In May, the California State Assembly overwhelmingly passed a bill set to have a major impact on how companies classify their workers in the state. Assembly Bill 5 (AB 5) aims to codify the new standard expounded by Dynamex Operations West, Inc. v. Superior Court of Los Angeles for determining whether workers regulated by the 17 Wage Orders in California are employees or independent contractors.

Proponents of AB 5 see it as a means to address inadequate workplace protections and loss of revenue due to underpaid payroll taxes, workers’ compensation premiums, state unemployment, and disability insurance. Critics, however, argue that the bill harms workers’ schedule flexibility and opportunities for supplemental income.

AB 5 must still pass the State Senate and be signed by the governor. But if AB 5 becomes law, certain industries where independent contractors are prevalent may face increased labor costs, as many of those workers require reclassification to employee status and obtain all the benefits and protections of employee status triggered under state law.

Origins of AB 5

The Dynamex case arose when a nationwide courier and delivery company reclassified its drivers from employees to independent contractors in 2004. The drivers brought a class action lawsuit alleging they had been misclassified, given that they performed essentially the same tasks in the same manner as when they were employees.

On April 30, 2018, the California Supreme Court issued its monumental ruling in the Dynamex case in favor of a new legal standard under state law for classifying workers regulated by wage orders. The decision marked a dramatic departure from the prior test governing worker classification. For several decades, California courts used the Borello test to determine whether a worker was an employee or an independent contractor. The Borello test was a facts-and-circumstances test that used multiple factors but placed particular emphasis on the factor of “whether the person to whom services is rendered has the right to control the manner and means of accomplishing the result desired.” The Borello test is more flexible and easier to establish independent contractor status under.

The Dynamex Court rejected the Borello test and adopted a new standard dubbed the “ABC” test. Under the ABC test, a worker is an independent contractor only if:

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

The court explained that the first prong aligns with the common law test for employment, evaluating the degree of control exercised by the company over the worker. The second prong examines whether the worker can reasonably be viewed as working in the hiring company’s business. Lastly, the court provides that the third prong inquires whether the worker independently made the decision to go into business. The fact that the hiring company does not prohibit the worker’s engagement in such an independent business is not sufficient.

Impact of AB 5 on companies

The California Legislature introduced AB 5 to codify the ABC test set forth in the Dynamex holding and proposes additional parameters to specify to whom and when the ABC test applies.

In its current form, AB 5 exempts several professions including licensed insurance brokers, licensed physicians and surgeons, registered securities broker-dealers or investment advisers, direct salespersons (if compensation is based on actual sale), real estate licensees, hairstyling and barbering (if the worker is free from direction or control from the contracting entity), and professional service providers working under a contract with another business entity. In such cases, the original worker classification test described in Borello will continue to govern.

In addition to codifying Dynamex, the bill provides that for purposes of the Labor Code, the Unemployment Insurance Code, and the Industrial Welfare Commission’s (“IWC’) Wage Orders, where definition for employee is not provided, the ABC test shall apply. For example, the ABC test will be used to determine whether workers in certain industries are considered employees for purposes of unemployment insurance, overtime pay, such as administrative, executive, or professional workers that are currently exempt from the IWC Wage Orders As a result, the bill may increase liability for employers engaging workers newly determined to be employees.

If signed into law in its current form, AB 5 carries sweeping consequences for certain industries that engage a significant independent contractor workforce. Particularly the technology industry that has facilitated the growth of the gig economy. Recent cues from the National Labor Relations Board and the Department of Labor signal how worker classification for virtual marketplace companies might be determined on a federal level. Applying tests similar to Borello, both agencies determined workers in this space to be independent contractors. Under Dynamex, the standard AB 5 seeks to apply, these same workers may be classified as employees. This could unravel the gig economy for a growing percentage of California’s workforce.

What companies should consider

The California State Assembly passed AB 5. The bill passed through the California Senate’s Labor, Public Employment and Retirement Committee last month and is expected to undergo more revisions in the Senate Appropriations Committee before coming to a full vote in the Senate. If passed, it could land on Governor Newsom’s desk in September.

If the AB 5 is passed and signed into law, employers will likely have a window of time to work towards compliance. Some best practices to consider would include:

Performing a worker classification audit with the assistance of legal counsel, including review of all contracts with personnel.
Determine which benefits and protections should now be provided to the reclassified workers. For example, must the company’s retirement plan, health insurance and other benefits be extended to the reclassified employees.
Determine whether any actions must be taken to notify or correction prior misclassification with any state agency.
Assess whether worker classification under state law conflicts with, or requires changes to, the company’s responsibilities under federal law. For example, will the reclassification require the company to perform federal income tax withholding, FICA payment and withholding.
Review of messaging used to workers versus employees.

Even if AB 5 is not passed and adopted, employers should determine whether their current worker classification determinations comply with applicable state and federal law. Given the potential impact of the proposed law, companies are well-advised to monitor the evolution of AB 5 in consultation with legal counsel.

By Nancy Hilu, Raymond Lynch, Jennifer Yazdi, and Nancy Dollar of Hanson Bridgett.

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What employers should know about California's proposed worker classification bill

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