AB5 California Contractor Law: A US Company Compliance Guide

If your company contracts with anyone living or working in California, AB5 applies. It does not matter where your company is headquartered. It does not matter what the contract says. If the contractor is in California, California’s worker classification rules cover the relationship.

This guide explains what AB5 is, the ABC test it codified, the exemptions that actually matter, the Prop 22 carve-out for gig drivers, and what misclassification costs. Everything is cited to the California Legislative Information site or to the underlying court decisions, so you can read the actual law rather than a summary of a summary.

For the federal layer (IRS common law test, Section 530, Form SS-8), see our IRS worker classification guide. For the state-by-state picture, see our ABC test state-by-state guide.

Where AB5 came from

In April 2018 the California Supreme Court decided Dynamex Operations W. v. Superior Court (2018) 4 Cal.5th 903. The case involved a class of same-day delivery drivers who claimed they were misclassified as contractors and denied wage-order protections. The Court agreed, and replaced the older multi-factor test (S.G. Borello and Sons v. Department of Industrial Relations) with a stricter three-prong ABC test for wage-order purposes.

The Dynamex ABC test was novel in California but not in US law. Massachusetts, New Jersey, and several other states had used ABC tests for decades. What made the decision politically explosive was the breadth. If the ABC test applied to every wage-order claim, large parts of California’s gig economy were operating under the wrong classification.

The Legislature responded with AB5, signed by Governor Gavin Newsom in September 2019. AB5 codified the Dynamex ABC test into Labor Code section 2750.3, extended it beyond the wage orders into the Labor Code and Unemployment Insurance Code, and added a list of statutory exemptions.

A year later, in response to industry complaints, the Legislature passed AB2257. AB2257 repealed section 2750.3 and recodified the rules into Labor Code sections 2775 through 2787, with broader exemptions, particularly for creative professionals and B2B relationships.

The ABC test, in the words of the statute

Labor Code section 2775(b)(1) reads:

For purposes of the provisions of this code and the Unemployment Insurance Code, and for the wage orders of the Industrial Welfare Commission, a person providing labor or services for remuneration shall be considered an employee rather than an independent contractor unless the hiring entity demonstrates that all of the following conditions are satisfied:

(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.

You can read the section at leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=LAB&sectionNum=2775.

Three things make this test stricter than the federal IRS test.

The burden is on the hiring entity. The presumption is employment. The hirer has to prove all three prongs to escape it.

All three prongs must be satisfied. Not a balancing of factors. If any single prong fails, the worker is an employee.

Prong B is the killer. “Outside the usual course of the hiring entity’s business” knocks out most engagements where the contractor’s work is part of what the company sells. A software company hiring a freelance engineer almost always fails B, because software engineering is the usual course of business. A coffee shop hiring a plumber to fix a sink passes B easily.

The exemptions in 2778 to 2784

AB5 was politically possible because the Legislature wrote exemptions for specific professions. AB2257 expanded those exemptions. They live in Labor Code sections 2776 through 2784. Per the statute, when an exemption applies, the older Borello multi-factor test is used instead of ABC. Borello is still tough, but easier to pass.

The main exemption categories:

Specific occupations (section 2783). Licensed insurance agents, physicians, surgeons, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, certified public accountants, private investigators, securities broker-dealers and investment advisers, direct salespersons (under Unemployment Insurance Code 650), commercial fishermen, real estate licensees (where Business and Professions Code 10032(b) governs), and several others.

Professional services (section 2778). Marketing involving original and creative content, human resources administrators, travel agents, graphic designers, grant writers, fine artists, IRS-enrolled agents, payment processing agents, photographers and photojournalists, freelance writers, editors, content contributors, advisors, producers, narrators, cartographers, translators, copy editors, illustrators, freelance newspaper cartoonists, registered professional foresters, home inspectors, real estate appraisers, manufactured housing salespersons, digital content aggregators, specialized performers teaching master classes, and a few others added since AB2257.

The professional services exemption is not automatic. The worker must:

• Maintain a business location separate from the hiring entity (a home office counts)
• Have a business license in addition to any professional license
• Negotiate their own rates
• Be free to set their own hours
• Be customarily engaged in similar work outside the engagement
• Exercise discretion and independent judgment in performing the work

You can read the conditions at Labor Code section 2778.

Business-to-business contracting relationship (section 2776). A contracting business that is a sole proprietor, partnership, LLC, LLP, or corporation may contract with a hiring business under Borello rather than ABC if all 12 of the following conditions are met:

1. The contracting business is free from control and direction of the hiring business.
2. Services are provided directly to the hiring business, not to its customers (with limited exceptions).
3. The contract is in writing and specifies payment, payment timing, and the services.
4. If the work is in a place requiring a business license, the contracting business has one.
5. The contracting business maintains a business location separate from the hiring business.
6. The contracting business is customarily engaged in the same type of work for other clients.
7. The contracting business actually contracts with other businesses to provide similar services.
8. The contracting business advertises and holds itself out to other potential customers.
9. The contracting business provides its own tools, vehicles, and equipment.
10. The contracting business can negotiate its own rates.
11. The contracting business can set its own hours and location, consistent with the nature of the work.
12. The contracting business is not performing work that requires a license from the Contractors State License Board (or, if it is, holds such a license).

Missing any one of the 12 voids the exemption. The B2B carve-out is narrow on purpose.

Referral agencies (section 2777). A bona fide referral agency that connects clients with service providers can use Borello if conditions in section 2777 are met. The “service provider” must be a business entity, advertise, set rates, etc.

Single-engagement events (section 2775(b)(2)). Where two individuals each act as sole proprietors or business entities and contract together for a single event, ABC does not apply.

Construction subcontracting, motor club services, data aggregation, and a handful of others also have specific carve-outs in sections 2779 through 2784.

Prop 22: the gig-driver carve-out

In November 2020, California voters approved Proposition 22 with 59 percent of the vote. Prop 22 created a separate regime for “app-based” transportation and delivery drivers (Uber, Lyft, DoorDash, Instacart, Postmates). Under Prop 22, these drivers are classified as independent contractors and not subject to AB5, with a defined benefits package (healthcare subsidy, accident insurance, earnings floor).

Prop 22 was challenged on constitutional grounds. In Castellanos v. State of California (2024) 16 Cal.5th 1027, the California Supreme Court upheld Prop 22 in a unanimous decision. The carve-out stands.

Two practical points. First, Prop 22 only covers app-based transportation and delivery drivers using a digital platform. It does not extend to other gig categories. A freelance writer or a contract engineer is still under AB5. Second, Prop 22 is statutory and could be repealed by voters in a future initiative, but for now it is the law.

What “willful misclassification” means

Labor Code section 226.8 makes willful misclassification a violation in its own right, separate from any underlying wage-and-hour claim. The penalties are:

Civil penalty of not less than five thousand dollars ($5,000) and not more than fifteen thousand dollars ($15,000) for each violation.

Where the Labor and Workforce Development Agency or a court determines that an employer has engaged in a pattern or practice of these violations, civil penalty of not less than ten thousand dollars ($10,000) and not more than twenty-five thousand dollars ($25,000) for each violation.

Read the full section at leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=LAB&sectionNum=226.8.

“Willful” is a low bar. It means the employer voluntarily and knowingly misclassified. There is no requirement of bad faith or intent to evade taxes. An employer who follows incorrect advice and treats engineers as contractors when they are employees in fact can be hit with willful misclassification penalties.

These 226.8 penalties stack on top of:

• Unpaid wages and overtime. California requires overtime over 8 hours a day and 40 hours a week. Misclassified employees can claim two to three years (four under unfair competition law) of unpaid overtime, plus liquidated damages.
• Meal and rest break premiums. One additional hour of pay per missed break, under Labor Code 226.7.
• Waiting time penalties. Up to 30 days of wages for late final paychecks, under Labor Code 203.
• Unreimbursed business expenses. Mileage, home office, equipment. Under Labor Code 2802, reimbursement is mandatory for employees.
• PAGA exposure. The Private Attorneys General Act lets employees sue on behalf of all aggrieved employees and collect 25 percent of recovered penalties. Misclassification PAGA settlements often run into seven and eight figures.
• State payroll tax liabilities. California Unemployment Insurance, ETT, SDI, and state income tax withholding all become due, plus interest and penalties.

A misclassification audit by the California Employment Development Department (EDD) or a Labor Commissioner’s office complaint can lead to all of the above simultaneously. The IRS bill for back federal employment taxes is a separate matter on top.

Dynamex applies retroactively

A point that many founders miss. In Vazquez v. Jan-Pro Franchising International (2021) 10 Cal.5th 944, the California Supreme Court held that Dynamex applies retroactively. Misclassification claims for periods before Dynamex was decided in 2018 are still measured against the ABC test, not the older Borello standard. The statute of limitations for unpaid wages is typically three years under Labor Code 200, extended to four years under Business and Professions Code 17200 (unfair competition law).

Compliance checklist for a US company with California contractors

1. Inventory every California-based contractor. Apply the ABC test to each. Be honest about prong B.
2. Check for an exemption. If the contractor is in an exempt category (lawyer, physician, accountant, licensed real estate agent, qualifying freelance writer, etc.), document the basis and apply Borello.
3. Check for the B2B exemption. If the contractor incorporated and meets all 12 conditions, document each condition with evidence (separate business location, business license, other clients, etc.).
4. Where ABC cannot be satisfied and no exemption applies, convert to employment. Either hire directly as a W-2 California employee, or engage through an Employer of Record that hires the worker as their California employee and assigns them to your project.
5. Document the analysis at engagement. A short memo applying the ABC test or the exemption conditions, dated and saved, is a meaningful defense if EDD ever audits.
6. File every 1099-NEC and Form 1099-MISC as required. A missed 1099 invites scrutiny.
7. Train hiring managers. A well-meaning manager who hands a contractor a laptop and adds them to Slack channels can drift the relationship into employment territory without realizing it.

A note on remote workers and which state applies

A California-resident contractor working remotely for an out-of-state company is still covered by California law. Physical location in California controls. Conversely, a contractor in Texas working for a California-headquartered company is not generally subject to AB5, because the work is performed outside California and the worker is not a California resident.

The hard cases are workers who split time between California and another state, or who relocated mid-engagement. The EDD looks at where the work is performed. Pay attention to relocations: a contractor who moves from Austin to San Francisco changes the applicable law.

What an EOR or contract management platform does for AB5

For California-resident workers you need to direct, an Employer of Record (EOR) hires the worker as a W-2 employee of the EOR and assigns them to you. Classification risk disappears because the worker is unambiguously an employee, just not yours.

For genuine contractors, a contract management platform helps document the ABC analysis, generates compliant contracts, files 1099s, and tracks the indicators (business license, multiple clients, separate location) that support contractor status. Our contract management product is built for this case. For pricing, see our pricing page.

AB5 is one of the strictest worker classification regimes in the United States. The ABC test is bright-line, the exemptions are conditional and narrow, and the penalties for getting it wrong reach $25,000 per violation under Labor Code 226.8, before wage-and-hour, expense, and tax consequences pile on.

The right move for any US company with California contractors is to run the ABC test today, find the workers who fail it, and decide between conversion to employment, restructuring the engagement to fit an exemption, or moving on. Doing nothing and hoping the EDD never audits is not a strategy.