On September 11, 2019, the answer just got difficult, maybe even impossible, to classify an entity providing services to your business as anything but an “employee.” 

On January 1, 2020, newly enacted Section 2750.3 of the California Labor Code will go into effect, codifying the ABC test set forth the 2018 California Supreme Court case of Dynamex Operatiosn West, Inc. v. Superior Court. Dynamex created a new rule for determining when an independent contractor needs to be treated as an employee for purposes of the California wage orders. The new Labor Code section takes that further, applying the rule for tax purposes. And violation of the new law may actually result in criminal penalties under existing criminal statutes that are based on misclassification of workers. 

It is therefore imperative that California businesses evaluate all service contracts very carefully to determine whether those individuals or entities would be defined as “employees” under Section 2750.3. 

Under the statute, a worker is considered to be an independent contractor only if you can establish that all three of the following factors are present:

  1. The worker must be free from the control and direction of the payor in connection with the performance of the work, both under the contract and in fact;
  2. The worker must perform work that is outside the usual course of the payor’s business; and
  3. The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed by the worker for the payor.

Section 2750.3 applies to payments to both individuals and entities, including corporations. In fact, to clarify this point, the statute adds a narrow exception for payments to entities only if all of the following requirements are met:

  • The payments are made between two entities, which oddly is defined to include sole proprietorships along with the usual list of entities;
  • The service provider meets the test to be an independent contractor under the Common Law Test;
  • The contract is in writing;
  • The services are rendered directly to the payor, and not to its customers.
  • The service provider has all required business licenses;
  • The service provider provides the same service to third parties;
  • The service provider provides its own tools, vehicles, and equipment to perform the services; and
  • Most importantly, the service provider must have its own “business location” that is separate from the work location of the payor.

Bear in mind that, even if the “entity” meets each of these requirements, it must meet all three of the factors of the test. In other words, it cannot be providing work that is part of your usual course of business. 

While we concede that this may be unfair to persons or entities providing business to business services who do not want to be classified as someone else’s “employee,” the costs of violating the statute are high and, although there are stated exceptions in the statute, care must be taken in classifying any service provider as an “independent contractor.” It is as yet unclear whether the statute will be applied retroactively to existing relationships and all business retaining service providers in California should reevaluate those relationships immediately.