California Assembly Bill 5 (California A.B.5), a new California law effective January 1, 2020, applies a stricter standard for classifying workers as independent contractors under California law. The new law largely codifies the California Supreme Court's decision in Dynamex Operations West, Inc. v. Superior Court of Los Angeles, 4 Cal.5th 903 (2018). Under this decision, a worker is presumed to be an employee for limited wage-rule purposes, and the hiring entity has the burden of establishing that the worker is an independent contractor based on a three-part test, commonly referred to as the "ABC test." It is widely reported that California A.B.5 was enacted in response to "gig economy" or on-demand workers, such as rideshare and delivery drivers.

In contrast to California A.B.5, the Internal Revenue Code generally applies a "common law" test to determine who is an employee for federal income and employment tax purposes and does not incorporate a legal presumption as to a worker's status. Because California will apply a different standard beginning in 2020, a business could properly classify an individual worker as an independent contractor for federal tax and employment law purposes but have to treat that same worker as an employee under California law. As California businesses analyze their response to, and compliance with, California A.B.5, they should consider the effect of any changes made in the relationship with their temporary and "on-demand" workforce and whether those changes affect their federal tax obligations.

This Tax Alert provides (i) a summary of the California A.B.5 provisions; (ii) a summary of the common law and other standards that apply for federal income tax and employment rules; and (iii) a discussion of the potential considerations for employers that will need to coordinate California's treatment with the federal tax rules applicable to employees and independent contractors.

California A.B.5

Before the California Supreme Court's Dynamex decision and the enactment of A.B.5, workers were classified for California state law purposes by applying the multi-factor test established in Borello & Sons, Inc. v. Department of Industrial Relations, 48 Cal. 3d 341 (1989). The Borello test concentrated on whether the hiring entity retained control of the worker. Dynamex replaced the Borello multi-factor test by establishing a presumption that a worker who performs services is considered an employee, rather than an independent contractor.

Dynamex created a new standard, referred to as the "ABC test," for determining a worker's classification. Under the Dynamex ABC test, "a person providing labor or services for remuneration" is presumed to be an employee rather than an independent contractor, unless the hiring entity demonstrates that each of the following three conditions is satisfied:

1. 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 the work and in fact.
2. The person performs work that is outside the usual course of the hiring entity's business.
3. The person is customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed.

The Dynamex decision applies only for the purposes of California's wage orders under the Industrial Welfare Commission Wage Orders (the Wage Orders). California A.B.5 extends the Dynamex presumption of employment status and "ABC test" to classify workers for purposes of workers' compensation, unemployment insurance, paid sick leave, and paid family leave rules under the California Labor Code, Unemployment Insurance Code, and in applying the minimum wage and other rules under the Wage Orders. The California attorney general and city attorneys of cities with populations of more than 750,000 may seek injunctive relief to force the reclassification of workers for purposes of California law.

California A.B.5 includes exceptions to the ABC test. These exceptions include services performed by:

• Doctors
• Dentists
• Veterinarians
• Lawyers
• Accountants
• Licensed insurance agents
• Registered securities broker-dealers or investment advisers
• Others performing work under a contract for professional services with another business entity or under a subcontract in the construction industry

In these cases, the multi-factor Borello test continues to apply to determine a worker's classification.

Common-law standard

Under the Internal Revenue Code's baseline rule, an employee is an individual who, under the common law, has the status of an employee on account of the service recipient's right to direct and control that individual in the performance of his or her job. The "common law" employment test is based on historical precedent and case law, which is described in employment tax regulations at Treas. Reg. Section 31. 3121(d)-1(c) as follows:

[G]enerally, the relationship of employer and employee exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which the result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but as to how it shall be done.

This common-law standard is generally the standard for determining whether a business is subject to federal income and employer tax reporting and withholding obligations for wages. This standard also governs whether individuals are employees for purposes of participating in tax-qualified retirement plans and health and welfare plans.¹ Other tax rules also turn on employment status. For example, an independent contractor may deduct unreimbursed business expenses, but there typically is no deduction for unreimbursed business expenses by an employee.² In addition, a business may be eligible for certain income tax credits and deductions depending upon whether wages are paid to employees.³

The common-law standard for federal tax rules is a facts-and-circumstances test that has proven difficult to apply with certainty. The application of the common-law standard has morphed as the character and structure of the labor force and work have changed in the US economy. In Revenue Ruling 87-41, the IRS catalogued what has been commonly referred to as the "20-factors" for determining whether a worker is an employee or an independent contractor. These 20 factors are taken from the historical precedents and include items such as whether the service recipient or the service provider sets the work hours; whether the service recipient must regularly provide written or oral reports on the status of an assignment; whether the service recipient provides the work tools to the service recipient or the service recipient must purchase his or her own tools; and the extent to which the work is integrated in the service recipient's business.

In the past, some taxpayers were critical of what was viewed as an overly mechanical attempt to apply the common-law facts-and-circumstances test when many of the factors were not relevant to particular industries or workers. In an administrative effort to refine worker classification audits, the IRS, without disavowing the 20 factors, published training materials in 1996 directing its examiners to develop three categories of inquiry:

(i)Behavioral control, which looks to the right of the business to control the behavior of a worker. Evidence of behavioral control includes both instructions and training.

(ii) Financial control, which looks to the right of the business to direct and control the means and details of the business aspects of how a worker provides services. This is not a simple question of economic dependence of the worker on the business, but more a question of the degree to which the business has taken over the worker's opportunity for profit and loss. Relevant factors include (1) significant worker investment, (2) unreimbursed expenses, (3) services available to the relevant market, (4) method of payment, and (5) opportunity for profit and loss.

(iii) Relationship of the parties, which is a "catch all" category that takes into account the objective evidence of how the parties intended to treat their relationship. These factors include how the relationship is described in any contract; whether a Form W-2 or 1099 was filed; whether the worker was incorporated; whether the worker was included in an employee benefits program; the permanency or indefinite nature of the business-worker relationship; the extent to which the services performed by the worker are a key aspect of the regular business of the company.⁴

The Training Guidelines remain the most comprehensive IRS description of the common-law factors for worker classification. Although the Training Guidelines assert that the factors can be divided into three categories, it can be challenging to determine which factors are the most relevant for determining a particular worker's status. As pointed out in the Training Guidelines, "control is a matter of degree" and the factors must be weighed to determine the extent, if any, of the business's right to direct and control.

While the common-law test remains the baseline in the Internal Revenue Code, separate standards have been enacted for particular industries and jobs. For example, IRC Section 7701(a)(20) defines "employee" to mean a full-time life insurance sales person, even if that person does not meet the common-law test; IRC Section 3121(d) imposes employment tax withholding for categories of workers even if they are not common-law employees (e.g., certain home workers and salespeople); and IRC Section 3508 deems real estate agents and direct sellers to be independent contractors.

A high-water mark for congressional attention to worker classification issues was the enactment of Section 530 of the Revenue Act of 1978 (Rev. Act Section 530), which provides special relief to businesses that (i) acted reasonably in classifying workers as independent contractors, and (ii) consistently treated those workers as independent contractors (including reporting earnings on Forms 1099 when required), notwithstanding that those workers are later determined to be employees. Rev. Act Section 530 continues to apply, and businesses may continue to rely on its relief provisions as protection from retroactive assessments of employment tax withholding.

Issues for staffing firms and PEOs

Any analysis of worker classification must also take into account the rulings and cases addressing three-party scenarios in which a business benefits from the services of workers who are treated as the employees or the independent contractors of a third-party vendor, such as a staffing firm or a professional employer organization (PEO). Unlike the Department of Labor, which recognizes a worker as an employee of two entities simultaneously for purposes of certain federal labor laws, the IRS generally does not recognize dual employment status for federal tax purposes.⁵ Hence, for federal tax purposes, an assessment must be made of whether the worker is employed by the staffing firm or the service recipient business entity.

In Revenue Ruling 75-41, the IRS held that a staffing firm engaging workers to perform services for its customers was the employer of the workers based on the staffing firm's ultimate legal right to "hire and fire" the workers. The status of workers employed by a third-party staffing firm — and whether they were due employee benefits and stock options issued by the employer — has also been the subject of litigation, including the line of cases in Vizcaino v. Microsoft,⁶ in which staffing firm workers and contractors performing services for the benefit of Microsoft were ultimately viewed as Microsoft common-law employees for purposes of Microsoft's employee stock purchase plan.

More recently, Congress has weighed in with IRC Section 3511, which affects certain three-party arrangements. Under IRC Section 3511, a "certified" PEO is deemed to be the employer of workers for federal income and employment taxes, even though those workers may be viewed as employees of the business contracting with the PEO under a common-law test.

Implications

It is possible that individual service providers could be presumed to be employees for California state law purposes and their wages subject to California tax withholding, even if they are not considered common-law employees and are treated as independent contractors for federal tax purposes.

As the prior discussion illustrates, the federal tax law is a proverbial patchwork quilt of standards for determining a worker's employment status and whether the employer is obligated to withhold or report taxes. Because specific rules in the Internal Revenue Code override the common-law test, it is possible to be an employee for one purpose and an independent contractor for another. California A.B.5 is yet another part of the worker classification fabric. Third-party vendors that direct workers where to perform their services and treat these workers as independent contractors receiving Forms 1099 should examine their compliance.

Considerations for employers

Questions may arise for federal tax and employee benefit purposes if a business or third-party vendor determines that California A.B.5 applies and workers are employees under California law.

What happens if workers are simply "reclassified" as employees for federal tax purposes?

If an employer determines that its on-demand workers are considered employees under California A.B.5, the employer should evaluate whether it is appropriate to restructure the relationship with the workers to treat them as employees for all purposes so that there is consistency for both California and federal tax laws. Reclassification of workers from independent contractors to employees for federal tax purposes presents a number of issues, including:

• The worker's earnings would be reported on Form W-2, rather than reporting the earnings (over $20,000) on a Form 1099-K.
• The worker's earnings would be subject to income and employment tax (FICA and FUTA) withholding and deposit.
• The worker may become eligible to participate in the employer's tax-qualified retirement plan, employee stock purchase plan, or other employee benefits; alternatively, the worker may affect "nondiscrimination" testing of existing plans even if the worker is not covered by the plans.
• The employer may be required to treat the worker as eligible to participate in the employer's health care plan to avoid excise taxes under the Affordable Care Act.
• The worker may become eligible for other tax-favored fringe benefits.
• The employer would be required to incorporate the "reclassified workers" into the employer's existing payroll and employee benefits systems or establish new internal and external systems for payroll and employee benefits, determining participation in employee benefit plans, and tracking human resources.

From the worker's perspective, being an employee is not always favorable. Workers with significant unreimbursed expenses likely will not be entitled to tax deductions for those business expenses if they are employees.

Does the California A.B.5 determination of a worker's status affect employee benefit plans?

After the Vizcaino v. Microsoft decisions, many employers amended their employee benefit plans to preclude participation by individuals who are "not treated as employees for payroll purposes even if later reclassified." If workers are deemed employees under California A.B.5, it is advisable to review and refine employee benefit plan language.

Does the California A.B.5 determination of a worker's status affect reliance on Rev. Act Section 530?

Employers that currently rely on Rev. Act Section 530 relief for classification of workers as independent contractors should consider how reporting of wages under California A.B.5 might affect their position that they have consistently treated workers as independent contractors and filed 1099s. Presumably, employers would continue to have disparate reporting for federal and California purposes. This issue, however, needs to be reviewed.

What other issues may arise if a worker is an employee under California A.B.5?

While California A.B.5 technically does not change the definition of "employee" for federal income or employment tax purposes, employers with multi-state operations must determine whether they want to maintain disparate payroll systems for workers in and outside California. If California tax and withholding are required, the terms of payment will necessarily vary between California and other jurisdictions where the on-demand workers continue to be treated as independent contractors.

Employers that determine that their on-demand workers should be treated as employees under California A.B.5, but remain independent contractors for federal tax purposes, will need to consider how to report and withhold on the employees' California wages while continuing to report the workers' earnings on a Form 1099 for federal tax purposes. Although bifurcated reporting of this sort is possible, employers and payroll service and staffing firms are not accustomed to issuing separate information statements that treat workers as employees for purposes of California law, but independent contractors for purposes of federal income and employment tax reporting and withholding. This wage reporting will be a challenge for businesses to maneuver going forward.

This Tax Alert focuses on tax matters arising from California A.B.5. Clearly, there are broader employment law and other legal issues that are implicated by a worker's employment status for purposes of California A.B.5. Every business utilizing on-demand workers should coordinate with tax, legal, and human relations professionals in developing their analysis and compliance plans.

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ENDNOTES

¹ See Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318 (1992) (holding that, for purposes of ERISA, which governs employee benefit plans, an employee is defined using the same common-law standard as applies for federal tax purposes).

² See IRC Section 62(a).

³ See, e.g., IRC Sections 52, 199A.

⁴ IRS training manual "Worker Classification Training Guidelines: Employee or Independent Contractor" (October 1996).

⁵ The only ruling to adopt a co-employment theory is Revenue Ruling 66-162. In that ruling, the IRS concluded that both a concessionaire in a department store and the department store itself were co-employers of certain sales clerks who worked in the store. The critical fact in the ruling was that the clerks received payments in the form of salary from the store and separate payments in the form of commission directly from the concessionaire. Thus, the tax issue was whether both the salary and the commissions were "wages" from employment, subject to employment taxes. The IRS resolved the question by finding that the clerks were co-employees of the concessionaire and the department store, noting that the co-employment theory "has been cited with approval in court cases deciding common-law employer liability in the area of tort law." While Revenue Ruling 66-162 still exists, it is rarely cited by the IRS.

⁶ Vizcaino v. Microsoft, 97 F.3d 1187 (9th Cir. 1996) (Vizcaino I), reh'g en banc granted, 105 F.3d 1334 (9th Cir.), reh'g en banc, 120 F.3d 1006 (9th Cir. 1997) (Vizcaino II), cert. denied, 522 U.S. 1098, 118 S. Ct. 899 (1998) (rejecting company's request to reverse or remand Ninth Circuit's decision on the issue of workers' eligibility to participate); Vizcaino v. U.S. District Court for W.D. Wash., 173 F.3d 713 (9th Cir. 1999) (Vizcaino III) (leased employees allowed to participate).