AB 5 Alternative or How Business Owners Can Better Spend $800 Per Year

In September 2019, California enacted a new worker classification approach called the ABC test (AB 5 - see Oct 2019 post). Basically, AB 5 starts with the presumption that all workers are employees rather than independent contractors (unless they work for the State of California which is exempt from many state labor laws). If A, B and C of the law are met, the worker is a contractor.  If A, B and C are not met, the parties need to see if any of about 50 exemptions apply and if yes, then apply the pre-AB 5 classification system which primarily looks at factors to determine if the employer has the right to control the manner and means of how the worker does his/her work.

While one goal was to be sure workers are not disadvantaged by some employers who may pay low amounts, I believe the law has far more disadvantages than advantages, there were definitely better and more modern ways to improve the law, and there are a lot of new complexities and confusion.  The new legislative year also started with over 25 proposals to add more exemptions and clarifications or even to repeal AB 5.

One aspect I want to address here is a 2/20/20 press release on AB 5 sponsor Assemblymember Gonzalez website. It includes:

"“We know many of California’s independent contractors who operate as actual small businesses are making a good faith effort to comply with AB 5 and formalize themselves and their business licenses,” Assemblywoman Gonzalez said. “This one-time relief will help these business owners with the transition to becoming LLCs.”

Under AB 5, some independent contractors who operate as bona fide small businesses can maintain contractual relationships with other businesses. This has resulted in a number of independent contractors forming single member limited liability companies (LLCs) to maintain their prior business relationships.

To form an LLC, a business pays an annual tax of $800, also called the Minimum Franchise Tax (MFT). To assist these independent contractors with the transition to formalizing their small businesses, this budget request proposes a one-year exemption of the $800 annual tax for the contractors who formed their businesses from September 2019 through December 2020."

I believe the underlying matter that led to this press release is a proposal in Governor Newsom's budget that new LLCs be exempt from the $800 minimum tax in their first year just as corporations are.  I don't see in his budget that he thinks forming an LLC makes someone a contractor as the press release incorrectly assumes. [See page 52 of the governor's budget summary.]

While there may be legal and business reasons for some businesses to form an LLC, it is not required.  An individual can operate as a sole proprietor and buy insurance in many cases. Also, when a person forms a single-member LLC, it is taxed as a sole proprietor for tax purposes BUT must pay an annual minimum tax of $800 (btw, minimum tax means you pay it even if you don't have any income).  I don't see what that sole proprietor gets though for that $800.

If there is any eagerness by lawmakers to see sole proprietors pay $800 every year, why not instead change California law to require ALL workers to pay SDI (State Disability Insurance). SDI is paid by employees, but not contractors. If all workers paid it, contractors would have a protection they don't have today unless they buy their own disability insurance. The cost is 1% of earnings capped at $1,229 for 2020.  So, let contractors pay SDI up to the maximum based on their net earnings.  This would provide a benefit they don't get by paying $800 LLC minimum tax each year.

Also, the press release is puzzling in implying that forming an LLC makes a worker a contractor.  That is not part of the ABC test and likely does not cause a worker to meet ABC or an exception. [Also see this 2/8/20 SF Chronicle article.] Also, take a look at AB 5 and note that it says in a few places that a legitimate business entity form for contractors includes a sole proprietorship. 

Also, a business license is completely different than the $800 minimum tax. Business license is generally a fee or tax paid to local government and some types of businesses may have additional license fees (workers required to have a license such as CPAs and manicurists).

I think what the press release is inferring about the governor's proposal harms his proposal. His proposal is a good one because it would make the law more equitable by giving all corporations and LLCs the same first year exemption from the $800 minimum tax (today only corporations get this tax break). 

What do you think?