New California Law Codifies – and Expands – Strict ABC Test for Independent Contractor Status

California Gov. Gavin Newsom signed Assembly Bill (AB) 5 into law on Sept. 18, 2019, codifying the strict "ABC" test for employee versus independent contractor classification adopted by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (Dynamex), 4 Cal. 5th 903 (2018). Dynamex was limited to California Industrial Welfare Commission (IWC) Wage Order violations. But AB 5 expands the reach of the "ABC" test generally to Labor Code violations, as well as to California unemployment insurance and workers' compensation proceedings.

How We Got Here: The April 2018 Dynamex Decision

The Dynamex opinion, decided on April 30, 2018, analyzed the then-existing common law test to determine employee versus independent contractor status as established in S.G. Borello & Sons, Inc. v. Dep't of Indus. Relations (Borello), 48 Cal. 3d 341 (1989), specifically in the framework of the IWC's Wage Orders. Under Borello, the primary test of an employment relationship, known as the "right to control" test, is whether the person to whom service is rendered has the right to control the manner and means of accomplishing the result desired. In addition to the primary "right to control" test, courts considered numerous secondary factors:

1. the right to discharge at will, without cause
2. whether the one performing the services is engaged in a distinct occupation or business
3. the kind of occupation, with reference to whether in the locality the work is usually done under the direction of the principal or by a specialist without supervision
4. the skill required in the particular occupation
5. whether the principal or the worker supplies the instrumentalities, tools, and the place of work for the person doing the work
6. the length of time for which the services are to be performed
7. method of payment, whether by the time or by the job
8. whether or not the work is part of the regular business of the principal
9. whether or not the parties believe they are creating the relationship of employer-employee

After revisiting the Borello test as applied to California Wage Orders, the California Supreme Court in Dynamex rejected the Borello standard for IWC Wage Orders and adopted the "ABC" test which had not previously been applied in California. Under the "ABC" test, a hiring party must establish all of the following conditions for a worker to be considered a contractor rather than an employee:

A. that 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

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

C. that the worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed

While Condition A is reminiscent of the primary right-to-control test under Borello, the secondary Borello factors in Dynamex were replaced with the conditions set forth in the B and C prongs of the test. The B and C conditions make it significantly more difficult to classify workers as independent contractors.

Almost immediately following the Dynamex decision, various stakeholders began highly publicized and highly contentious lobbying efforts seeking a legislative response to the decision. The end result of such efforts was the passage and Gov. Newsom's signing of AB 5.

AB 5's Codification, and Expanded Reach, of Dynamex's ABC Test

AB 5 adds to the Labor Code new Section 2750.3, effective Jan. 1, 2020, codifying the Dynamex ABC test. The statute provides that a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all of the following conditions are satisfied:

A. the person 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 work and in fact

B. the person performs work that is outside the usual course of the hiring entity's business

C. the person is customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed

Notably, whereas the reach of the Dynamex decision was limited to IWC Wage Order violations, AB 5 expands the reach of the ABC test to violations of the Labor Code generally (e.g., business expense reimbursement claims under Labor Code Section 2802 are not in the IWC's Wage Orders), and also for purposes of unemployment insurance and workers' compensation.

The Seven Exemption Categories

A myriad of exemptions in the final version of AB 5 reflect specific industry issues. Each exemption has its own stringent and complex set of requirements, and all exemptions must be closely analyzed on a case-by-case basis. The "exemptions" are also not true carve-outs – an individual whose work meets the exemption requirements is not automatically an independent contractor. Rather, an individual whose work meets the exemptions means that the ABC test does not apply, but the hiring party must still be able to demonstrate that contractor status is appropriate under Borello and/or by other statutory provisions as specified in the bill. In general, however, the exemptions apply to seven categories.

• Category 1: Specific occupations. This exemption includes, subject to numerous qualifiers, certain insurance agents, physicians, surgeons, dentists, podiatrists, veterinarians, lawyers, architects, engineers, private investigators, accountants, securities broker-dealers, investment advisers, direct sales salespersons and commercial fishermen.
• Category 2: Certain contracts for "professional services." This exemption includes certain contractual services related to marketing, human resources, travel agents, graphic design, grant writers, fine artists, agents practicing before the Internal Revenue Service, payment processing agents, still photographers, photojournalists, freelance writers, editors, newspaper cartoonists, estheticians, electrologists, manicurists, barbers and cosmetologists. It is crucial to note that the majority these listed professional services contain specific qualifiers. In addition to those qualifiers, the exemption for this category will apply only if the hiring entity demonstrates that all of the following six conditions are satisfied:

a. the individual maintains a business location, which may include the individual's residence, that is separate from the hiring entity's business location; nothing in this subdivision prohibits an individual from choosing to perform services at the location of the hiring entity

b. if work is performed more than six months after the Jan. 1, 2020, effective date of this section, the individual must have a business license, in addition to any required professional licenses or permits for the individual to practice in their profession

c. the individual has the ability to set or negotiate their own rates for the services performed

d. outside of project completion dates and reasonable business hours, the individual has the ability to set the individual's own hours

e. the individual is customarily engaged in the same type of work performed under contract with another hiring entity or holds themselves out to other potential customers as available to perform the same type of work

f. the individual customarily and regularly exercises discretion and independent judgment in the performance of the services

• Category 3: Certain real estate licensees and repossession agencies. The exemption for this category will apply to certain real estate licensees and repossession agencies licensed pursuant to the California Business and Professions Code, as specified.
• Category 4: Certain bona fide business-to-business contracting relationships. Subject to certain qualifiers, if a business service provider contracts to provide services to another business ("contracting business"), the exemption for this category will apply if the contracting business demonstrates that all of the following 12 conditions are satisfied:

a. the business service provider is free from the control and direction of the contracting business entity in connection with the performance of the work, both under the contract for the performance of the work and in fact

b. the business service provider is providing services directly to the contracting business rather than to customers of the contracting business

c. the contract with the business service provider is in writing

d. if the work is performed in a jurisdiction that requires the business service provider to have a business license or business tax registration, the business service provider has the required business license or business tax registration

e. the business service provider maintains a business location that is separate from the business or work location of the contracting business

f. the business service provider is customarily engaged in an independently established business of the same nature as that involved in the work performed

g. the business service provider actually contracts with other businesses to provide the same or similar services and maintains a clientele without restrictions from the hiring entity

h. the business service provider advertises and holds itself out to the public as available to provide the same or similar services

i. the business service provider provides its own tools, vehicles and equipment to perform the services

j. the business service provider can negotiate its own rates

k. consistent with the nature of the work, the business service provider can set its own hours and location of work

l. the business service provider is not performing the type of work for which a license from the Contractors State License Board is required, pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code

• Category 5: Certain relationships between contractors and individuals working under a subcontract in the construction industry. The exemption for this category generally applies if the contractor demonstrates that all of the seven conditions are met:

a. the subcontract is in writing

b. the subcontractor is licensed by the Contractors State License Board and the work is within the scope of that license (except for certain subcontractors providing construction trucking services)

c. if the subcontractor is domiciled in a jurisdiction that requires the subcontractor to have a business license or business tax registration, the subcontractor has the required business license or business tax registration

d. the subcontractor maintains a business location that is separate from the business or work location of the contractor

e. the subcontractor has the authority to hire and to fire other persons to provide or to assist in providing the services

f. the subcontractor assumes financial responsibility for errors or omissions in labor or services as evidenced by insurance, legally authorized indemnity obligations, performance bonds, or warranties relating to the labor or services being provided

g. the subcontractor is customarily engaged in an independently established business of the same nature as that involved in the work performed

• Category 6: Certain relationships between referral agencies and service providers. The exemption for this category generally applies if the contractor demonstrates that all of the 10 conditions are met:

a. the service provider is free from the control and direction of the referral agency in connection with the performance of the work for the client, both as a matter of contract and in fact

b. if the work for the client is performed in a jurisdiction that requires the service provider to have a business license or business tax registration, the service provider has the required business license or business tax registration

c. if the work for the client requires the service provider to hold a state contractor's license pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code, the service provider has the required contractor's license

d. the service provider delivers services to the client under service provider's name, rather than under the name of the referral agency

e. the service provider provides its own tools and supplies to perform the services

f. the service provider is customarily engaged in an independently established business of the same nature as that involved in the work performed for the client

g. the service provider maintains a clientele without any restrictions from the referral agency and the service provider is free to seek work elsewhere, including through a competing agency

h. the service provider sets its own hours and terms of work and is free to accept or reject clients and contracts

i. the service provider sets its own rates for services performed, without deduction by the referral agency

j. the service provider is not penalized in any form for rejecting clients or contracts; this subparagraph does not apply if the service provider accepts a client or contract and then fails to fulfill any of its contractual obligations

• Category 7: Certain relationships related to motor club services. The exemption for this category will apply to a relationship between certain motor clubs and individuals performing services under a contract between the motor club and a third party to provider motor club services using the employees and vehicles of the third party, if the motor club demonstrates that the third party is a separate and independent business from the motor club.

Significantly, despite extensive transportation industry lobbying efforts to exempt independent contractor owner-operators from AB 5, the list of exemptions omits trucking except under the narrowly drawn Category 5 exemption. The opposition from the Teamsters union as well as the State Building and Construction Trades Council of California outweighed industry efforts to reach a compromise on establishing clear criteria that would have allowed owner-operators who meet threshold requirements to continue to operate as independent contractors.

Retroactivity

AB 5 specifically provides that it "does not constitute a change in, but is declaratory of, existing law, with regard to wage orders of the [IWC] and violations of the Labor Code related to wage orders." Thus, the strong indication is that the ABC test will apply retroactively, at least as to wage and hour claims. However, AB 5 also provides that the exemptions in categories 1 through 7 above will apply retroactively to existing claims and actions to the maximum extent permitted by law.

In addition to adding Section 2750.3 to the Labor Code, AB 5 also amends Section 3351 of the Labor Code, the workers' compensation definition of "employee." AB 5 provides that for purposes of workers' compensation, "employee" will include individuals who are employees under Section 2750.3 "[b]eginning on July 1, 2020," but that the subdivision "shall not apply retroactively."

AB 5 also amends Section 621 of the Unemployment Insurance Code to restate the ABC test as one of the definitions of "employee" for unemployment insurance purposes. However, there is no similar statement as to retroactivity and, given that the addition will not become effective until Jan. 1, 2020, it remains to be seen whether the ABC test will apply retroactively for unemployment insurance purposes.

Next Steps for All Businesses Utilizing Independent Contractors and Gig Workers in California

It is anticipated that there will be a variety of legal challenges to AB 5, continued efforts in the Legislature for additional exemptions and revisions, as well as potential political action at the ballot box. In the meantime, businesses that use independent contractors or contract with "gig economy" workers in California should closely review all independent contractor classifications and gig worker arrangements to assess the potential impact of AB 5 on operations and to determine next steps to avoid potential misclassification exposure going forward. For more information on how the new law could affect your business specifically, contact the authors.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.