Tax Implications of Worker Classification Under California A.B. 5
A.B. 5 may impact employee or independent contractor status for California workers. Aimed to protect gig workers, it has tax applications. There are different tax reporting and filing requirements for employees or independent contractors. A.B. 5 may result in some inconsistent treatment of workers for federal and state purposes.
What does A.B. 5 do?
The law codifies the 3-part test established in Dynamex Operations West, Inc. v. Superior Court for determining independent contractor status. Under the test, a worker is an employee, unless the worker:
- is free from the control and direction of the hiring entity in connection with performance of the work;
- performs work outside the usual course of the hiring entity’s business; and
- customarily engages in an independently established trade, occupation, or business of the same nature as the work performed.
The test applies to worker classification for purposes of certain rights and benefits under state law. Some industries, occupations, and business relationships are exempt from the new test.
What are the possible scenarios under A.B. 5?
Under A.B. 5, a worker might be:
- an employee for both federal and California purposes;
- an independent contractor for both federal and California purposes; or
- an independent contractor for federal purposes and an employee for California purposes.
Employee for both federal and California purposes
For workers classified as employees for both purposes, the employer must:
- provide the employee with a Form W-2;
- withhold federal and state income taxes and state disability insurance (SDI) tax;
- withhold the employee’s share of Social Security and Medicare taxes;
- pay the employer’s share of Social Security and Medicare taxes; and
- pay state unemployment insurance and employment training taxes.
Employees generally cannot deduct the costs of being an employee. There is an exception only for some unreimbursed expenses required by the employer.
Independent contractor for both federal and California purposes
For workers classified as independent contractors for both purposes, the hiring entity may provide the worker with a:
- Form 1099-K, Payment Card and Third Party Network Transactions; or
- Form 1099-MISC, Miscellaneous Income.
Form 1099-K generally includes:
- the gross amount received from third party transactions (including gig platform transactions);
- the number of payments received; and
- any federal or state income tax withholding where the worker did not provide a taxpayer ID number.
Form 1099-MISC includes information on items like:
- other income; and
- nonemployee compensation.
For an independent contractor, there is no withholding for Social Security and Medicare taxes. But, the worker must pay the federal self-employment tax, which accounts for Social Security and Medicare taxes. For California purposes, the worker may elect to pay unemployment insurance tax, but it is not required.
An independent contractor can deduct ordinary and necessary business expenses.
Independent contractor for federal purposes and employee for California purposes
A worker classified as an independent contractor for federal purposes and an employee for California purposes will likely receive:
- Form 1099-K or Form 1099-MISC; and
- Form W-2.
The income reported on the 1099-K or 1099-MISC may differ from that reported on the W-2.
As independent contractors, workers must pay the federal self-employment tax. As employers for California purposes, hiring entities must withhold state income tax and SDI tax. They also must pay state unemployment insurance and employment training taxes.
Independent contractors can deduct their business expenses for federal purposes, as described above. If classified as employees for California purposes, they might not qualify for the same deductions. For example, assume a worker uses a vehicle for work. As an independent contractor, the worker could depreciate the vehicle and deduct maintenance costs for federal purposes. As an employee, the worker cannot take those deductions for California purposes.
Lawsuits and legislative fixes
The state of A.B. 5 remains in flux. While currently in effect, multiple lawsuits seek to block application of the law. In addition, there are dozens of legislature proposals to:
- repeal and replace A.B. 5;
- revert California law to a pre-A.B. 5 test;
- create a third classification of workers;
- provide some tax relief to independent contractors; and
- carve out many more exemptions under A.B. 5.
By Carolyn Kwock, J.D.