Worries over AB 5 are overstated because of federal law limits

There have been many promises and concerns voiced about Assembly Bill 5, which changes California law for who is an employee and not an independent contractor and is designed to help gig and other workers. Some say that it will bring major benefits to many workers, who on Jan. 1, 2020, will become employees, such as health care, retirement benefits, and employer-paid Social Security and Medicare. Some businesses predict that they will be badly hurt by the required new expenses. Both claims are overstated because of federal law limits.

Certainly many workers who become employees under AB 5 will have more California benefits. Yet the federal rules for determining who is an employee have not changed and they are the key to many benefits -- and possible increased costs. Federal law significantly undercuts both hoped for benefits and feared costs from AB 5.

Two Separate Standards

Let's begin with the two different standards for who is an employee.

Federal Law Employees: A worker generally is an employee under federal law only if the business has the right to control the worker's time, place, tools, process and other means of work.

California's New AB 5 Employees: A worker who meets the federal law employee standard is an employee under California law. However, AB 5 expands the definition of employee. Workers who are employees by this expansion are AB 5 employees. The Legislature intended to benefit gig workers with this expansion. A worker is an AB 5 employee even if the business does not control his or her work unless the work is outside the usual course of the business that he or she works for. Separately, a worker is an AB 5 employee unless he or she is engaged in an independently established trade, occupation or business of the same nature as is involved in the work. (There are statutory exemptions that are not relevant here.)

Therefore, a worker can be an AB 5 employee and not be a federal law employee. Dynamex Operations West, Inc. v. Superior Court, 4 Cal. 5th 903, n.20 (2018). That difference limits hoped for benefits from AB 5.

The Feds Protect Federal Law Employees, Not New AB 5 Employees.

Federal law governs much of health and retirement benefits for employees as well as Social Security and Medicare taxes and of course federal income tax withholding. These benefits, and these taxes, only apply if a worker is a federal law employee. They do not protect AB 5 employees. For example, the key federal protections for employee benefits in the Employee Retirement Income Security Act only apply to federal law employees. Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318 (1992).

Substantial Federal Penalties Can Apply If Benefits Are Extended to New AB 5 Employees

Health Benefits: Under IRS rules, generally employer-provided health benefits are tax free. However, under multiple IRS rulings, if an employer provides health benefits to even one individual who is not a federal law employee, then none of these benefits are tax free and they are taxed to all of the employees who are covered. This is bizarre but no one has ever claimed that tax rules make sense. Therefore, if a business provides health benefits to AB 5 employees, it must be careful to treat these benefits as taxable, not tax free.

Retirement Benefits: Under IRS rules, generally employee and employer contributions to a 401(k) plan are not taxed until they are paid out to the employee. Federal law requires that these plans be for the exclusive benefit of federal law employees. If 401(k) contributions are made for workers who are AB 5 employees, then the plan can lose its tax qualification with significant penalties on both workers and the business. As a practical matter, that is not likely to occur because the IRS has provided correction procedures, but these can be cumbersome and expensive to implement. Contributions and earnings may have to be repaid to workers and businesses, tax reporting for prior years redone, and tax penalties paid. It would be better for a business to avoid giving retirement benefits like a 401(k) plan to AB 5 employees. A business might be able to provide the new CalSavers program, but this is uncertain.

A Business that Pays Social Security and Medicare Taxes for AB 5 Employees Can Incur Penalties

Social Security and Medicare generally apply to federal law employees. Employers who pay these taxes for AB 5 employees will not comply with federal law. Instead, AB 5 employees must pay their own Social Security and Medicare taxes under the Self Employment Contributions Act.

The IRS consequences of incorrect reporting of Social Security and Medicare taxes can be painful for the business as well as the worker, and it can be quite an ordeal with the IRS to correct improper reporting. Moreover, some courts have held that a business may be held liable for any resulting damages and costs to the individual when a business improperly reports their federal taxes.

What to Do While AB 5 Is Being Sorted Out?

AB 5 is effective on Jan. 1, 2020. However, we can expect challenges, and, for now, exactly how it will work is uncertain. There are ways to avoid some of the uncertainties.

Employers could decide to ensure that workers are federal law employees and could change their relationships with workers to accomplish that.

Alternatively, employers could decide that they want to be sure that workers who are AB 5 employees are not inadvertently provided health and retirement benefits that could trigger federal penalties. These employers may want to carefully review the definition of "employee" in each of their benefit plans to be sure that only federal law employees are covered. Additionally, employers should work with their payroll provider to be sure that federal taxes are properly collected and paid.

Workers also can review their relationships with businesses to decide if they should take action to solidify their status, either as independent contractors or employees.

In all cases, if employers or workers have questions about the effect of AB 5 they should work with their counsel and tax advisor to sort out their status. 