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Impact of California AB 5 on Payroll Taxes and Benefits

Client Updates

On September 18, 2019 Governor Gavin Newsom signed Assembly Bill 5 (AB 5) into law. The new labor law codifies the "ABC" test adopted by the California Supreme Court last year in Dynamex Operations West v. Superior Court for determining employee vs. independent contractor status in California. The new law will become effective on January 1, 2020.

Recent media coverage has heralded the law as a watershed moment for the labor movement. Some have even predicted that a million workers in California will become "full" employees for all purposes as a result of the ABC test.

But the reality is more complicated. Payroll tax withholding and benefit plan eligibility are governed by less rigid common law tests. AB 5 doesn't change that. This means someone could be deemed an employee for certain purposes in California but remain an independent contractor for others after AB 5 takes effect. AB 5 will therefore offer both opportunities and administrative challenges for many California employers.

AB 5 Expands Application of the Dynamex ABC Test

In Dynamex, the court held that in order to be classified as an independent contractor, an employer must demonstrate that the worker

(A) is free from employer control over how the work is performed; and

(B) performs work outside the usual course of the employer's business; and

(C) has an independently established business providing services of the same nature as the services that the worker is providing to the employer.

Failing any of the three prongs (A, B or C) means the worker must be treated as an employee. But Dynamex only applied to wage order claims. For other purposes the less rigid multi-factor test developed by the California Supreme Court in S.G. Borello & Sons, Inc. v. Department of Industrial Relations still applied.

Enter AB 5. AB 5 not only codifies the ABC test but it also significantly expands its reach. In addition to wage order claims, the ABC test will now be the default test under the California Labor Code and Unemployment Insurance Code. In practice, this means a worker in California classified as an employee under the ABC test would be eligible for:

  • minimum wage;
  • overtime pay (if non-exempt);
  • meal and rest breaks;
  • paid sick days and paid family leave;
  • reimbursement of business expenses;
  • commission payment rules
  • protection against discrimination or sexual harassment;
  • state disability, unemployment and workers' compensation insurance coverage; and
  • paycheck timing and final paycheck requirements.

After months of lobbying by numerous interest groups, the final version of AB 5 exempts over 50 different occupations and professions from the ABC test. Instead, courts will apply the Borello test to determine whether workers in these categories are employees or independent contractors.

Payroll Tax and Benefit Plan FAQs

We address below some of the key payroll and benefit plan questions that California employers may be asking in the coming months following the passage of AB 5. We use "ABC worker" to mean a person currently being treated as an independent contractor who (1) does not fit under one of the exemptions in AB 5 and (2) does not meet all three prongs of the ABC test (most likely this will be prong B).

Q:        How is it possible for an ABC worker to still be treated as an independent contractor for tax and benefits law purposes?

 A:        Generally, tax and benefits-related statutes require the application of various common law tests to determine whether a worker is an employee or an independent contractor. Applicable common law tests outline a number of factors and require the decision maker (judge, jury, government agency) to determine the worker's status by balancing the factors.

There are two reasons why such multi-factor tests may yield different results from the ABC test:

  • There is no presumption the worker is an employee that must be overcome in order to demonstrate contractor status; and
  • No one factor or group of factors must be met.

The factors vary across these common law tests, but with significant overlap. Typically a worker's right of control and independence will be very important. The key takeaway is that when an employer treats an ABC worker as an independent contractor for other purposes, there must be a reasonable basis under the applicable common law test to conclude that the worker qualifies as an independent contractor for such other purposes.

Q:        Do we need to withhold income and employment taxes and make employer Social Security and Medicare contributions for our ABC workers?

 A:        For federal withholding purposes, this will depend on whether the ABC worker qualifies as an independent contractor under the IRS's common law test. The IRS common law test can be found here. This test specifically looks at behavioral control, financial control and the type of relationship between the employer and the worker. If the ABC worker qualifies as an independent contractor, then a California employer would be able to continue to report income for such worker on a Form 1099 for federal reporting purposes and would not have any obligation to make Social Security and Medicare contributions.

For California state income tax withholding purposes, it will depend on future state agency actions. After Dynamex, the California Employment Development Department (EDD) continued to apply the multi-factor Borello test for payroll tax matters because of Dynamex's narrow application to wage order claims. (A helpful EDD worksheet using the Borello test can be found here.)

California taxing agencies will likely reevaluate their approach now that AB 5 broadens the coverage of the ABC test. But it is not a foregone conclusion that they will apply the ABC test for state income tax withholding purposes. Massachusetts also uses a similar ABC test to classify workers for labor law purposes but continues to use the federal test for tax withholding.

Regardless, an employer will need to deposit state unemployment insurance and disability insurance contributions for an ABC worker starting as of January 1, 2020, and cover ABC workers under workers' compensation insurance as of July 1, 2020, even if the ABC worker is being classified as an independent contractor for other purposes.

California employers should also take care to treat similarly situated workers consistently regardless of whether they work in California in case the IRS challenges an independent contractor classification in an audit. Section 530 of the Revenue Act of 1978 provides protection against retroactive taxes and penalties when a worker is reclassified as an employee during an audit. This protection generally applies only if the employer has:

  • consistently treated similarly situated workers as independent contractors;
  • complied with the Form 1099 reporting requirements; and
  • had a reasonable basis for treating the workers as independent contractors.

Q.        Will our ABC workers be eligible to participate in our 401(k) plan? What are the risks of excluding ABC workers from our 401(k) plan?

A.        401(k) plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA), which generally preempts state laws. For purposes of ERISA benefit plan participation, the multi-factor test outlined by the U.S. Supreme Court in Nationwide Mutual Insurance Co. v. Darden is used to determine whether independent contractor status applies to a worker. As with the Borello and IRS common law tests, the Darden test also focuses on the worker's right of control and independence. The Darden test can be found here.

A plan sponsor can legitimately exclude from 401(k) plan participation ABC workers who qualify as independent contractors under the Darden test. However, excluding ABC workers who would likely qualify as employees under Darden could lead to plan qualification and ERISA violations. Such violations could result in an employer having to return contributions by its executives or making costly additional contributions for the benefit of non-highly compensated employees.

With the passage of AB 5, we recommend that clients confirm that their 401(k) plan (and other retirement plans) include so-called "Microsoft" plan language so as to avoid retroactive coverage under the plan if an ABC worker is later determined to be a misclassified employee. (See the 1997 decision by the Ninth Circuit in Vizcaino v. Microsoft Corp., where the court held that long-term, "temporary" workers, hired as independent contractors, were employees for common law purposes and were therefore entitled to retroactive benefits under Microsoft's 401(k) and stock purchase plan.)

Q:        Do we need to include ABC workers in our group health insurance plans? Will AB 5 impact our obligations under the Affordable Care Act?

A:        As with 401(k) plans, group health plans are also subject to ERISA. This means the Darden test will apply to determine whether a worker qualifies as an "employee" for health insurance plan coverage. Although AB 5 amends the definition of an employee under the California Unemployment Insurance Code, this change does not mean that ABC workers will be required to be covered under an employer's health insurance plan.

As a result, a plan sponsor may exclude an ABC worker from eligibility to participate in its group health insurance plan if the individual qualifies as an independent contractor under the Darden test. However, misclassifying ABC workers as independent contractors may result in additional costs and penalties under the Affordable Care Act (ACA). The ACA requires an "applicable large employer" (generally, an employer with 50 or more full-time and full-time equivalent employees) to offer affordable qualifying health insurance to at least 95% of its full-time employees. Employers must also comply with certain annual information reporting requirements. The ACA uses the IRS common law test (rather than the Darden test) to determine who qualifies as an employee, but as discussed above these tests are similar. An applicable large employer who fails to provide such qualifying insurance to full-time employees may be required to make certain employer shared responsibility payments to the IRS, possibly including retroactive payments, and may also face penalties for failing to comply with the reporting requirements.

Q:        Will classification of an ABC worker impact eligibility for equity awards?

A:        Stock option and other equity incentive plans must generally comply with applicable state and federal securities and tax laws. AB 5 likely will not have much of an impact on a company's equity grantmaking practices, except perhaps for gig economy employers.

Most companies that grant equity awards to service providers rely on either the exemption from registration under Rule 701 (for private companies) or under a Form S-8 registration statement (for public companies). Since 1999, the Securities and Exchange Commission (SEC) has taken the position that only a consultant that has a "de facto employment relationship" with an issuer is eligible to receive equity awards granted in reliance on Rule 701 and Form S-8. This requirement has proven problematic for many gig economy companies because workers provide services directly to end users of the app or platform rather than to the issuer. Last year the SEC solicited comments on possible ways to modernize the Rule 701 and Form S-8 rules "in light of the significant evolution in both the types of compensatory offerings and the composition of the workforce," but no new guidance has been issued to date. The passage of AB 5 may spur the SEC to finally issue proposed regulations that redefine who qualifies as an eligible employee or consultant under Rule 701 and Form S-8. Alternately, a gig economy employer might have a better chance at obtaining a No-Action Letter from the SEC under the theory that an ABC worker now qualifies as an "employee" under the Rule 701 and Form S-8 rules as currently written.

Q:        Can we treat every ABC worker as an employee for all purposes to keep things simple?

A:        While at first blush this seems like the simplest approach, it can result in unintended consequences. Just as there are risks in aggressively classifying ABC workers as independent contractors, there are also risks in taking an overly expansive approach to who qualifies as an employee. A few potential issues with this approach:

Tax Qualification Rules for 401(k) Plans. A tax-qualified plan may only benefit current and former employees of the plan sponsor (and its commonly owned subsidiaries and affiliated companies). Extending eligibility under the employer's 401(k) plan to ABC workers who are independent contractors for federal common law purposes can result in disqualification of the entire plan, triggering the loss of tax deferred status of all plan participant accounts.

Denial of Claims under an Insured Health Plan. Insured health plans generally restrict participation to employees of the plan sponsor. The insurance carrier of an insured health plan may retroactively deny claims made by an independent contractor who was treated as an employee under the plan solely based on classification under the ABC test.

Inadvertent Establishment of a MEWA. Allowing independent contractors to participate in an employer's health plan (whether self-insured or fully insured) may convert the health plan into a multiple employer welfare arrangement (MEWA). MEWAs are plans that cover the employees of two or more unrelated employers. Many states - including California - make it very difficult to operate MEWAs. Moreover, self-funded MEWAs are prohibited outright in California, so California employers with self-funded health plans need to take extra care.

Incompatible with Cafeteria/Section 125 Plans. Including an independent contractor in a cafeteria plan under Section 125 of the Internal Revenue Code may disqualify the plan for all participants.

Disqualification of Tax Qualified ESPP. Allowing an independent contractor to participate in an employee stock purchase plan intended to qualify for favorable tax treatment under Section 423 of the Internal Revenue Code would result in the loss of favorable tax benefits for all participants.

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