How To Tell If You Have An Employee Or Independent Contractor

Doing business is a complicated and sometimes grueling process that often involves juggling multiple responsibilities to employees’ clients, vendors, and governments. Some entrepreneurs, like me, enjoy the juggling act; others have come to despise it. Well, if you are an employer in the State of California as of January 1, 2020, the government was kind enough to throw another ball into our juggling act. It is commonly referred to as AB5, which is an amendment to the labor code.

What is AB5?

Up to this point, many of us have been working around the high costs of employment and workman’s compensation requirements found in the California labor code by contracting individuals as a 1099 sub-contractor. We have them sign a contract and jump through other formalities and try to legalize the relationship. AB5 changes everything. This new law outlines very specifically who is and who is not acceptable to be contracted as a sub-contractor, as well as who needs to be put on your payroll.

Recently, I attended a workshop provided by the Better Business Bureau and the Employment Development Department. I wanted to write this article to share my notes and give a basic overview of how this new way of doing business breaks down. With that in mind, let’s remember I’m not a lawyer, and advise that you don’t consider this article as legal advice. In fact, if you think you might need to make adjustments to the way you do business, I would recommend you seek legal counsel. Ok let’s dig in, because this is going to get deep really quick.

To start off with, there are two tests to determine if an individual should be classified as W-2 or 1099. We have the “ABC Test”, and the “Borrello Test”. For the ease of the conversation let’s change the names a little. Let’s call the ABC Test, Test 1. Then we’ll get really original and call the Borrello Test, Test 2.  Whether it’s Test 1 or Test 2, the test has to be passed to make them 1099.

So which test do we use and when?

Great question, glad you asked.

Before you go there let’s lay the foundation of what is defined as an employee and independent contractor.

An employee is:

An individual who performs services, or labor, is presumed to be an employee unless the hiring entity can prove the worker meets all three prongs of the ABC Test. 

An independent contractor is:

An individual for whom the hiring entity established all three prongs of the ABC test.

Well that clears things up right? I didn’t think so either.

Test 1

By default, we use Test 1. This test is broken down into three prongs: Prong A, Prong B, and (you guessed it) Prong C. Get it? A.B.C Test. It is apparent that the authors put a lot of effort into the titles within the law. Going through this reminds me of watching Indiana Jones and the Holy Grail, where he has to pass three test before he can actually find the treasure he is looking for.

Prong A:

“The individual 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.”

Does your worker have to perform their labor when you tell them to, and at your direction? Do you tell them when to show up? Do you have a specific way you want them to complete the job? Do they choose when they want to go home? If you answered, “Yes” to any of these questions you have failed the first test and your quest is now dead. You have yourself and employee. However, if you said “No” to all of them, you’ve passed and can move onto the next prong.

Prong B:

“The individual performs work that is outside the usual course of business.”

Is what you are hiring them to do part of your product offerings and how your business generates revenue? For example, if you are a tailor and you hire a seamstress to sew for you. Your “usual course of business” will consist of sewing services, and therefore your seamstress will fail this test, and your journey has ended. If you have a big tailoring operation and have machines constantly breaking down and need to get a regular guy that can fix sewing machines, this is not revenue-generating and will pass this test. Of course, it probably will also pass one of the exemptions we talk about later, but I digress, let’s move on.

Prong C:

“The individual is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.”

Are they truly independent? Does the person you are looking to hire do the same work for other businesses? Do they market their services to the public? Did they set up a company with things like, business license, insurance, commercial phone lines, etc.? If not, you have lost the final challenge. This is an individual who has independently and previously made a decision to go into business for themselves.

To simplify all this, all three prong tests must be passed. If you do, you get to enjoy the treasure of in good conscience determining the individual is an independent contractor.

Pretty cut and dry right? Well why have everything be so simple? Let’s add a level of redundancy and complication to this. Let’s add seven different categories of exceptions and a completely different test to really confuse things. Yup…they really did that.

Test 2

The seven categories are:

1. Specific occupations (e.g. Insurance Agents, Physician, Dentist, Podiatrist, Psychologist, Veterinarian, Lawyers, Architects, Engineer, Private Investigator, Accountant, Financial Services Provider, Direct Sales, Commercial Fisherman)
2. Contract Professional services (e.g. Marketing Services, Human Resources Administrator, Travel Agent Services, Graphic Designers, etc…)
3. Real Estate and Repossession Agencies
4. Business to Business Contracting (This is where our sewing machine repair guy might fit in)
5. Construction Industry
6. Referral Agencies
7. Motor Clubs

If one of the exceptions applies to your individual, then we can run Test 2. It is a multi-factor test that requires consideration of all relative facts. Facts like, what is the purpose you are hiring them for? And who maintains control of the relationship? Who controls their service fees? If it appears that the contractor doesn’t maintain the control, you probably have an employee in the eyes of the state.

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Overall, I share the opinion of Robert Fried, a partner with Atkinson, Andelson, Loya, Ruud & Romo, and wrote as a friend of the court brief in the Supreme Court case on the subject of independent work. He also has been involved in the AB5 process and in current amendment efforts. When I asked him, he replied, “The California Legislature needs to start over, re-establish the Industrial Welfare Commission and develop industry wage and hour rules with protection for gig workers and the economic realities of the transforming workforce.” Whatever we do as a state, this ultimately must be replaced with something that provides fairness to gig workers, and also the organizations that give the gig worker its opportunity.

To summarize, with this law in the current state that it exists, it comes down to this. They are employees unless they are not. Keep in mind, the burden is on you to prove they are not. It is my hope and intention to give you some broad knowledge and scope of your new guidelines. I hope I met this expectation.

This article originally published on GREY Journal.