California AB5 Law: What Small Business Employers Need to Know
California AB5 uses the ABC test to classify workers. Learn how it affects small businesses, who is exempt, and how to reclassify contractors as employees.
California AB5 Law
How the ABC test affects worker classification and what to do if you need to reclassify a contractor
If you have workers in California who are classified as independent contractors, AB5 is the law that determines whether that classification is legal. The law applies a strict three-part test (the ABC test) that presumes every worker is an employee unless the employer can prove otherwise. For small businesses that rely on contractors for design, marketing, bookkeeping, or specialized project work, AB5 changes the calculation significantly.
This guide covers what AB5 requires, how the ABC test works, which professions are exempt, and the step-by-step process for reclassifying a contractor as a W-2 employee when AB5 requires it. The employee vs contractor guide covers the broader federal classification framework. This guide focuses specifically on California's stricter standard.
What Is AB5?
Assembly Bill 5 (AB5) is a California law that took effect on January 1, 2020. It codified the ABC test from the California Supreme Court's 2018 decision in Dynamex Operations West, Inc. v. Superior Court. Before Dynamex and AB5, California used the multi-factor Borello test (similar to the federal IRS test) to classify workers. The ABC test is significantly stricter: it presumes the worker is an employee and places the burden on the hiring entity to prove all three prongs of the test.
The California Department of Industrial Relations maintains the official FAQ on independent contractor classification under AB5. The Franchise Tax Board covers the tax implications.
The ABC Test: All Three Prongs Must Be Met
To classify a worker as an independent contractor under AB5, the hiring entity must prove all three of the following conditions. If any single prong fails, the worker is legally an employee.
| Prong | What the Employer Must Prove | Where SMBs Typically Fail |
|---|---|---|
| A: Free from control | The worker is free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work and in fact. | Setting the worker's schedule, requiring them to use specific tools or methods, dictating how (not just what) the work is done, or requiring on-site presence. |
| B: Outside usual course of business | The worker performs work that is outside the usual course of the hiring entity's business. | A marketing agency hiring a freelance marketer fails Prong B because marketing IS the agency's usual business. A restaurant hiring a freelance web designer passes Prong B because web design is not the restaurant's business. |
| 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. | The worker has no other clients, no business license, no website, no independent marketing presence. They work exclusively or primarily for one hiring entity. |
Who Is Exempt from the ABC Test
AB5 and its follow-up legislation (AB2257, passed in 2020) exempt certain professions and business relationships from the ABC test. Exempt workers are instead evaluated under the older, more flexible Borello multi-factor test. Being exempt from the ABC test does not mean the worker is automatically an independent contractor. It means the classification uses a different, less strict test.
| Exempt Category | Examples | Notes |
|---|---|---|
| Licensed professionals | Lawyers, architects, engineers, accountants, securities broker-dealers, insurance agents, real estate licensees | Must hold a professional license issued by a state regulatory body |
| Professional services (with conditions) | Graphic designers, grant writers, fine artists, payment processing agents, enrolled agents, human resources administrators, travel agents | Must meet specific conditions: maintain a business location, set own rates, have the ability to work for multiple clients |
| Business-to-business relationships | A plumbing company subcontracting to a general contractor | Must meet 12 specific criteria including: provides services to the hiring entity rather than to the hiring entity's customers, maintains a business location separate from the hiring entity |
| Proposition 22 exemptions | App-based rideshare and delivery drivers (Uber, Lyft, DoorDash, Instacart, Postmates) | Classified as independent contractors with specific benefits (minimum earnings guarantee, healthcare stipend, accident insurance) |
| Other specific exemptions | Direct sales, commercial fishermen, newspaper distributors, youth sports coaches, competition judges, data aggregation specialists | Each has specific statutory conditions that must be met |
The California EDD provides guidance on determining employment status for payroll tax purposes. If you are unsure whether a specific contractor relationship qualifies for an exemption, consult a California employment attorney before relying on the exemption.
How AB5 Affects Small Businesses with 5 to 50 Employees
| Scenario | AB5 Impact | What to Do |
|---|---|---|
| You hire a freelance graphic designer to create your website | Likely passes Prong B if your business is not a design agency. But the designer must also pass Prongs A and C (independent, has other clients). | Verify all three prongs. If the designer works exclusively for you, Prong C may fail. |
| You hire a freelance bookkeeper who comes to your office 3 days/week | Likely fails Prong A (you control the schedule and location) and possibly Prong C (if the bookkeeper has no other clients). | Reclassify as a part-time W-2 employee or use a bookkeeping firm (B2B exemption may apply). |
| You hire a contractor to do the same work as your employees | Fails Prong B. The work is within your usual course of business. | Reclassify as W-2 employee. This is the most common AB5 violation for SMBs. |
| You use a staffing agency to provide temporary workers | The staffing agency is the employer, not you. AB5 applies to the agency's relationship with the worker, not yours. | Ensure the agency is properly classifying its workers. Your risk is lower but not zero (joint employer liability is possible). |
| You hire an exempt professional (licensed CPA, attorney) | Exempt from ABC test. Use the Borello multi-factor test instead. | Document the professional license, separate business location, and other Borello factors. |
How to Reclassify a Contractor as a W-2 Employee
If AB5 requires you to reclassify an existing contractor as an employee, the process involves both administrative and relationship management steps. The contractor onboarding guide covers the initial setup for new contractors. This section covers the transition from 1099 to W-2.
At FirstHR, the onboarding workflow handles the document collection, e-signature, and employee profile creation for reclassified workers the same way it handles any new hire. The full text of AB5 is available on the California Legislature's website. The California compliance guide covers the broader state employment requirements including CFRA, CalSavers, and paid sick leave.
Penalties for Misclassification in California
| Penalty Type | Amount | Enforced By |
|---|---|---|
| Civil penalty per violation (Labor Code 226.8) | $5,000 to $15,000 per violation | Labor Commissioner (DLSE) |
| Civil penalty for willful misclassification pattern | $10,000 to $25,000 per violation | Labor Commissioner (DLSE) |
| Back wages and overtime owed | All unpaid minimum wage, overtime, meal/rest break premiums | Worker lawsuit or Labor Commissioner |
| Employer-side payroll taxes owed | Social Security (6.2%), Medicare (1.45%), FUTA, CA SUI, CA SDI for the entire misclassified period | EDD and IRS |
| Workers' compensation insurance premiums | Retroactive premiums for uninsured period plus penalties | DIR / Workers' Comp carrier |
| Attorneys' fees | If the worker prevails in a lawsuit, the employer pays the worker's attorney fees | Court |
The financial exposure for misclassifying even one contractor at a small business can easily reach $30,000 to $80,000 when back wages, employer taxes, penalties, and legal fees are combined. The workers' compensation guide covers the insurance requirements that apply once a worker is reclassified as an employee.
Frequently Asked Questions
What is AB5 in California?
AB5 (Assembly Bill 5) is a California law that took effect on January 1, 2020. It codified the ABC test established by the California Supreme Court in Dynamex Operations West v. Superior Court (2018) for determining whether a worker is an employee or an independent contractor. Under AB5, workers are presumed to be employees unless the hiring entity can demonstrate that the worker meets all three prongs of the ABC test. The law applies to California employers and affects wage orders, unemployment insurance, and workers' compensation classification.
What is the ABC test under AB5?
The ABC test requires the hiring entity to prove all three conditions to classify a worker as an independent contractor: (A) the worker is free from the control and direction of the hiring entity in the performance of the work, both under the contract and in fact; (B) the worker performs work that is outside the usual course of the hiring entity's business; and (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. If any prong fails, the worker must be classified as an employee.
Is AB5 still in effect in 2026?
Yes. AB5 remains in effect in California. Proposition 22 (passed November 2020) created an exemption for app-based transportation and delivery companies (Uber, Lyft, DoorDash, Instacart), classifying their drivers as independent contractors with certain benefits. The California Supreme Court upheld Proposition 22 in July 2024 (Castellanos v. State of California). AB5 continues to apply to all other industries and hiring relationships not covered by Prop 22 or the specific professional exemptions listed in the law.
Who is exempt from AB5?
AB5 exempts certain professions and business relationships from the ABC test, applying the older Borello multi-factor test instead. Exempt categories include licensed insurance agents, certain licensed health care professionals, registered securities broker-dealers, direct sales salespersons, real estate licensees, commercial fishermen, newspaper distributors, and workers providing professional services under specific conditions (lawyers, architects, engineers, accountants, financial advisors, graphic designers, grant writers, fine artists, and others). AB2257 (2020) expanded the exemption list. Even exempt workers must still pass the Borello test to be classified as independent contractors.
How does AB5 differ from the federal IRS test?
The federal IRS uses a multi-factor 'right to control' test that evaluates behavioral control, financial control, and the type of relationship. This test is more flexible and considers the totality of circumstances. California AB5 uses the stricter ABC test, which presumes the worker is an employee and places the burden on the employer to prove all three prongs. The key difference is Prong B: the work must be outside the usual course of the hiring entity's business. Under the IRS test, a web design firm hiring a freelance designer might classify them as a contractor. Under AB5 Prong B, the designer performs work within the firm's usual business, making employee classification likely.
What are the penalties for misclassifying workers under AB5?
Penalties for misclassifying employees as independent contractors in California include back wages and overtime owed, employer-side payroll taxes (Social Security, Medicare, unemployment, disability insurance), penalties of $5,000 to $25,000 per violation under Labor Code Section 226.8, additional penalties for willful misclassification (up to $25,000 per violation), restitution to workers, and potential civil and criminal liability. The California Labor Commissioner, EDD, and the Attorney General can all pursue enforcement actions. Individual workers can also file private lawsuits.