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?

Gig Worker Compliance Challenges Including AB 5

On 10/1/19, the Franchise Tax Board (FTB) held a meeting, chaired by State Controller Betty Yee, focused on compliance for gig workers. You can see by the agenda that many topics were covered including background data on understanding the gig economy which for the meeting meant those finding income opportunities from web platforms such as Uber, Postmates, TaskRabbit or hundreds of other similar sites. A video of the meeting is available.

I was honored to participate on a panel on Challenges and Opportunities for Tax Compliance in a Gig Economy. A few points I offered:

• The issue of worker classification is decades old and a big issue that Congress left unaddressed since at least 1978 with "Section 530" of the Revenue Act of 1978. This provision results in some workers being contractors for purposes of the employer's employment taxes, but employees for other purposes including for the worker's tax obligations. It is unfortunate that the multitude of classification schemes among federal and state laws has been allowed to continue for so long. I was hoping that the emergence of the platform work arrangement might finally be a time to look at this broken system, but apparently not yet. Instead we are getting more variations (such as California's AB 5 making many workers employees where other states enacted laws in 2018 clarifying that the platform workers were contractors).  The hearing didn't delve into the possibility of the need for a third category of work arrangement as this was focused on compliance rather than policy changes via legislation.
• We need to provide wider tax education to everyone, such as by including tax education in K-12 curriculum!
• For contractors – change the law to require the hiring person to get a Form W-9 and electronically submit it to IRS and State tax agency. These agencies then check if the person has filed a Schedule C or equivalent form (W-9 requires taxpayer to note type of business entity).  If yes – likely nothing need be done.  If no, email and mail that worker clear information about their tax obligations as a new self-employed entrepreneur. Connect them to tax agency YouTube videos as well. Ideally, this could also be when the federal government deposits $500 into their new retirement account (or perhaps does that once the first return with the Schedule C is filed).
• Lower the Form 1099-K threshold to match Form 1099-MISC ($600). California should not wait for Congress to do this but should instead do what Massachusetts and Vermont already did and drop the threshold to $600. This will help workers and reduce non-filing and the tax gap. It will also mean that more folks renting their property through Airbnb and similar thresholds get a reporting form (and that the government does as well).
• The  IRS has an online withholding calculator for employees that freelancers can also use – but it only works if the taxpayer has wage withholding.  The IRS and FTB should create online calculators to make it easy to compute quarterly estimated tax payments (federal and state) and to pay them online even if a taxpayer doesn't have wage income.
• A gig worker testifying lamented that she would not be able to prove her expenses for mileage on her own but would have to rely on the information provided by Uber and Lyft. That's a great point.  Rather than duplicate the recordkeeping, I suggest that the tax agencies find a way to "certify" the platform's recordkeeping so that the workers can use that information for tax preparation without issue. This should also help the worker understand the information. For example, did the app also track miles  between a drop off and next pick up (it would be helpful for tax recordkeeping if it did).

What about AB 5 enacted in California in September that will cause all employers with California contractors to determine the classification standard under the ABC test. That test starts with the presumption that the worker is an employee. To see if they are not an employee, the ABC test is met requiring meeting each of the following 3 requirements:

  (A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

  (B) The person performs work that is outside the usual course of the hiring entity’s business.

  (C) The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If not met, next see if one of the roughly 50 exceptions in AB 5 is met.  If an exception is met, then apply the Borello factors which are basically the common law approach to see if the service recipient has the right to control the manner and means of how the work is performed. If the service recipient can control the manner and means, the worker is an employee; otherwise, is a contractor.

It is important to read the AB 5 exceptions carefully.  I have seen summaries that say accountants are excepted. That is far too simplified. The exception actually reads: "An individual who holds an active license from the State of California and is practicing one of the following recognized professions: lawyer, architect, engineer, private investigator, or accountant." Like this one, more exceptions will raise interpretive issues such as what does "practicing" mean. In addition parts of the ABC test, particularly "B" will raise interpretive issues. Unfortunately rather than clarifying worker classification by using objective factors, AB 5 leaves us with mostly subjective criteria. 

The results of AB 5 are many but include:

• A worker might be an employee for California law but a contractor for federal. It will be very important for the worker and payor to understand the tax consequences. For example, there is no form equivalent to a Form W-2 that is only issued to a worker and the EDD and FTB (rather than also to the IRS and Social Security Administration); one will need to be created. While this different in classification is not new, it is likely to affect far more workers starting in 2020.
• A worker may continue to be a contractor for both California and federal but more documentation is needed to show that the work arrangement met the ABC test or met an exception.
• The worker is unfortunately out of a job because the payor doesn't want to hire them as an employee. I'm concerned that this may be the case for many part-time workers. The person presenting on October 1 from Postmates noted that many on the platform work just 3 to 5 hours per week and then only for about 3 to 5 months. It's a lot of work to hire these short-term workers as employees.  It is also possible that those hired will not get all benefits, such as offering of health insurance as they might be hired to work less than 30 hours per week with no legal requirement to offer coverage. And virtual workers might find that the employer prefers now to just use workers outside of California.
• And there are other possibilities - let's see what happens.

One additional tax compliance issue I raised involved freelancers that provide services to people outside of California, such as a virtual worker might who is consulting, providing graphic art services or tech services (such as Amazon Mechanical Turks provide). Like all of the tax issues, this is not unique to gig workers but any contractor or any-size business, what is the guidance for sourcing the income to California or other states - and what are the rules in other states. Unfortunately, this can be a complex tax issue not only for individual sole proprietors but also large multistate corporations.

So, lots of issues for compliance, not only for gig workers but other contractors PLUS new complications of the ABC test and its exceptions added by AB 5 effective 1/1/20. All employers with California contractors need to take a look at this legislation to see what changes. While the worker might still be a contractor, the service recipient (payor) will need new documentation to show that the person is a contractor beyond what was needed before 2020.

What do you think?  (btw, I expect to write more on AB 5 later as it is not an example of law changes that help move tax systems into the 21st century to reflect how we live and do business today. There are much better ways to actually get more safety net benefits and beyond to ALL workers.  Also, note that lots of employees don't get many benefits and have very low wages. I think we need to do more as a civil society to address levels of pay and safety net and retirement benefits for EVERYONE and there are ways to accomplish this!