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Assembly Bill 5, which took effect January 1, 2020, is one of the most consequential pieces of employment legislation in California’s history — and one of the most misunderstood. It’s commonly described as a law targeting gig economy companies like Uber and Lyft. It is that. But it’s also a law that affects every California business that engages independent contractors, which includes the vast majority of small businesses and startups. Understanding AB5 is essential for anyone building a team in California.
The ABC Test
Before AB5, California used the Borello test — a multi-factor balancing test — to determine whether a worker was an employee or an independent contractor. AB5 replaced Borello with the stricter ABC test for most industries. Under the ABC test, a worker is presumed to be an employee unless the hiring entity proves all three of the following:
(A) The worker is free from the control and direction of the hiring entity in connection with performing 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.
(C) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
Part B is where most small business contractor arrangements fail. If you run a software company and engage a software developer as a contractor, the developer’s work is within your usual course of business — failing Part B and requiring employee classification. If you run an accounting firm and engage a freelance accountant, same problem. The rule essentially prohibits the most natural and common form of contractor engagement: hiring specialists who do what your company does, but as independent contractors rather than employees.
Who Is Exempt (and Who Isn’t)
AB5 created dozens of industry-specific exemptions through intense lobbying — doctors, lawyers, architects, engineers, certain insurance and real estate professionals, performing artists under specific conditions, and others. The exemption list is long, complex, and internally inconsistent. A musician performing at a venue may be exempt in one context and not another. A freelance writer who exceeds 35 submissions per year to the same publication loses the freelance exemption. The complexity of the exemptions has itself become a source of compliance uncertainty and litigation.
Notably, Proposition 22 — passed by California voters in November 2020 — created a specific exemption for app-based gig workers in transportation and delivery, allowing Uber, Lyft, and DoorDash to continue classifying their drivers as contractors under specific conditions. This exemption was the result of a $200 million campaign by gig platforms. Small businesses don’t have $200 million to spend on ballot initiatives and generally don’t get their own exemptions.
The Cost of Reclassification
When a contractor relationship must be converted to employment under AB5, the cost increase is immediate and substantial. The employer must add the worker to payroll, withhold state and federal income taxes, pay the employer share of payroll taxes, provide workers’ compensation coverage, offer mandatory benefits including paid sick leave, and comply with all California wage-and-hour requirements. For a worker previously engaged at $80 per hour as a contractor, the all-in employee cost may be $95-$105 per hour — a 20-30% increase before any consideration of benefits.
The Enforcement Reality
AB5 enforcement comes through multiple channels: the Labor Commissioner, the Employment Development Department (particularly interested in payroll tax compliance), the Attorney General, and most significantly, private plaintiffs’ attorneys using PAGA. A competitor, a disgruntled former contractor, or a plaintiffs’ firm doing systematic enforcement can file a PAGA claim alleging AB5 violations covering all similarly situated contractors — potentially creating class-wide exposure for payroll taxes, employee benefits, overtime, and PAGA penalties going back the full lookback period.
For businesses building in California, AB5 means the flexible contractor model that works everywhere else must be approached with extreme caution. Get proper legal advice before structuring any contractor engagement. The cost of a classification error in California is orders of magnitude higher than in any other state.
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