are satisfied. That test stems from a California Supreme Court ruling in Dynamex Operations West, Inc. v. Superior Court. Having a signed independent contractor agreement isn’t enough to establish the worker’s status. In California, a worker’s automatic default classification status is employee under Labor Code 2775(b)(1).

Being able to prove the worker’s status is crucial for the business because it impacts significantly more than just one area. The worker’s classification can impact how the business operates under California’s Labor Code, the Unemployment Insurance Code, the tax code, and wage compliance. The worker's classification directly impacts the statutes that the business must comply with when calculating the worker’s wages, overtime, meal and rest breaks, final pay, and payroll taxes.

The Three Prongs of the California ABC Test for Independent Contractors

For a business facing a worker misclassification accusation, the place to start is with the three-prong California ABC test for independent contractors. As the party with the burden of proof, employers must gather evidence to support why their classification is correct. All three prongs must be proven under Cal. Lab. Code § 2775(b)(1), or the business fails the test.

The prongs are as follows:

• Prong A: The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
• Prong B: The worker performs work that is outside the usual course of the hiring entity’s business; and
• Prong C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

For prong A, the business needs to show that the worker is not under its control and direction. This applies to both the contract between the parties and how they function day-to-day. This is why an independent contractor agreement alone isn’t enough. It’s common for the paperwork to matter less than how the relationship actually functions.

To satisfy prong B, the hired worker needs to be performing tasks that are outside of the business’ normal course. This is the prong where employers often fail. For example, a bakery hires an electrician to repair the lighting in their storefront. The electrician is performing work that is outside of the bakery’s normal course of business. However, the situation changes if the bakery hires a wedding cake decorator as an independent contractor. The decorator may be performing the same function as an on-site employee who decorates the other desserts. Both people are performing similar functions, placing the independent contractor’s role within the bakery’s normal course of business.

Under prong C, the court looks at the worker's actions as a stand-alone entity. The business must show that the worker operates and presents themselves as an independent, hireable entity. The worker would need to have operated as an independent business with actions that could include public advertising of their services, working with other clients, licensing, insurance or business incorporation. Under this test, it isn’t enough for the hiring business to label the individual as an independent contractor.

Why the Second Prong Trips Up Most Small Business Owners

A California business will generally have trouble satisfying prong B when the contractor performs work that falls within the company's usual course of business, even if the contractor works independently and has other clients. The business could genuinely not control the worker, and the worker may run their own business, but if that work is similar to the hiring entity’s work, the test may be failed.

When the Exemptions Apply, and Why They Rarely Rescue the Average Small Business

Only certain types of professions qualify for exemption from the California ABC test for independent contractors. A business shouldn’t assume they are exempt. California narrowly defines the exemptions under Labor Code 2776 through 2784. There are often additional requirements to qualify under an exemption. For example, in addition to being a qualifying exempt profession, the contractor must have their own business license, set their own rates, and show other evidence supporting independent contractor status. This makes qualifying for an exemption challenging for California businesses.

Exempt professions include business-to-business contracting relationships, referral agencies, and certain professional services. The list is extensive and includes lawyers, architects, landscape architects, engineers, private investigators, and accountants, among the categories covered, alongside several creative and consulting professions.

Business-to-business exempt relationships must also pass the test outlined in Labor Code 2776. Relationships that qualify under these exemptions are still evaluated under the older Borello test. Under this test, the court takes a holistic approach to its determination. It asks if the hiring business has a right to control and how it controls the worker performing their duties. Then, the court looks at other factors, such as the skill required, who supplied the equipment and workplace, length of employment, and payment structure.

It’s also a common misconception that just because a business qualifies for an exemption, the contractor is automatically classified as an independent contractor. This determination only happens after the 12-factor Borello test from S.G. Borello & Sons, Inc. v. Department of Industrial Relations is applied and passed.

What Getting It Wrong Costs a Business

The consequences for intentionally misclassifying workers in California can compound quickly. Companies can face civil penalties and claims from employees owed damages. A company could face lawsuit claims, including representative actions under PAGA or class actions. Former and current employees could seek back wages, unpaid overtime, and meal and rest break premiums. Employers may also be required to pay outstanding payroll taxes and workers’ compensation.

A company could end up facing multiple legal issues from several state agencies. California’s Employment Development Department, the Labor Commissioner, and the Franchise Tax Board can all seek their own misclassification claim.

Under California’s Labor Code 226.8, penalties can range from $5,000 to $15,000 per violation. The fines increase to $10,000 to $25,000 per violation when there’s a pattern or practice of misclassification.

Work With a California Employment Attorney Before You Classify a Worker

Worker classification isn’t about the contract the parties signed. It’s about addressing the three-prong California ABC test for independent contractors. It’s the employer’s responsibility to prove it has passed the test and show that the worker is truly an independent contractor. Getting it wrong and failing the test can result in harsh consequences for the employer.

At JDS Law, Inc., we assist California employers with their employment needs. Our experienced legal team can assist with reviewing existing relationships, properly structuring future relationships, and addressing claims of incorrect classification. Schedule a meeting with a California attorney to discuss your hiring needs.