IT Hiring After California’s AB5 Legislation

Hiring really has changed in the past 10 years, especially in Silicon Valley.

Whereas businesses and startups once hired part-time or full-time employees when they needed more hands, the gig economy has significantly increased the the volume and role of contract workers. Many businesses, mine included, now go so far as to rely almost exclusively on contract workers.

There are many benefits from the new gig economy hiring model. But there also are problems with it, especially around the potential for job instability, exploitation, and skirting around employer responsibility through worker misclassification. The hiring practices of Uber and other disruptive tech firms have sparked concern among the public, and governments are finally stepping in with rules to curb the rough edges of gig economy employment.

California Assembly Bill 5Opens a new window , which came into effect January 1 and is known widely as AB5, is one of the earliest attempts at regulating these rough edges of gig economy employment. It is a response to the 2018 California Supreme Court rulingOpens a new window that introduced an ABC test for determining if a worker is truly an independent contractor or a covert employee.

The 2018 ruling defined three basic criteria necessary for classification as an independent contractor:

a) The worker 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 worker performs work that is outside the usual course of the hiring entity’s business.

c) The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

As should be immediately apparent, this test challenges how many California businesses are structured, and it leaves a lot of room for concern around current IT hiring. So in response, the California legislature got involved and formalized the rules around gig economy employment, as well where there are exemptions. That’s AB5.

The bad news is that there aren’t exemptions for IT workers. The tech industry must pay close attention to AB5.

“There are many enumerated exceptions to AB5, but IT professionals or consultants are not listed,” says Nancy Yaffe, a partner at law firm Fox Rothschild LLPOpens a new window . “So unless IT professionals lobby the state legislature to get an exemption (which seems unlikely), AB5 will apply.”

Here’s how AB5 affects IT hiring.

Hiring Limitations

Some of the new rules around AB5 actually are just formalizations of old rules around independent contractors, but now those old rules are enforced and with teeth.

Don’t Hire Contractors for Normal Operations

Flexible IT staffing takes a big hit under AB5. While hiring IT contractors for special projects still works, AB5 takes a dim view of new economy hiring practices around using contractors for normal operations. It is okay to bring on an ERP contractor for a new systems rollout, for instance, but businesses can’t run their analytics department with contractors.

“Hiring companies must ensure that their ‘usual’ course of business is distinguishable from the business of their IT contractors,” says Jason Geller, regional managing partner for the San Francisco office of law firm Fisher PhillipsOpens a new window .

“As should most hiring companies,” he says, “they must evaluate how they describe their businesses in marketing collateral and their websites, and the sources of their revenue, to appropriate evaluate the risk of misclassification. Companies that derive significant revenue from the services of their contractors run the risk of failing part B of the ABC test.”

Business Entities Now Required

Businesses no longer can hire individuals on a contractor basis in many cases. While there are some exemptions, the general rule is that businesses should only hire contractors with a separate legal entity for their business. LLC is in, sole proprietorship is out.

“Individuals who perform IT work (the typical ‘IT guy’) who is working under this own Social Security Number and maybe a DBA, and has no entity, will no longer be compliant,” stresses Yaffe. “Either those IT guys will need to be hired by the retaining entity as W2 employees, or be convinced to set up a business.”

Control and Management Are Limited

One of the key distinctions between an independent contractor and an employee is the control function. You don’t micromanage contractors because they are separate businesses and not employees. They provide services, they don’t follow the methods and hours you set like an employee might.

AB5 stresses this distinction in part A of the ABC test.

“IT departments need to ensure that they are not controlling the activities of IT contractors who are engaged to perform supplemental IT services,” says Geller. “This means hiring companies need to review their management practices, take steps to minimize control over contractors, and evaluate whether to expand or reduce their internal IT departments to minimize exposure.”

This can be a real challenge for new economy business models that have evolved around the gig economy. When contractors replace employees, some of the typical employment assumptions remain even though the nature of contractor hiring is different. The use of hourly rates, for instance.

“Managers should look to use milestones and statements of work wherever possible instead of hourly rates,” advises Jason Posel, co-founder and CEO of contractor compliance firm, GreenLight.aiOpens a new window .

On-Site IT Contractor are Problematic Even with the B2B Exemption

The Business to Business exemptionOpens a new window is one of the workarounds for IT consultants based in California, but even this potentially requires careful setup and some adjustment.

Consultants who work on site, for instance, now pose a potential threat for hiring businesses unless these consultants maintain separate business offices (which excludes IT consultants that work on-site and from their bedroom, for instance).

There’s a laundry list of requirements that consultants must meet under the Business to Business exemption, otherwise AB5 classifies these consultants as employees.

“All of the following factors apply, not a majority,” says Yaffe. “One inapplicable factor will moot the [B2B] exemption.”

• The contractor is free from the hiring firm’s control and direction while performing the work (this must be set forth in the contract and be true in fact).

• The contractor provides services directly to the contracting business rather than to customers of the contracting business.

• The parties have a written contract.

• The contractor has all required business licenses or business tax registration.

• The contractor maintains a business location separate from the business or work location of the hiring firm.

• The contractor is customarily engaged in an independently established business of the same nature as that involved in the work performed.

• The contractor actually contracts with other businesses to provide the same or similar services and maintains a clientele without restrictions from the hiring firm (is not exclusive to the retaining entity).

• The contractor advertises and holds itself out to the public as available to provide the same or similar services (has a web site, for instance).

• The contractor provides its own tools, vehicles, and equipment to perform the services.

• The contractor can negotiate its own rates.

• The contractor, consistent with the nature of the work, can set its own hours and location of work.

• The contractor is not performing the type of work for which a license from the Contractor’s State License Board is required.

Contract Adjustments

Contracts for independent contractors are especially important after AB5 came into effect in January. While most businesses use formal contracts when hiring IT contractors, AB5 makes it mandatory both for the B2B exemption and as a legal shield against later reclassification of a contractor as an employee.

Firms that hire IT contractors will want to revisit their existing contracts in light of AB5, too, since the new law suggests some changes to existing contracts.

State and Imply the B2B Exemption

Part of satisfying the B2B exemption under AB5 is clearly stating it in contractor agreements. Businesses that hire after AB5 and want the B2B exemption must state it in the contract. They also should make sure that the agreement around management, tools, deliverables and other factors reflects a contractor relationship and not an employee relationship. Contractual evidence of a legitimate contractor relationship is important.

“An updated independent contractor agreement will need to be entered into between the IT contractor entity and the retaining entity that addresses the B2B factors and sets forth evidence that the exemption is applicable,” notes Yaffe.

Spell Out Misclassification Processes

The new rules under AB5 are dicey and specific, with lots of scope for gotchas that could lead to reclassification and financial penalties. Contracts with IT independent contractors should include terms that outline how the business and its contractor will handle potential issues around misclassification.

“Both IT contractors and hiring companies must review their agreements with each other to identify how risks of misclassification will be shared,” says Geller. “This includes an evaluation of who will be responsible for monetary losses if misclassification is found, and whether hiring companies should exert some control or review of the pay practices of IT contractors for which the hiring companies may potentially be jointly liable under applicable laws.”

So instead of assuming the hiring relationship will stay on the correct side of AB5, make provisions in all current and future contracts for issues around misclassification.

Hiring Marches On

On first glance, AB5 looks like a considerable headache for businesses that have evolved their hiring practices for agility and gig economy opportunities. The first time I heard about AB5, I worried my entire operational model was in jeopardy.

The reality is less extreme, however. There are new limitations, and some of the innovation around employment is getting squashed. There definitely is new liability and some legal headaches around IT contractor hiring now.

Businesses still can hire in the way that works for them, though. AB5 just protects against abuse and potentially raises the cost and compliance for IT contractor hiring.

“Instead of fighting the law, or penalizing their own business by not taking advantage of the benefits of contract workers, businesses should continue to embrace freelancers but budget for higher costs to cover social security contributions,” says Posel.

The wild gig economy party is over, at least in California. But gig economy hiring is not.

This article is for informational purposes only, and does not constitute legal advice.