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, 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.

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.

Does AB5 Apply to Your Business?

Two questions decide this, 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, the Unemployment Insurance Code (which is what the EDD administers for state payroll taxes), and, for injuries occurring on or after July 1, 2020, workers' compensation. It 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 FLSA.

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. A two-person business is subject to the same ABC test as a company with 5,000 employees. What does change with headcount is the downstream consequence: reclassifying a contractor pushes your employee count up, which can cross thresholds for California Fair Employment and Housing Act coverage and CFRA leave at 5 employees, paid sick leave obligations that carry no employer-size threshold at all, CalSavers retirement access (extended by SB 1126 to employers with at least one eligible employee), and applicable large employer status under the ACA at 50 full-time equivalents.

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.

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. 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 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.

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. Both of these are the 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: 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 of those occupations carry extra conditions of their own. Marketing and human resources services, for instance, only qualify when the work is original and creative or predominantly intellectual and varied in character rather than standardized and repetitive.

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 entity rather than an individual: a bookkeeping firm, a cleaning company, a marketing shop. It is often described as having twelve conditions because it does, and all twelve must be met. 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; must hold any business license or tax registration the jurisdiction requires; 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; must advertise and hold itself out to the public as available for that work; must provide its own tools, vehicles and equipment where the nature of the work allows; 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 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. 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. It 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. Note that this is the "right" to control: 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. The practical implication for an exempt relationship 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 with 5 to 50 Employees

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. It matters for the business-to-business exemption in Labor Code 2776, where it is one input among twelve, but 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. A business that pays an independent contractor $600 or more, or enters a contract worth $600 or more, has 20 calendar days from whichever comes first to report that person to the Employment Development Department on Form DE 542.

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 process involves both administrative and relationship management steps. 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.

What Triggers an AB5 Audit and How Far Back It Reaches

Almost no small business is audited because an inspector picked its name at random. The overwhelmingly common trigger is a former contractor filing for unemployment insurance after the engagement ends. 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. An EDD payroll tax audit conventionally covers the most recent three years, or twelve quarters, and 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. On the wage side, statutory claims for unpaid minimum wage and overtime generally carry a three-year statute of limitations, which can be stretched to four years when the claim is brought as an unfair competition claim under Business and Professions Code section 17200.

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 prospectively for federal employment tax purposes at a reduced cost, and it is worth asking your tax advisor whether you qualify. It does not touch California. There is no state analogue 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

The financial exposure from 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. 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. The work is marketing, which is the agency's own business, so 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 $48,000 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 lines deserve a note. Unwithheld state income tax and State Disability Insurance 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. And meal and rest premiums 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.

Frequently Asked Questions