Freelancers and AB5 Tax Law

Now that California Assembly Bill 5 (AB5) is in effect, the federal tax classification for freelancers and independent workers may affect their client relationships.

What is AB5?

AB5 tax law provides new rules for the way companies classify workers. Many workers who had been acting as freelance workers are now considered employees who are entitled to the benefits traditional employees receive. As a result, many California businesses severed their relationships with hundreds of freelance workers in the months leading up to 2020.

Worker Classification

Employers must classify new workers in one of two ways.

Employees are workers who do not run their own business. Companies pay workers classified as employees through payroll and withhold and pay payroll taxes on their behalf. Employers must pay these workers at least minimum wage and adhere to other state and federal labor laws.

Independent workers run their own independent trade or business. Contractors sell services to multiple clients or customers and are not under the direction of any hiring entity. Contractors are paid directly and must pay taxes on their own by reporting self-employment income to the IRS. As independent contractors, these workers have few rights under state and federal labor laws.

The ABC Test

AB5 freelance requires employers to determine a worker's classification through what it calls the “ABC Test.”

There are three criteria an employer must consider when identifying a worker as an independent contractor.The federal tax classification for freelancers requires that all three criteria are met.

A) The worker is free from the control and direction of the hirer.

“Control” in this context means behavioral, financial, or relational.

• Behavioral controls include direction from the company on how and when work is completed. For example, when a company hires an outside contractor to produce a deliverable like content writing, they cannot dictate how the writer works, when they work, or what they do on a daily basis. They can simply accept or reject the final product.
  

• Financial control cannot be a part of a contractor-client relationship. The client and contractor need to develop an agreement for the rate of pay when payment is to be made, and decisions about reimbursement. Financial control also includes supplies and equipment. Contractors who use the company’s tools or materials are likely considered employees.
  

• Relationship controls are those that determine how a worker can interact with other clients. If a company hires a contractor to perform work under the condition that they will not allow the worker to perform services for another company, the worker would be classified as an employee. Indefinite workers, as opposed to those expressly hired on a short-term basis, likely qualify as employees.

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

AB5 freelance work cannot be a part of the essential way a business operates or earns revenue. In other words, contractors cannot perform the same functions as workers acting in an employee capacity.

C) Independent workers are customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

In order to be classed as an independent contractor, you must be a business owner. Common ways to establish business ownership include having a separate office, conducting advertising efforts, employing assistants, investing in your business, holding workers’ compensation insurance, working for multiple firms simultaneously, holding a business license, and filing IRS Schedule C federal income tax returns.

Freelancing Just Got More Complicated. Lunafi Can Help.

Are you worried about complying with AB5 Tax Law so that you can retain the benefits you enjoy as freelancers or independent workers? Lunafi can help you keep your finances in order so you won’t be scrambling when it’s time to file taxes. Completing Schedule C accurately is one of the easiest ways you can establish yourself as an official independent contractor under the new guidelines.

Lunafi aims to boost your business by automating deductible expenses for tax savings with cash flow management to maximize your earnings. Best of all, we make it easy. Learn more and get started today.

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