The Govt. War against Independent Contractors: A Progress Report

Tax Planning

For decades, many state and federal agencies have had it in for businesses that hire independent contractors rather than employees.

The business reasons for independent contractors are obvious: when you hire a worker whom you classify as an independent contractor, you don’t pay unemployment taxes or workers’ comp premiums, or provide any employee benefits;

  • you don’t pay employer payroll taxes;
  • you are not subject to most federal and state labor laws that require a minimum wage, overtime,
  • and the right to unionize; and
  • you don’t have to withhold any taxes from independent contractors’ compensation and pay them to the IRS.

The primary government objection to independent contractor status is the failure by contractors to pay their taxes. And the big reason for that failure to pay is the lack of prepaid taxes that the government enjoys from W-2 employees.

But millions of Americans want to work as independent contractors, and millions of businesses want to hire them.

Indeed, due to the COVID-19 pandemic, more people than ever want the freedom that comes with being an independent contractor rather than an employee.

As a result, businesses have offered stiff resistance and made some progress against recent government efforts to make independent contractors W-2 employees.

The California Problem

Before getting into the California problem, know this:

  • Both the federal government and the states can create trouble for your classification of a worker as an independent contractor.
  • If you are located in a state other than California but you have an independent contractor in California, you have a California problem that can affect all your independent contractors. Think of the company that had 45 independent contractor sales reps, three of whom were in California. So that all sales reps would be treated the same, the company converted all the traveling sales reps to employees, who now suffer alongside the individual.

AB 5

In 2020, California launched the broadest assault on independent contractors in recent memory when it enacted a law popularly known as AB 5.1 This law established a new “ABC test” for determining whether California workers should be classified as employees for purposes of California and thus enjoy the benefits of

  • unemployment insurance,
  • workers’ compensation insurance,
  • state income tax withholding, and
  • state labor and wage and hour laws, including the state’s minimum wage and overtime laws.

The ABC Test

Under the ABC test, all workers are presumed to be employees. Under this test, a worker qualifies as an independent contractor only if that worker

  1. 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, and
  2. performs work that is outside the usual course of the hiring entity’s business, and 
  3. is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Be alert. Some 33 states have used a version of the ABC test for decades, but never one as strict as California’s.

The “B” prong of the test is the big obstacle. A worker can’t satisfy Prong B if he or she performs services related to the hiring firm’s core business. This is so even though the worker is running an independent business.

For example, a freelance writer can’t satisfy Prong B if he or she writes for a newspaper or news website, since that is the hirer’s core business. In states other than California, workers can satisfy Prong B only if they work outside the hiring firm’s premises.

To reduce the harsh impact of the ABC test, AB 5 as originally enacted contained about 50 exemptions. Workers who fall within one of the exemptions aren’t automatically independent contractors. Instead, the worker’s status is determined under the much more employer-friendly test that California used before AB 5.

AB 5 also imposes select rules that allow some workers to qualify as independent contractors under an ABC test exemption. For example, freelance writers are exempt only if they create no more than 35 articles per year for a hiring firm.

AB 5 went into effect on January 1, 2020, and the California Supreme Court held that certain portions of the new law were retroactive going back four years.

Rocky Road

Many feared that AB 5 would drastically limit the use of independent contractors in California. But it hasn’t worked out that way.

AB 5’s road to full implementation was rocky, to say the least. Some businesses declared that they would not hire any independent contractors in California because they didn’t want to deal with the new law. This created a firestorm of complaints by many California-based independent contractors.

Proposition 22

AB 5 was particularly aimed at Uber, Lyft, DoorDash, and other “gig worker” hiring platforms that classified drivers and other gig workers as independent contractors.

In response, Uber, Lyft, and similar companies spent over $200 million to sponsor a successful ballot proposition in 2020 (Proposition 22). The proposition completely exempted most drivers for app-based rideshare and delivery platforms from AB 5. In return, the platforms promised to provide their drivers with healthcare subsidies, a minimum earnings guarantee, and compensation for vehicle expenses.

Proposition 22 passed overwhelmingly (59% of Californians voted yes). But a trial court judge recently ruled that the proposition violated the state constitution. Prop. 22 remains in effect while the ruling is on appeal.

Massachusetts. The proposition’s backers plan to put a similar law on the ballot in Massachusetts in November 2022.

Meanwhile, the California Legislature bowed to public pressure and amended AB 5 to add more exempt job categories and make existing exemptions easier to use.6 For example, lawmakers dropped the requirement that freelancers write no more than 35 articles for a single hiring firm.

Exemptions Galore

There are now over 100 exemptions to AB 5’s ABC test. These include exemptions for7

  • physicians, surgeons, dentists, podiatrists, psychologists, and veterinarians;
  • insurance brokers, underwriters, premium auditors, and risk managers;
  • lawyers;
  • architects, landscape architects, and engineers;
  • private investigators;
  • accountants;
  • registered securities broker-dealers and investment advisers;
  • direct sales salespeople;
  • manufactured housing salespersons;
  • individuals engaged by an international exchange visitor program recognized by the U.S. Department of State;
  • competition judges, including amateur umpires and referees;
  • marketing professionals (provided that the contracted work is original and creative);
  • travel agents;
  • human resources administrators;
  • graphic designers;
  • grant writers;
  • fine artists;
  • enrolled agents;
  • appraisers;
  • professional foresters;
  • home inspectors;
  • payment processing agents through independent sales organizations;
  • freelance writers, editors, translators, copy editors, illustrators, newspaper cartoonists, still photographers, photojournalists, videographers, and photo editors;
  • digital content aggregators for still photographers, photojournalists, videographers, and photo editors;
  • individuals who provide content for a journal, book, periodical, evaluation, other publication, or educational, academic, or instructional work;
  • specialized performers hired by a performing arts company or organization to teach a master class for no more than one week;
  • licensed barbers, manicurists, electrologists, cosmetologists, and estheticians;
  • DJs, caterers, and musicians who provide services at a single location event;
  • construction industry subcontractors;
  • licensed real estate salespeople and real estate brokers;
  • most occupations involved with creating, marketing, promoting, or distributing sound recordings or musical compositions;
  • businesses that obtain work through job referral agencies that connect them with clients to provide services such as graphic design, photography, tutoring, event planning, minor home repair, moving, home cleaning, errands, furniture assembly, animal services, dog walking, dog grooming, web design, picture hanging, pool cleaning, yard cleanup services, and interpreting services;
  • data aggregators who perform paid surveys or market research;
  • commercial fishermen on American vessels (exception ends on January 1, 2023);
  • licensed repossession agencies; and
  • individuals providing driving services for motor clubs.

The most significant exemption is the broad exemption for business-to-business contractors.

Unlike the other exceptions, this exemption is not limited to workers performing specific types of services. It applies to individuals who conduct business as sole proprietors, partners in partnerships, members of limited liability companies, or corporations. Under this exemption, business service providers involved in a bona fide business-to business contracting relationship are independent contractors if they satisfy all the following 12 criteria—i.e., the

business service provider (worker) 

  1. 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);
  2. provides services directly to the contracting business rather than to customers of the contracting business;
  3. has a written contract;
  4. has all required business licenses or business tax registrations in order;
  5. maintains a business location separate from the business or work location of the hiring firm;
  6. is customarily engaged in an independently established business of the same nature as that involved in the work performed;
  7. contracts with other businesses to provide the same or similar services, and maintains a clientele without restrictions from the hiring firm;
  8. advertises and holds itself out to the public as available to provide the same or similar services;
  9. provides its own tools, vehicles, and equipment to perform the services;
  10. can negotiate its own rates;
  11. can set its own hours and location of work, consistent with the nature of the work; and
  12. is not performing the type of work for which a license from the Contractors State License Board is required.

As a result of all these exemptions, it appears that few bona fide independent contractors in California have to satisfy the strict ABC test established by AB 5.

What’s Happening in Other States?

Many experts believed other progressive “blue” states would follow California’s example and enact laws similar to California’s AB 5. Perhaps because of the pushback AB 5 received, however, this hasn’t happened.

For example, New Jersey passed a series of laws giving the New Jersey Department of Labor and Workforce Development more authority to combat worker misclassification and increased the penalties on employers who do so. It even made misclassifying workers to evade unemployment or other insurance premiums a form of insurance fraud under state law.

But New Jersey has not changed its ABC test to make it as strict as California’s. A proposal to do so has been dropped for now. In New Jersey, working outside the hiring firm’s place of business can satisfy Prong B of the state’s ABC test.

What’s Happening with the Federal Government?

The Trump administration was strongly in favor of laws that helped workers qualify as independent contractors.

The Biden administration takes the opposite stance. It supports adoption of an ABC test like California’s across all federal law, declaring: “Employers in many industries misclassify employees as independent contractors to reduce labor costs at the expense of millions of workers and to gain an advantage over competitors. These employers undercut law-abiding employers doing right by their employees, drive wages and labor standards down across the

workforce, and deprive the economy of good-quality jobs.”

The Biden administration has put its money where its mouth is. It requested a $30.5 million budget increase for the Department of Labor’s Wage and Hour Division so it can hire 175 new enforcement personnel to allow the division to combat worker misclassification.

The Biden administration also withdrew a new Labor Department rule promulgated during the waning days of the Trump era that would have made it easier for workers to qualify as independent contractors under the federal Fair Labor Standards Act (FSLA), which establishes national minimum wage and overtime standards for covered employees.

As a result, the Labor Department’s long-standing “economic realities” test remains in effect.Under this test, workers are employees if they are economically dependent upon the businesses for which they render services.

Meanwhile, a federal version of AB 5 called the PRO Act has passed the House of Representatives. The PRO Act implements the ABC test to classify workers for purposes of the right to unionize and collectively bargain under the National Labor Relations Act.

But it’s highly unlikely this law will pass the Senate and be signed into law by President Biden. Indeed, it’s doubtful both houses of Congress will be able to pass any new legislation on this issue for the foreseeable future. As a result, most of the action in this area will occur in state legislatures and federal and state agencies.

A Look at the IRS

Federal law looks to common-law principles for worker classification, which over the years have proven difficult to apply. But there’s the Section 530 rule that protects most businesses.

The IRS, in its efforts to make 1099 independent contractors W-2 employees, relied for years on a 20-factor test. This test proved cumbersome, and today the IRS has broken the 20 factors into three broad factors as described below:

  1. Behavioral control. You look more like an employee if the company you work for has a lot of control over the day-to-day details of your work, such as through specific instructions in your contract or through a supervisor. On the other hand, you look more like an independent contractor if you primarily decide how to perform your work.
  2. Financial control. You look more like an independent contractor if you have invested significantly in your business, if you have unreimbursed expenses, and if you run the possibility of incurring a loss.
  3. Type of relationship. You look more like an employee if you work exclusively for the company; plan to work there indefinitely; and get benefits such as a retirement plan, sick days, and medical benefits.


If you can hire independent contractors to do the work, keep the tax savings in mind. When you hire a worker whom you can classify as an independent contractor, you (as the employer) enjoy the following benefits:

  • You don’t pay unemployment taxes or workers’ comp premiums, or provide any employee benefits.
  • You don’t pay employer payroll taxes.
  • You are not subject to most federal and state labor laws that require a minimum wage, overtime, and the right to unionize.
  • You don’t have to withhold any taxes from independent contractors’ compensation and pay them to the IRS.

And keep this in mind: millions of Americans want to work as independent contractors.

But as you see, many state and federal agencies have it in for businesses that hire independent contractors rather than employees. Make sure you have a good basis for your classification of a worker as an independent contractor.

The latest thorn in the worker classification bush, California’s AB 5 law, has been dramatically watered down in response to widespread complaints by both independent contractors and businesses.

Today, California’s AB 5 law has more than 100 exceptions that make it far easier to classify workers as independent contractors.

Other states seem to have learned from California’s example and have thus far not implemented a law like California’s.

If the Biden administration creates new trouble for your worker status, you will have time to change your worker classifications without penalty. The one thing to know is that you need to keep an eye on the law if you classify workers as independent contractors.

Christopher Ragain

My name is Christopher Ragain, I am the founder of Tax Planner Pro.  I love helping small business owners find creative and legal ways to beat the TaxMan.  My team and I love to write and you can find all of our insights on this blog!

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