California AB5 Law: What Small Business Employers Need to Know

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, a wrong classification gets expensive.

This guide covers what AB5 requires, whether it applies to your business, how the ABC test works, which professions are exempt, what misclassification costs, and the step-by-step process for reclassifying a contractor as a W-2 employee when AB5 requires it.

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. The full text of AB5 is available on the California Legislature's website.

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: the hiring entity must prove all three of its prongs.

What changed is the structure of the test, not its starting point. The California Department of Industrial Relations states that both Borello and the ABC test assume the worker is an employee and make the hiring entity prove otherwise. Borello weighs many factors together, so no single one decides the case. Under the ABC test, one failed prong does.

Classification also decides what you file at the end of the year. The Franchise Tax Board says AB5 and Labor Code sections 2775 to 2787 may affect who is required to file a Form 1099, but did not generally change the Form 1099 reporting requirements themselves. A worker who is an employee under the ABC test gets a W-2, whatever the contract called them.

Does AB5 Apply to Your Business?

Two questions decide whether AB5 applies to your business, and neither of them is where your company is incorporated. The first is where the work happens. California wage and hour law generally follows the work, not the employer: if a person performs services inside California, the state's wage orders and Labor Code reach that work even when the hiring entity is headquartered in Texas, New York, or outside the United States.

A fully remote company with one contractor sitting in Sacramento is inside AB5's reach for that contractor. Conversely, a California-based company that hires a contractor who lives and works entirely in Nevada is generally applying Nevada and federal standards to that relationship, not the ABC test.

The second question is which body of law you are asking about. AB5 is not a universal definition of "employee." It sets the test for the California Labor Code, the Industrial Welfare Commission wage orders, and the Unemployment Insurance Code (which the Employment Development Department, or EDD, administers for state payroll taxes). Beginning July 1, 2020, Labor Code section 3351 extended the same test to workers' compensation.

AB5 does not rewrite federal law. The IRS still applies its own right-to-control analysis to federal employment taxes, and the Department of Labor applies its own economic-reality standard under the Fair Labor Standards Act, which asks whether the worker is in business for themselves or economically dependent on you.

There is no small-business carve-out. AB5 has no employee-count minimum, no revenue floor, and no exception for a company that hires a single contractor for a few hours a month. The smallest business is subject to the same ABC test as a large enterprise.

Headcount changes the downstream consequence, not the test. Reclassifying a contractor pushes your employee count up, which can cross the thresholds for California Fair Employment and Housing Act (FEHA) coverage and California Family Rights Act (CFRA) leave at 5 employees, and for applicable large employer status under the Affordable Care Act (ACA) at 50 full-time equivalents (FTEs).

Two other obligations do not wait for a threshold at all. California paid sick leave carries no employer-size minimum, and CalSavers retirement access now reaches every employer with at least one eligible employee: SB 1126 extended the mandate with a December 31, 2025 compliance date.

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 conditions in Labor Code section 2775. If any single prong fails, the worker is legally an employee.

Working the three prongs on paper, once per contractor, is what turns this from an opinion into a record. Do it before the engagement starts and again whenever the scope of the work changes.

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. Except for app-based rideshare and delivery drivers under Proposition 22, whose status is set by Business and Professions Code section 7451, 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.

The exemptions matter for payroll tax too, not just wage and hour. The California EDD applies the same ABC test when it decides employment status for unemployment insurance (UI), the Employment Training Tax (ETT), State Disability Insurance (SDI), and personal income tax withholding, and states that in some cases the Borello multifactor test must be used instead.

The practical consequence is that one classification decision gets tested twice. The exemption you rely on for the Labor Code is the same one the EDD will examine in a payroll tax audit. If you are unsure whether a specific contractor relationship qualifies, consult a California employment attorney before relying on the exemption.

Inside the Two Biggest Exemptions

The exemption table above is where most articles stop, and it is where most misclassification starts. "Graphic designer is exempt" and "we have a business-to-business relationship" are not conclusions. They are the names of two statutory checklists that a hiring entity has to satisfy item by item. They are also the two exemptions small businesses reach for most often, so it is worth seeing what they actually contain.

The professional services exemption (Labor Code 2778)

This exemption covers a defined list of occupations, including marketing, human resources administration, travel agent services, graphic design, grant writing, fine art, services by an IRS enrolled agent, payment processing through an independent sales organization, still photography and photojournalism, freelance writing, editing, translation, copy editing and illustration, licensed esthetician, electrologist, manicurist, barber and cosmetologist services, and appraisal work.

Several occupations on that list carry extra conditions of their own. Marketing, for instance, qualifies only when the work is original and creative in character, and human resources administration only when it is predominantly intellectual and varied rather than work whose output can be standardized.

Landing on the occupation list is only the entry ticket. The hiring entity must also show all six of the following, and a single miss sends the relationship back to the ABC test.

The business-to-business exemption (Labor Code 2776)

This is the exemption that applies when you contract with another business: a bookkeeping firm, a cleaning company, a marketing shop. That business can be a sole proprietor as well as a partnership, LLC, or corporation. It is often described as having twelve conditions because it does, and all twelve must be met.

The first four set the basic terms of the relationship. The service provider must be free from your control in performing the work; must provide services to your business rather than directly to your customers; must have a written contract specifying the payment amount, rate, and due date; and must hold any business license or tax registration the jurisdiction requires.

The next four test whether the provider is a genuinely independent business. It must maintain a separate business location; must be customarily engaged in an independently established business of the same nature; must be free to contract with other businesses and maintain its own clientele without restriction from you; and must advertise and hold itself out to the public as available for that work.

The last four cover equipment, rates, hours, and licensing. The provider must provide its own tools, vehicles, and equipment consistent with the nature of the work, apart from any proprietary materials the contract requires; must be able to negotiate its own rates; must be able to set its own hours and work location where the nature of the work allows; and must not be doing work that requires a Contractors State License Board license.

The Borello Test: What Applies When the ABC Test Does Not

Every exemption discussed above, except Proposition 22 for app-based drivers, has the same consequence: the relationship is evaluated under S.G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) instead of the ABC test. App-based drivers fall under Business and Professions Code section 7451, which makes them independent contractors when its four conditions are met. Borello is a multi-factor balancing test, not a checklist. No single factor controls, and the factors are weighed together against the facts of the relationship.

Borello is more forgiving than the ABC test, but it is not a rubber stamp. A worker who is supervised daily, works only for you, and uses your equipment fails Borello too.

The principal factor is whether the hiring entity has the right to control the manner and means of accomplishing the result, not just the result itself. The key word is "right": an employer who has the authority to direct the work but chooses not to exercise it still has the right. Around that principal factor, courts and agencies weigh the secondary factors summarized below.

Borello also imports several factors from the federal economic-realities analysis, including whether the worker has an opportunity for profit or loss depending on their managerial skill and whether the worker has invested in equipment or materials.

For an exempt relationship, the practical implication is that documentation matters. Keep the written contract, the business license, evidence of other clients, and the invoices showing project-based billing. Borello is decided on facts, and the facts you cannot produce three years later are the facts you lose.

How AB5 Affects Small Businesses

For a small business, AB5 shows up in ordinary hiring decisions: the freelancer who builds your website, the bookkeeper who comes in three days a week, the contractor doing the same work as your staff. The table below walks through five common scenarios, how AB5 treats each one, and what to do about it.

Why a Contract, an LLC, or a 1099 Does Not Settle the Question

Three artifacts get treated as proof of contractor status, and none of them is. The first is a signed independent contractor agreement. Prong A explicitly requires freedom from control "both under the contract for the performance of the work and in fact," so the statute anticipates that the paper and the reality will diverge and tells the decision maker to look at both.

A contract that says the worker sets their own hours is worthless if the Slack history shows you assigning shifts. The contract is necessary, but it is evidence, not a verdict.

The second is a single-member LLC or an S-corp. Forming an entity does not exempt anyone from the ABC test. Even the business-to-business exemption in Labor Code 2776 is open to a sole proprietor and turns on its twelve conditions rather than on the entity.

A worker who incorporates on a Tuesday and does exactly the same supervised work on Wednesday has changed nothing about Prongs A, B, or C. Requiring a contractor to incorporate as a condition of the engagement is, if anything, a fact an investigator will read as evidence that you knew the classification was fragile.

The third is the worker's own preference. Contractors often want the arrangement (no withholding, deductible expenses, more flexibility) and will say so in writing. California employment protections are not waivable by agreement.

A worker who asked to be a 1099 can file an unemployment claim, a wage claim, or a workers' compensation claim the day the relationship ends, and the agency will apply the ABC test without regard to what either party wanted. There is no consent defense.

Because an auditor who questions one contractor will ask about everyone paid on a 1099 for similar work, keep the file at the roster level as well as the individual level. One row per contractor, reviewed on a set date, shows at a glance where the evidence is thin.

Reporting a Contractor to the State

Even when the classification holds, California still makes you report the engagement. The duty applies when you must file a federal Form 1099-NEC or 1099-MISC for the services and you either pay an independent contractor $600 or more or enter into a contract worth $600 or more. From whichever comes first, you have 20 calendar days to report that person to the EDD on Form DE 542.

You report contractors who are individuals, sole proprietors, or single-member LLCs, not corporations, partnerships, or multi-member LLCs. Each contractor is reported once a calendar year, whether the contract is new or ongoing. The department charges $24 for each failure without good cause, and $490 where the failure is intentional or the report is false.

The penalty is the small part. What matters more is that a missing report leaves the state with no record of a person who was working for you, and that gap is what opens the audit described further down this page.

How to Reclassify a Contractor as a W-2 Employee

If AB5 requires you to reclassify an existing contractor as an employee, the work has two sides: the paperwork and payroll changes, and the conversation with the worker. The six steps below take you through the move from 1099 to W-2 in order.

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.

What Triggers an AB5 Audit and How Far Back It Reaches

Some EDD audits are picked at random or by payroll size, industry, and location. The rest are what the EDD's tax audit guidelines call request audits, opened because the EDD has a specific reason to look at one employer. They generally start from a benefit, status, or delinquency assignment.

A former contractor filing for unemployment insurance after the engagement ends is exactly that kind of benefit signal. When the claim arrives, the EDD looks for wage records under that person's Social Security number, finds none, and opens an inquiry into why a person who was working had no reported wages.

From the worker's side this is not an accusation (they are just trying to collect benefits), but it starts the same process an accusation would.

The lookback is what makes this expensive. According to the EDD, a payroll tax audit generally covers a three-year statutory period, the 12 most recently completed calendar quarters. Once the auditor concludes one contractor was misclassified, they will look at everyone you paid on a 1099 in the same role over the same period. A single reclassification rarely stays single.

Wage claims run on a similar clock. The Labor Commissioner takes claims for unpaid minimum wage and overtime within three years. The period stretches to four years when the claim is brought as an unfair competition claim under Business and Professions Code section 17200, whose limitations period is set by section 17208.

If you conclude on your own that a classification is wrong, correcting it forward is far cheaper than being found out, but be clear-eyed about what a correction does and does not resolve. The IRS Voluntary Classification Settlement Program lets eligible employers reclassify workers going forward for federal employment tax purposes at a reduced cost, and it is worth asking your tax advisor whether you qualify.

The IRS program does not touch California. There is no state equivalent that clears EDD assessments, Labor Commissioner claims, or private lawsuits, so a federal settlement leaves your state exposure exactly where it was. Reclassification decisions with any real dollar value behind them should go through a California employment attorney before you act, not after.

Penalties for Misclassification in California

Misclassification penalties in California come in two layers. The first is the statutory penalty: Labor Code section 226.8 sets a civil penalty of $5,000 to $15,000 for each willful misclassification, and $10,000 to $25,000 for each violation once the Labor and Workforce Development Agency or a court finds a pattern or practice of willful misclassification.

The second layer is everything else in the table below, which is money the worker or an agency was already owed. Back wages, employer payroll tax, the withholding you never made, and retroactive workers' compensation premiums are restitution rather than punishment, and together they usually dwarf the civil penalty.

The financial exposure from misclassifying even one contractor at a small business can easily reach tens of thousands of dollars when back wages, employer taxes, penalties, and legal fees are combined. It is worth walking the arithmetic once, because the headline penalty is rarely the largest line.

A worked example: one contractor, two years

Take a small marketing agency that paid a social media contractor $4,000 a month for 24 months, $96,000 in total. Marketing is on the professional services list, but assume the arrangement misses one of that exemption's conditions, so the ABC test applies. Because the work is marketing, the agency's own business, Prong B fails and the contractor was an employee the whole time.

Treating the monthly pay as a salary produces a regular rate of roughly $23 an hour ($923 a week divided by 40). Assume no time records were kept, no meal breaks were recorded, and the contractor worked about 46 hours in half the weeks. The tally below uses that scenario; your own numbers will differ, but the shape of the bill will not.

That lands somewhere around $46,000 before interest, before the worker's attorney fees, and before the auditor asks whether the other three people you paid on a 1099 for the same work should be treated the same way.

Two points deserve a note. The tally leaves out unwithheld state income tax and State Disability Insurance. Both are funded by the employee, not the employer, but when an employer never withheld them, the EDD assesses the shortfall against the business. The personal income tax portion can sometimes be relieved if the worker filed and paid their own return, but SDI generally cannot.

Meal and rest premiums also accrue for each day worked rather than for each pay period, which is why the absence of time records tends to hurt more than the absence of any single policy.

The cheapest version of this bill is the one you never run up. Work the three prongs for every contractor before the engagement starts, keep the file current while it runs, and if a classification fails, correct it before a claim forces the question.

Frequently Asked Questions