California Worker Classification & AB 5: The ABC Test Explained

Getting worker classification wrong in California is not a minor payroll error. It is one of the most expensive compliance failures an employer can make. A single misclassified worker can trigger liability across multiple agencies — the DLSE for unpaid wages and overtime, the EDD for unpaid payroll taxes and SDI contributions, the IRS for unpaid federal employment taxes, and potentially OSHA for failing to cover the worker under your Injury and Illness Prevention Program.

When the misclassification is willful, the penalties compound dramatically. Labor Code § 226.8 imposes penalties of $5,000 to $15,000 per violation for initial offenses and $10,000 to $25,000 per violation for subsequent offenses, plus the employer must pay the misclassified individual's attorneys' fees. A "violation" is per worker, so misclassifying 10 workers creates 10 separate violations.

Beyond statutory penalties, the employer owes back wages (including overtime, meal and rest break premiums, and minimum wage differentials), payroll tax liability with interest and penalties, unemployment insurance contributions, workers' compensation insurance premiums, and expense reimbursements under Labor Code § 2802. The aggregate exposure from misclassifying a small team of workers for even one year can easily reach six figures.

Prior to 2020, California used the multi-factor "Borello" test (S.G. Borello & Sons, Inc. v. Department of Industrial Relations, 1989) to distinguish employees from independent contractors. The Borello test examined the "totality of circumstances," weighing factors such as:

• The right to control the manner and means of accomplishing the work
• Whether the worker is engaged in a distinct occupation or business
• Whether the work is usually done under the direction of the principal or by a specialist without supervision
• The skill required in the particular occupation
• Whether the principal or the worker supplies the tools and place of work
• The length of time the services are performed
• The method of payment (by time vs. by the job)
• Whether the work is part of the regular business of the principal
• Whether the parties believe they are creating an employer-employee relationship

The Borello test was similar in structure to the IRS's common law test and the tests used in most other states. It was flexible, fact-intensive, and — critically — somewhat unpredictable. Employers could structure arrangements to satisfy some factors while failing others, and courts weighed the factors differently depending on the industry and context.

On April 30, 2018, the California Supreme Court decided Dynamex Operations West, Inc. v. Superior Court of Los Angeles County (4 Cal.5th 903). The case involved delivery drivers for a nationwide same-day courier company that had reclassified its drivers from employees to independent contractors.

The court adopted the ABC test for determining worker classification under California's wage orders. The ABC test fundamentally shifted the burden of proof: instead of the worker proving they were an employee, the hiring entity must prove the worker is an independent contractor by satisfying all three prongs.

Under the ABC test, a worker is presumed to be an employee unless the hiring entity proves all three of the following:

### Prong A — Free from Control and Direction

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.

• The hiring entity does not dictate when, where, or how the work is performed
• The worker sets their own schedule
• The worker decides the methods and means of accomplishing the result
• The hiring entity does not provide detailed instructions, training on how to do the job, or tools and equipment
• The worker is not subject to performance reviews in the manner of an employee

Key distinction: It is permissible to specify the deliverable, the deadline, and the quality standard. It is not permissible to control the process by which the worker achieves that deliverable.

Important: The analysis looks at both the contract and actual practice. A contract that says the worker is "free from control" is meaningless if the hiring entity actually directs their daily activities.

### Prong B — Outside the Usual Course of Business

The worker performs work that is outside the usual course of the hiring entity's business.

This is the prong that creates the most difficulty for many businesses. The question is whether the work the contractor performs is the same type of work that the hiring entity's employees perform or that is central to the hiring entity's business.

• A software company hiring freelance software developers
• A trucking company hiring independent truck drivers
• A marketing agency hiring freelance copywriters
• A restaurant hiring freelance line cooks
• A law firm hiring contract attorneys to do legal work

• A software company hiring an electrician to rewire the office
• A trucking company hiring a graphic designer to create a new logo
• A restaurant hiring a plumber to fix a leak
• A law firm hiring an IT consultant to migrate their servers

The test asks whether the service provided is a regular, integrated part of the hiring entity's business or an ancillary service that any type of business might need.

### Prong C — Independently Established Trade

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.

• Has their own business entity (LLC, sole proprietorship, corporation)
• Markets their services to multiple clients
• Has a business license, professional website, or other indicia of an independent business
• Has other clients besides the hiring entity (or is actively seeking them)
• Maintains their own tools, equipment, and workspace
• Has made an investment in their business

What fails Prong C: A worker who has no other clients, formed an LLC solely at the hiring entity's request, and performs services exclusively for one company. The "independently established" requirement means the business must be genuine and pre-existing, not a formality created to facilitate misclassification.

In September 2019, the California legislature passed Assembly Bill 5 (AB 5), which codified the Dynamex ABC test into statute effective January 1, 2020. AB 5 amended the Labor Code and the Unemployment Insurance Code to establish the ABC test as the default standard for determining worker status.

AB 5 is codified primarily in Labor Code § 2775 et seq.

### What AB 5 Changed Beyond Dynamex

AB 5 did more than simply codify the Supreme Court's decision:

1. Expanded scope: Dynamex applied to claims under IWC wage orders (minimum wage, overtime, meal/rest breaks). AB 5 extended the ABC test to the entire Labor Code, the Unemployment Insurance Code, and workers' compensation.

1. Created exemptions: AB 5 identified specific occupations and business relationships that would continue to be evaluated under the older Borello test rather than the ABC test (discussed below).

1. Provided enforcement mechanisms: AB 5 authorized the Attorney General and city attorneys of cities with populations exceeding 750,000 to seek injunctive relief against companies engaged in misclassification, without needing to wait for individual worker complaints.

Almost immediately after AB 5 took effect, the legislature began carving out exemptions for specific professions and business relationships that struggled under the ABC test. AB 2257, passed in September 2020, consolidated and expanded these exemptions.

### Professions Exempt from the ABC Test (Borello Test Applies Instead)

The following occupations are evaluated under the multi-factor Borello test rather than the ABC test, provided certain conditions are met (typically: the worker sets their own rates, maintains a business location, has the ability to serve multiple clients, and holds applicable professional licenses):

• Licensed professionals: Insurance agents, physicians/surgeons, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, private investigators, accountants
• Financial services: Securities broker-dealers, investment advisors, direct sales salespersons
• Creative professionals: Fine artists, enrolled agents, freelance writers/editors/photographers/newspaper cartoonists (subject to a 35-submission cap per client per year — removed by AB 2257 for some categories)
• Professional services: Marketing, human resources administrators, travel agents, graphic designers, grant writers, specialized performers (subject to meeting specific criteria in Labor Code § 2778)
• Business-to-business relationships: Where both the hiring entity and the service provider are bona fide businesses with separate business locations, separate clienteles, and the service provider has the ability to set rates and negotiate terms (Labor Code § 2776)

### Conditions for the B2B Exemption

The business-to-business exemption (Labor Code § 2776) is frequently invoked but has 12 specific requirements that must all be met:

1. The business service provider is free from control and direction
2. The business service provider is providing services directly to the contracting business rather than to customers of the contracting business
3. The contract is in writing and specifies the payment rate
4. If the work is performed in a jurisdiction requiring a business license, the business service provider has the required license
5. The business service provider maintains a business location separate from the contracting business
6. The business service provider is customarily engaged in an independently established business of the same nature
7. The business service provider can contract with other businesses
8. The business service provider advertises and holds itself out to the public as available to provide the same type of services
9. The business service provider provides its own tools and supplies
10. The business service provider can negotiate its own rates
11. Consistent with the nature of the work, the business service provider can set its own hours and location
12. The business service provider is not performing the type of work for which a license from the Contractor's State License Board is required

Every single condition must be met. Failing any one reverts the relationship to the ABC test.

In November 2020, California voters passed Proposition 22 by a 58.6% margin. Proposition 22 exempted app-based transportation (rideshare) and delivery companies from AB 5, allowing their drivers to continue as independent contractors with certain guaranteed benefits:

• Earnings guarantee: 120% of the local minimum wage for engaged time (time between accepting a ride/delivery and completing it — not total time logged into the app)
• Healthcare subsidy: For drivers averaging 25+ hours of engaged time per week, the company pays a healthcare stipend equal to 82% of the average ACA Marketplace premium; for 15-25 hours, 41%
• Vehicle insurance and accident coverage paid by the company during engaged time
• Anti-discrimination and sexual harassment protections
• Rest policy: After 12 hours of driving, the app must enforce a 6-hour rest period

Legal status: In 2021, a Superior Court judge ruled Prop 22 unconstitutional, but the California Court of Appeal reversed that ruling in 2023, upholding the initiative. The case reached the California Supreme Court, which largely upheld Prop 22 in 2024 while striking a narrow provision that limited the legislature's ability to allow drivers to collectively bargain.

Scope of Prop 22: It applies only to app-based rideshare and delivery platforms. It does not apply to other gig economy platforms, traditional delivery companies, or any other industry.

Many employers accustomed to using the IRS common law test for worker classification are surprised by how different the California ABC test is.

### IRS Common Law Test (20 Factors, 3 Categories)

The IRS evaluates classification based on three categories of evidence:

1. Behavioral control: Does the company control how the worker does the job? (instructions, training, evaluation)
2. Financial control: Does the company control the business aspects? (investment, expenses, opportunity for profit/loss, payment method, availability to open market)
3. Relationship type: What are the terms? (contracts, benefits, permanency, key services)

No single factor is determinative. The IRS weighs the totality of the relationship.

### Key Differences

Practical consequence: A worker who would clearly be an independent contractor under the IRS test may be an employee under the California ABC test. The most common failure point is Prong B — many businesses hire contractors to do work that is central to the company's operations, which satisfies the IRS test but fails the ABC test.

The EDD conducts payroll tax audits that frequently scrutinize worker classification. Understanding how these audits work is essential for any employer using independent contractors in California.

### Audit Triggers

• Unemployment claim: A worker you classified as an independent contractor files for unemployment benefits. The EDD investigates whether they should have been covered.
• Random selection: The EDD conducts routine audits of businesses, particularly in industries known for misclassification (construction, trucking, janitorial services, home healthcare).
• Referral from another agency: The DLSE, CRD, or IRS may refer cases to the EDD.
• Employee complaint: A current or former worker files a complaint with the EDD alleging they were improperly classified.

### The Audit Process

1. Notice: The EDD sends a letter requesting an appointment and specific documents (payroll records, 1099s, contracts with independent contractors, business records).
2. Initial review: The auditor reviews your records and selects specific workers or categories of workers to examine.
3. Interviews: The auditor may interview the workers in question to determine the actual nature of the relationship.
4. Determination: The auditor issues a determination for each worker or category of workers: employee or independent contractor.
5. Assessment: If workers are reclassified as employees, the EDD assesses back taxes, interest, and penalties for the audit period (typically 3 years).

### Potential Assessments

• Unemployment Insurance (UI) taxes: Employer rate (1.5%-6.2%) on the first $7,000 per worker per year
• Employment Training Tax (ETT): 0.1% on the first $7,000 per worker per year
• State Disability Insurance (SDI): Employee-side contribution that the employer should have withheld (1.1% with no wage cap)
• Personal Income Tax (PIT) withholding: If applicable, the employer may owe the amounts that should have been withheld
• Penalties: 15% penalty for late payment (Unemployment Insurance Code § 1112.5), plus 10% assessment penalty, plus interest
• Revenue and Taxation Code § 19178: If the employer paid the worker $600+ without filing the required information return, additional penalties apply

Beyond the EDD audit consequences, willful misclassification carries additional statutory penalties:

• Per violation (per worker): $5,000 - $15,000 for each initial violation; $10,000 - $25,000 for each subsequent violation
• Pattern or practice: If the LWDA or a court finds a "pattern or practice" of misclassification, penalties increase to $15,000 - $25,000 per violation
• Required posting: An employer found to have willfully misclassified workers must post a notice of the violation in a prominent place at the worksite for one year
• Contractor's State License Board: For licensed contractors, misclassification can result in license suspension or revocation

"Willful" means voluntary and intentional. It does not require proof that the employer knew they were violating the law — only that the misclassification was not accidental. If you chose to classify a worker as an independent contractor when the facts did not support it, that is willful.

California recognizes joint employer doctrine, meaning that staffing agencies, client companies, and subcontractors may all share liability for misclassification and wage-and-hour violations.

Under Labor Code § 2810.3, a client employer that obtains workers from a labor contractor (staffing agency) shares all civil legal responsibility and civil liability for the workers with the labor contractor. This includes:

• Payment of wages
• Compliance with health and safety requirements
• Workers' compensation coverage
• Proper classification

Practical consequence: You cannot outsource liability by using a staffing agency. If the staffing agency misclassifies workers, you are jointly liable.

### Step 1: Audit Your Current Contractor Relationships

Review every current independent contractor relationship using the ABC test framework. For each contractor, ask:

• Prong A: Do we control when, where, or how they work? Do we provide tools, equipment, or training? Do we set their schedule?
• Prong B: Is the work they perform the same type of work our employees do, or central to our business operations?
• Prong C: Do they have their own established business? Other clients? Their own tools and workspace? A business license? A website or marketing materials?

If you cannot clearly satisfy all three prongs, the worker should be classified as an employee.

### Step 2: Check Whether an Exemption Applies

If the ABC test is problematic, determine whether the specific worker or relationship qualifies for one of the Borello-test exemptions under AB 2257. Review:

• Does the worker hold a license in one of the exempt professions?
• Does the relationship qualify under the B2B exemption (all 12 requirements)?
• Does any other specific exemption apply to this industry or occupation?

### Step 3: Document the Basis for Classification

For every independent contractor, maintain a written file that includes:

• A written independent contractor agreement that accurately reflects the actual relationship
• Documentation of the contractor's independent business (license, EIN, website, other clients)
• Evidence that the contractor controls the manner and means of performing the work
• Analysis of which prong(s) of the ABC test or Borello test support the classification
• Periodic review notes (at least annually) confirming the relationship has not changed

### Step 4: Structure the Relationship Correctly

If you need to engage an independent contractor, structure the relationship to genuinely satisfy the test:

• Do not set the contractor's schedule or require them to work from your location
• Do not provide tools, equipment, or branded materials (let them use their own)
• Pay by project or deliverable, not by the hour
• Do not provide training on how to perform the work (specifications for the deliverable are acceptable)
• Do not require exclusivity — they must be free to work for competitors
• Do not integrate them into your team (no company email, no inclusion in org charts, no employee meetings)

### Step 5: Monitor for "Drift"

Contractor relationships often start correctly and drift toward employment over time. A contractor who begins working full-time at your office, attending your meetings, using your equipment, and serving no other clients has effectively become an employee regardless of what the contract says.

Conduct at least an annual review of every contractor relationship. If the relationship has drifted, either reclassify the worker or restructure the engagement.

1. Pull your complete list of 1099 contractors. For each one, write down in one sentence the work they perform. Then ask: is that work the same type of work my employees do, or is it central to what my company does? If the answer is yes for any contractor, that relationship likely fails Prong B of the ABC test and needs immediate attention — either reclassification or a documented exemption analysis.

1. Review your independent contractor agreements. Ensure each agreement explicitly states that the contractor controls the manner and means of performing the work, is not required to work set hours or at a set location, provides their own tools and equipment, and is free to work for other clients including competitors. If your agreements do not say these things — or worse, if they say the opposite — update them immediately. But remember: the contract must reflect reality, not just aspirations.

1. Check whether you have any contractors who work exclusively for your company. Exclusive or near-exclusive arrangements are the strongest indicator of misclassification. A contractor with no other clients will struggle to satisfy Prong C. If you have contractors in this position, begin planning either to reclassify them or to ensure they develop an independent client base.

1. Create a classification decision tree for your hiring managers. Before any manager engages a new contractor, they should answer three questions: (1) Will we control how the work is done? (2) Is this work central to our business? (3) Does this person have their own independent business? If the answer to any question points toward employment, engage the person as an employee.

1. If you have never been audited by the EDD, prepare as if an audit were coming next month. Assemble your contractor files: agreements, invoices, evidence of independent businesses, classification analyses. If you cannot produce this documentation on request, you are unprepared for an audit that could arrive at any time.