How California’s AB 5 Affects Your Small Business Tax Filing
If you run a small business in Los Angeles or the San Fernando Valley and you pay anyone who isn’t on your payroll, AB 5 has a direct impact on how you handle your taxes. Getting the classification wrong isn’t just a labor issue, it creates real exposure with the IRS, the California Franchise Tax Board (FTB), and the Employment Development Department (EDD).
Here is what you need to know.
What AB 5 Actually Says
California’s Assembly Bill 5 took effect January 1, 2020. It established the ABC test as the default standard for determining whether a worker is an employee or an independent contractor.
Under the ABC test, a worker is presumed to be an employee unless all three of the following are true:
- The worker is free from the hiring company’s control and direction in performing the work
- The work performed is outside the usual course of the hiring company’s business
- The worker is customarily engaged in an independently established trade, occupation, or business
That second prong is where most small businesses run into trouble. If you hire a graphic designer to build marketing materials for your consulting firm, or a bookkeeper to help with your records, those workers are performing work that is arguably within your business’s operations. Under the ABC test, they are likely employees, not independent contractors.
The 1099 vs. W-2 Tax Difference
The financial gap between these two classifications is significant.
When a worker is classified as an independent contractor, you issue a 1099-NEC, pay no payroll taxes, and have no obligation for workers’ compensation or benefits. The worker handles their own self-employment tax, which is 15.3 percent on net earnings.
When a worker is classified as an employee, you are responsible for:
- Withholding federal and California income taxes
- Paying the employer’s share of Social Security and Medicare (7.65 percent)
- Paying California SDI, SUI, and ETT contributions
- Filing quarterly payroll tax reports with both the IRS and the EDD
The compliance overhead increases, but so does your legal exposure if you have been misclassifying workers.
A Real-World Example: A San Fernando Valley Contractor
Consider a general contractor based in Woodland Hills who regularly uses the same plumber on renovation jobs. That plumber does not have their own clients, does not advertise independently, and works exclusively through this contractor.
Under the ABC test, all three prongs are in question. The work is directly related to the contractor’s business. The plumber may not meet the standard for an independently established trade. This is exactly the scenario the FTB and EDD examine when they audit construction businesses.
If the contractor has been issuing 1099s for three years and an audit determines those workers should have been W-2 employees, the liability includes back payroll taxes, penalties, and interest — not just going forward, but retroactively.
AB 5 Exemptions: Who Is Actually Excluded
The law does include a long list of occupations that are exempt from the ABC test and instead evaluated under the older Borello standard, which is more favorable to independent contractor classification. Exempted categories include:
- Licensed professionals: physicians, dentists, attorneys, architects, engineers, accountants
- Real estate licensees
- Insurance agents
- Certain creative professionals under AB 2257 (photographers, writers, musicians, and others under specific conditions)
- Freelance writers, editors, and translators for certain uses
- Direct sales professionals
- Trucking operators (subject to ongoing litigation)
If your business uses contractors who fall into one of these categories, you may still qualify to issue 1099s. But the exemptions are specific, and the conditions matter. Assuming an exemption applies without verifying it is a common and costly mistake.
FTB Audit Risk Under AB 5
The FTB and EDD have become more active in auditing worker classification since AB 5 passed. Businesses that are flagged tend to share certain characteristics:
- High volume of 1099 payments relative to W-2 payroll
- The same contractor receiving 1099s for multiple years in a row
- Contractors working exclusively for one business
- Industries with known misclassification history: construction, healthcare staffing, gig economy platforms, and professional services
If your books show a pattern of recurring contractor payments with no corresponding W-2 workforce, that is worth reviewing with a CPA before the FTB reviews it first.
What to Do If You Receive a Notice
If you receive a notice from the FTB or EDD related to worker classification, the worst thing you can do is ignore it. These notices have response deadlines, and missing them removes your ability to contest the findings.
Your first step should be to gather documentation for each worker in question: their contracts, invoices, proof of their independent business operations (their own clients, marketing, licenses), and records showing how work was assigned and supervised.
A CPA with experience in California tax matters can help you assess whether reclassification is required, whether any penalty abatement applies, and how to respond to the agency formally.
The Bottom Line
AB 5 did not eliminate independent contractors in California, but it made the bar for that classification significantly higher. If your business relies on contractors and you have not reviewed your classification practices since 2020, now is the right time.
Proper classification protects you from back taxes and penalties, reduces audit exposure, and keeps your financial records accurate — all of which matter whether you are filing quarterly or planning for the year ahead.
If you are unsure where your business stands, our business tax planning services are a good starting point. And if payroll has become part of the picture as you bring workers on as employees, we can help with that too through our payroll management services.
Schedule a consultation to review your contractor situation before it becomes a compliance problem.
