California Assembly Bill 5 (AB-5) is the new standard by which employers must classify employees. AB-5 took effect on January 1, 2020. Small business owners (SBOs) should familiarize themselves with AB-5 and the ABC test to avoid employee misclassification and potential penalties from the Internal Revenue Service (IRS).
If you’ve been targeted for an Employment Development Department (EDD) audit, there are steps you should take immediately to protect yourself and ensure your company’s workers are correctly classified. It is essential EDD understands your company’s unique facts and correctly analyzes the legal factors used to confirm their independent contractor status.
How Does EDD Classify Independent Contractors?
AB-5 introduced the ABC test as a stricter guideline to determine how to classify a worker as a 1099 independent contractor. The worker must meet all three criteria of the ABC test in order to be classified as a 1099 independent contractor instead of a W-2 employee.
- The worker is free from the control and direction of the hiring entity in connection to the performance of the work.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
If the contractor misses even one of the criteria in the ABC test, he or she is automatically classified as a W-2 employee.
Learn more about how this law came into effect, and how Dyanmex ruined it for everyone, here.
How Do I Avoid Misclassification?
You can avoid misclassification by carefully analyzing the arrangement you have with your worker in relation to the guidelines described in the ABC test and regulations set forth by AB-5.
Employers may also use the Borello Test as a resource in determining if their employees are correctly classified.
What is the Borello Test?
Before AB-5 was signed into law, the Borello test was used to determine if an employee should be classified as a 1099 independent contractor or a W-2 employee. The Borello test was established by the Supreme Court in S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989). The test relies on 13 factors to determine employee classification.
Even with new AB-5 regulations, the Borello test can still be a useful resource to help classify employees.
EDD provides the full Borello test worksheet with the following questions to help guide classification:
- Do you instruct or supervise the person while he or she is working?
- Can the worker quit or be discharged (fired) at any time?
- Is the work being performed part of your regular business?
- Does the worker have a separately established business?
- Is the worker free to make business decisions that affect his or her ability to profit from the work?
- Does the individual have a substantial investment in their job which would subject him or her to the financial risk of loss?
- Do you have employees who do the same type of work?
- Do you furnish the tools, equipment, or supplies used to perform the work?
- Is the work considered unskilled or semi-skilled labor?
- Do you provide training for the worker?
- Is the worker paid a fixed salary, an hourly wage, or based on a piece-rate basis?
- Did the worker previously perform the same or similar services for you as an employee?
- Does the worker believe that he or she is an employee?
Answering “yes” to questions 1-3 would provide a strong indication that the worker is an employee. Answering “no” to questions 4-6 would indicate that a worker is not in business for themselves and would likely classify as an employee. Questions 7-13 indicate important factors to be considered.
While answering “yes” to any one of the questions may indicate that a worker should be classified as an employee, no single factor is enough to determine classification independently.
The full worksheet provided by EDD provides further clarification on certain factors and circumstances.
If completing the provided worksheet does not provide sufficient clarification for employers, EDD also offers the ability to request a written ruling by completing a seven-page form called Determination of Employment Work Status. The form supports any business entity looking to determine if a worker is an employee or an independent contractor.
What To Do If You’re Under EDD Investigation
The first step you should take when your company is under EDD investigation is to determine whether your audit is a Verification Audit or a Request Audit.
Verification Audits are not based on an assumption of wrongdoing but are random checks based on factors such as business size, size of payroll or other factors determined by EDD.
Request Audits are based upon evidence collected by CA EDD from former employees or people closely associated with your business.
Once you are aware your business is being investigated, it’s important to reach out to a qualified Tax Attorney to represent you. Crafting the narrative around the “why” and “how” of your contractors’ classification can make the difference between your case being dismissed or your company owing back payroll taxes and fines.