Under California’s AB 5, a worker is presumed to be an employee unless the hiring business can prove all three parts of the “ABC test.” If the work falls within one of AB 5’s exemptions, the older, multi-factor Borello test applies instead. Getting classification wrong can mean back wages, tax assessments and significant penalties.
Many founders first run into AB 5 when a freelancer, a payroll provider or an investor’s diligence checklist asks whether a role should really be a 1099 position. The question matters more in California than almost anywhere else, because the state’s test is among the strictest in the country and the costs of misclassification add up quickly.
What AB 5 Is (and Where the Rules Live Now)
Assembly Bill 5 was signed in 2019 and took effect on January 1, 2020. It codified the ABC test the California Supreme Court adopted in Dynamex Operations West, Inc. v. Superior Court (2018) and extended it beyond the wage orders to most of the Labor Code, the Unemployment Insurance Code and workers’ compensation. In 2020, AB 2257 repealed AB 5’s original section and moved the rules into Labor Code sections 2775 through 2787, revising several exemptions along the way. When people refer to “AB 5” today, they generally mean this recodified framework.
The ABC Test, Prong by Prong
A worker is an employee unless the hiring entity can show all three of the following:
- A – Freedom from control. The worker is free from the company’s control and direction in performing the work, both under the contract and in fact.
- B – Outside the usual course of business. The work is outside the usual course of the hiring entity’s business. A software company hiring a plumber to fix an office leak can likely satisfy this prong; a software company engaging “contract” engineers to build its core product usually cannot.
- C – Independent business. The worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed, for example someone with their own business, multiple clients, marketing and tools.
Failing any single prong makes the worker an employee for purposes of the laws AB 5 covers. Prong B is where most startups run into trouble, because companies tend to hire contractors to do exactly what the company does.
Exemptions and the Return of Borello
AB 5 and AB 2257 carved out a long list of exemptions. If an exemption applies, the ABC test does not; instead, classification is decided under S.G. Borello & Sons, Inc. v. Department of Industrial Relations (1989), which weighs the right to control the work along with factors such as the worker’s investment, opportunity for profit or loss, required skill and the permanence of the relationship. Common exemptions include:
- Certain licensed professionals, such as physicians, lawyers, accountants and insurance brokers;
- Professional services, such as marketing, human resources administration, graphic design, grant writing and certain freelance writing, editing and photography, each subject to specific conditions;
- Bona fide business-to-business relationships that meet a detailed list of criteria (Lab. Code §2776);
- Referral agencies that connect clients with service providers (Lab. Code §2777); and
- Other specific occupations and industries listed in the statute.
The exemptions are technical. Most require several conditions at once, such as the worker setting their own rates and hours, maintaining a business location and being free to work for other clients. An exemption is not a safe harbor; it simply swaps in a different test.
Proposition 22 and App-Based Drivers
Voters approved Proposition 22 in November 2020. It allows app-based rideshare and delivery companies to treat drivers as independent contractors if the companies provide certain alternative benefits, such as an earnings guarantee and some insurance coverage. After years of litigation, the California Supreme Court upheld Prop 22 in 2024 in Castellanos v. State of California. Prop 22 is narrow: it covers only qualifying app-based transportation and delivery network companies, not gig or freelance work generally.
What Misclassification Costs
A misclassified worker is owed what California law gives employees, often retroactively. Exposure can include:
- Unpaid minimum wage and overtime, including daily overtime;
- Meal and rest break premiums;
- Unreimbursed business expenses under Labor Code §2802;
- Wage statement and waiting time penalties;
- Payroll taxes, unemployment and disability insurance contributions assessed by the EDD, plus interest and penalties;
- Uninsured workers’ compensation exposure; and
- Civil penalties for willful misclassification under Labor Code §226.8, which increase when there is a pattern or practice of violations.
Workers can also file wage claims with the Labor Commissioner (see our guide on how California wage claims work) or bring representative claims under the Private Attorneys General Act (PAGA). PAGA was significantly reformed in 2024; among other changes, the reforms tightened who can bring claims, gave employers ways to cure certain violations and reduced penalty exposure for employers that take reasonable compliance steps before receiving notice. Those changes make a proactive audit more valuable, not less.
Contracts and Staffing Agencies Don’t Settle the Question
A written independent contractor agreement is useful, but it does not decide classification. Courts and agencies look at how the relationship actually works. Calling someone a “consultant,” issuing a 1099 or having them form an LLC will not help if the company controls their schedule and methods and they do the company’s core work.
Using a staffing agency can shift payroll and administrative duties, but the worker is then typically the agency’s employee, not an independent contractor, and California law can make the client business share liability for certain wage and workers’ compensation obligations (Lab. Code §2810.3). Federal law and other states use different classification tests, so a worker can be a contractor under one regime and an employee under another. If your team is spread across states, our overview of California remote work laws covers related issues.
A Practical AB 5 Audit Checklist
- List every 1099 worker who performs work in California, including part-time and long-term “consultants.”
- Test prong B first. If the work is part of what your company sells or does day to day, assume employee status unless an exemption clearly applies.
- Check exemptions carefully, confirming each statutory condition, and then apply Borello.
- Review practice, not just paper: who sets hours, provides tools, supervises and evaluates the work.
- Update agreements to reflect real independence and include IP assignment and confidentiality terms; for employees, use a CIIAA.
- Convert where needed, with counsel’s help on timing, communications and back-pay exposure.
- Revisit periodically, because roles drift over time.
Frequently Asked Questions
Does AB 5 apply to out-of-state companies that hire workers in California?
Generally, yes. California’s classification rules focus on work performed in California, so a company based elsewhere that engages someone working in the state should evaluate that relationship under AB 5. Workers located entirely outside California may be governed by other states’ tests.
Can a worker agree to be an independent contractor to get around AB 5?
No. A worker’s preference or a signed contractor agreement does not determine classification. The ABC test looks at the actual working relationship, and most employee protections under the Labor Code cannot be waived by contract.
Does hiring a worker’s LLC automatically qualify for the business-to-business exemption?
No. The business-to-business exemption requires a detailed list of conditions to be met, and having a business entity is only one of them. Even when the exemption applies, the relationship must still pass the Borello test.
What should we do if we discover a worker is misclassified?
Talk to counsel before making changes. Reclassifying the worker going forward is usually the right step, but how and when you do it, and how you address possible back pay, taxes and penalties, can significantly affect your exposure.
The Takeaway
Under AB 5, California presumes workers are employees. Unless you can prove all three ABC prongs, or a specific exemption applies and the worker passes the Borello test, treat the role as employment. Fixing classification early almost always costs less than defending it later.
How Sutter Law Can Help
Sutter Law helps California startups and growing companies audit contractor relationships, evaluate AB 5 exemptions, draft agreements and transition misclassified workers to employment. Learn more about our employment law and compliance practice, or contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
