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What Are the Tax Implications of AB5?


When you begin to examine the business tax implications of California’s AB5 law, it’s easy to make things complicated. We’d like to simplify them.

A quick recap

First, though it’s been just over a month since California Governor Gavin Newsom signed Assembly Bill 5 (AB5) into law, let’s recap the main points of this legislation. To qualify as an independent contractor (IC) in California, a worker must:

  1. Be free from the control and direction of the hiring organization
  2. Work outside the normal scope of the hiring organization’s business
  3. Be engaged in an independently established trade, occupation or business

If an IC doesn’t meet these three requirements, and they’re not included under “carve-out” exclusions to the law (read about those here), he or she may need to be reclassified as an employee.

The impacts of misclassification

Before we look at the tax implications of AB5, we need to understand why misclassification of workers has become a huge issue, for the U.S. government and businesses alike.

A big tax bill

The IRS estimates that payroll fraud, including misclassification of employees as ICs, costs the federal government $16 billion each year in lost taxes.

How could this be? Well, for one, there are loopholes in reporting requirements for independent contractors. For example, although businesses paying an independent contractor $600 or more per year are required to send the contractor and tax authorities a 1099-Misc. form showing the gross amount paid, taxes are not withheld by the businesses issuing the 1099s, and underreporting by ICs of their 1099 income, and failure to pay self-employment taxes is well documented.

Paying estimated taxes including Social Security and Medicare tax is the responsibility of the contractor. However, many small businesses do not comply with reporting requirements.

“That’s mainly because independent contractors are subject to less third-party reporting than employees,” writes Kathleen Pender of the San Francisco Chronicle in Converting from contractor to employee has benefits, but taxes aren’t one of them.

Larger “gig-economy” companies, also known as third-party settlement organizations, have discovered and use loopholes in IRS reporting requirements to avoid reporting worker payments under certain thresholds as well.

Some states such as Massachusetts and Vermont have tried to close these loopholes with stricter reporting standards.

In spite of state attempts to reduce under-reporting, the end result is billions in unpaid taxes. Read more about U.S. tax gap (the difference between what was actually paid to the IRS and what should have been paid).

Competitive disadvantage

In the long-run, businesses that report wages and classify workers correctly, “are disadvantaged by higher labor and administration costs relative to employers who misclassify.” according to a paper published by the Economic Policy Institute.

AB5 employment laws and taxes

Where an IC is found to be an employee as a result of AB5 there are implications at both State and Federal levels for the purposes of multiple employment laws, many of them with tax implications.


If a California IC is misclassified, meaning he or she doesn’t meet all of the components of the ABC test, then many employment laws become effective. These laws must be complied with as the said contractor has been determined to be an employee. The various requirements of the employment relationship which come into play at the state level include:

  • State income tax and income tax withholding
  • Worker’s Compensation
  • State Unemployment
  • Wage and hour (enforced by the Department of Labor)
  • Many different types of benefits (overtime, sick leave, reasonable and necessary expenses, retirement)


At a Federal level, the situation is more complex. Since the various tests for worker classification at a Federal level have not changed, it is possible that a worker who no longer qualifies as an IC in California will still qualify as an IC for Federal purposes. However, the practicality of having a worker providing services for a client and being treated as an IC for some taxes, but as an employee for others may not be feasible, and making a clear and convincing argument in court, even more challenging. Companies are therefore likely to treat the disqualified CA IC as an employee for all purposes, in which case the following federal laws also apply:

  • Social Security and Medicare taxes
  • Verification of an I-9 (United States Citizenship and Immigration Services form)
  • Wage and hour (enforced by the Department of Labor)
  • Equal Employment Opportunity Commission (nondiscrimination requirements)
  • Fair Labor Standards Act (FLSA)
  • Americans with Disabilities Act (ADA)
  • Affordable Care Act (ACA)

Let’s take a closer look at just two of the items on this list which have tax implications.

ACA Compliance

The tax requirements for the ACA alone are huge. According to the IRS,

Under the ACA Employer Mandate, organizations with 50 or more full-time employees [30 hours per week or 130 hours per month] and full-time equivalent employees are required to offer Minimum Essential Coverage (MEC) to at least 95 percent of their full-time workforce (and their dependents) whereby such coverage meets Minimum Value (MV) and is affordable for the employee or be subject to Internal Revenue Code (IRC) penalties.

In anticipation of a possible reclassification, employers who may have to reclassify workers as employees should consider tracking hours, wages and other details to comply with ACA regulations, as well as offer these new employees health insurance. Plus, employers will need to update their reporting requirements and be aware that submitting the required ACA forms annually to the IRS could increase costs.

Social Security and Medicare

Employers reclassifying employees will need to pay half of the Social Security and Medicare taxes for misclassified workers—taxes previously paid for by ICs who correctly reported their quarterly income.

Turn to TalentWave

The AB5 landscape continues to shift rapidly. Uber and Lyft recently introduced a ballot measure asking California voters to exempt their drivers from AB5. Only time will tell what future legal decisions will be delivered pertinent to the law.

TalentWave specializes in IC classification and worker engagement solutions. We help businesses properly engage ICs around the world every day. TalentWave can help you navigate uncharted waters, like AB5, keeping your organization and your ICs safe. Please contact us with any questions.

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