California Independent Contractor Rules: AB5 Compliance Guide
If you pay people to do work for your California business, you have to decide whether each one is an employee or an independent contractor. California makes that decision harder than most states do. Assembly Bill 5 (AB 5), enacted in 2019 and codified in Labor Code 2775 and the sections that follow, starts from the assumption that a worker is an employee. The hiring business has to prove otherwise. This guide covers the ABC test, the main exemptions, the penalties for getting it wrong, and the reporting you owe.
Disclaimer: This is informational content, not legal or tax advice. Classification depends on the facts of each working relationship. Before you reclassify anyone or rely on an exemption, talk with a qualified employment attorney or CPA.
The ABC Test: The Default Rule
Under Labor Code 2775, a person who provides labor or services for pay is an employee, not an independent contractor, unless the hiring business shows all three of the following:
- Prong A, freedom from control: The worker is free from the hiring business's control and direction in connection with the work, both under the contract and in fact.
- Prong B, outside the usual course: The work is outside the usual course of the hiring business's operations.
- Prong C, independent business: The worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.
The hiring business carries the burden of proof, and it must satisfy all three prongs. Failing one prong makes the worker an employee under this test. Prong B is the one most businesses fail. A trucking company that hires drivers as contractors to haul its own freight has a hard time arguing that hauling is outside its usual course of business. The same company hiring an outside accountant to prepare its taxes has a much easier case.
The ABC test applies across the Labor Code, the Unemployment Insurance Code and the wage orders. One classification decision therefore drives your wage obligations, your unemployment insurance obligations and your payroll tax obligations at the same time.
When Exemptions Apply: The Borello Test
AB 5 includes exemptions for specific relationships and occupations. If an exemption applies, the question is no longer answered by the ABC test. It moves to the older Borello multifactor test, which weighs many factors about the whole relationship. The right to control the work is a central factor, but the analysis also considers the worker's investment, opportunity for profit or loss, and whether the work is part of the hiring business's regular operations. Because Borello is a fact-heavy analysis, a document that says a worker is a contractor does not settle the question on its own.
The California B2B exemption under Labor Code 2776
The business to business (B2B) exemption covers a sole proprietor, partnership, LLC, LLP or corporation that contracts with another business or a public agency. The contracting business must show all 12 of the following conditions:
- The worker is free from the hiring business's control and direction.
- The services are provided directly to the contracting business, not to its customers. One exception applies where the provider's own employees do the work and the provider regularly contracts with others.
- A written contract states the payment amount and the payment due date.
- The provider holds a required business license or business tax registration, if the jurisdiction where the work is performed requires one.
- The provider maintains a business location separate from the contracting business. A residence may qualify.
- The provider is customarily engaged in an independently established business of the same nature as the work.
- The provider can contract with other businesses and keep its clients without restriction.
- The provider advertises and holds itself out to the public as available to perform the work.
- The provider supplies its own tools, vehicles and equipment consistent with the work.
- The provider can negotiate its own rates.
- The provider can set its own hours and location, consistent with the nature of the work.
- The provider does not perform work that requires a Contractors State License Board (CSLB) license.
The last condition matters most for the construction trades. A subcontractor doing work that requires a CSLB license cannot use the B2B exemption, so the ABC test or the Borello analysis governs that relationship instead. Check each condition against the actual relationship, not just the contract language. A contract that promises independence does not help if the hiring business sets the hours and supervises the work.
The professional services exemption under Labor Code 2778
Labor Code 2778 is a separate exemption with its own conditions, including a business location separate from the hiring business and a list of covered services. Freelance writers, translators, editors, copy editors, illustrators and newspaper cartoonists are among the covered occupations. They qualify when all of the following are true:
- They work under a written contract that states the rate of pay, the intellectual property rights and the obligation to pay by a defined time.
- They are not directly replacing an employee who did the same work at the same volume.
- They do not primarily work at the hiring business's location.
- They are not restricted from working for more than one hiring business.
There is no submission cap in this exemption. A writer who sends a steady flow of pieces to one publication can still qualify, as long as the other conditions are met. Other occupations under 2778 have their own conditions, so read the statute or ask counsel before you rely on it for a role that is not on the list above.
Proposition 22 applies only to app-based drivers
Voters passed Proposition 22 in 2020, and the California Supreme Court upheld it in Castellanos v. State of California on July 25, 2024. Proposition 22 sets its own classification rules for app-based rideshare and delivery drivers working for app-based companies. It does not apply to other businesses. A marketing consultant, a construction subcontractor or a bookkeeper cannot rely on it.
Misclassification Penalties Under Labor Code 226.8
Labor Code 226.8 makes willful misclassification of an employee as an independent contractor unlawful. It also makes it unlawful to charge a willfully misclassified person fees or deductions. The civil penalties are:
- $5,000 to $15,000 per violation
- $10,000 to $25,000 per violation where there is a pattern or practice
The penalty applies per violation, so the total depends on how many violations the agency or court finds. The word willful matters. The statute targets knowing misclassification, so a business that can show a good-faith, documented analysis is in a different position than one that ignored the test. If the business is a licensed contractor, an order can also be sent to the CSLB for discipline against the license.
Penalties under 226.8 are only one part of the exposure. A misclassified worker also creates payroll tax, workers' compensation and wage law issues. Our guides on California workers' compensation insurance requirements and on registering as an employer with the EDD cover those obligations in more detail.
Reporting: The DE 542 and Form 1099
The EDD requires a DE 542 report within 20 days when a business pays or contracts to pay an independent contractor $600 or more. This is the California reporting obligation that most small businesses miss, and it applies whether or not the contractor is ultimately found to be correctly classified. Submit the report to the EDD and confirm the current filing method on the EDD website.
Federal reporting is separate. The federal Form 1099-NEC threshold is $2,000 for payments made after 2025. Because state and federal thresholds differ, verify both figures before you file. Confirm the current federal amount with the IRS and the current California reporting requirements with the EDD. Do not assume one threshold applies to both.
A Practical Compliance Checklist
- Map every role that uses outside labor against the ABC test, one prong at a time. For Prong B, write down why the work is or is not part of your core operations.
- If you plan to use an exemption, check all of its conditions, including the ones that seem minor. The B2B exemption has 12 conditions, and missing one removes it.
- Put every engagement in a written contract that states the rate, the payment due date and, for writers and similar professionals, who owns the intellectual property.
- Check whether the city where the work is performed requires a local business tax or registration certificate. Most California cities charge one, but there is no common formula, so check the rule for your city.
- File a DE 542 within 20 days for every contractor you pay or contract to pay $600 or more.
- Track federal 1099-NEC obligations separately and verify the threshold with the IRS.
- Keep records that show the contractor sets its own schedule, uses its own tools, serves other clients and negotiates its own rates.
- Review any reclassification decision with an employment attorney before you change how someone is paid.
Where to Confirm Current Rules
California statutes change, and agency guidance is updated over time. Check the current text of the statute and the agency pages before you rely on any figure in this guide.
- Employment Development Department (EDD): https://edd.ca.gov/
- Contractors State License Board (CSLB): https://www.cslb.ca.gov/
- California Legislative Information, for the Labor Code text: https://leginfo.legislature.ca.gov/
- California Small Business Development Center network, for free one-on-one advising: https://californiasbdc.org/
If your relationship falls under an exemption, a professional services role, or a licensed trade, the cost of a short consultation with an employment attorney or CPA is usually far less than the cost of a misclassification dispute. Get that advice before the first payment goes out.