In one of the most quietly devastating EDD audits of the past few years, a small Bay Area marketing agency walked in confident. The owner had ten "contractors," each with a signed independent contractor agreement, each invoicing monthly, each filing their own taxes. Six months later, the agency owed roughly $480,000 in back payroll taxes, penalties, and interest — plus reclassification of every "contractor" into an employee. The owner had never heard the letters "ABC."
If you operate in California, the way you write checks to the people who help you run your business is no longer a private choice. Assembly Bill 5 (AB5) flipped the burden of proof, redefined the legal default, and gave the Employment Development Department (EDD), the Franchise Tax Board (FTB), and the courts a powerful new test. The cost of getting it wrong is measured in five- and six-figure assessments per misclassified worker. The cost of getting it right is mostly procedural — and that procedure is what this article unpacks.
How California Got Here: Dynamex, AB5, AB 2257, and Prop 22
Before 2018, California used the multi-factor Borello test (named after the 1989 California Supreme Court case S.G. Borello & Sons, Inc. v. Department of Industrial Relations). Under Borello, classification turned on the "right to control" the work, balanced against eleven or so secondary factors. It was flexible, fact-intensive, and friendly to companies that wanted contractors.
That changed on April 30, 2018, when the California Supreme Court decided Dynamex Operations West, Inc. v. Superior Court. The case involved same-day delivery drivers who had been reclassified from employees to contractors in 2004 — purely as a cost-saving move. The court adopted the ABC test for claims arising under California wage orders and shifted the burden onto the hiring entity to prove independent contractor status.
The legislature went further. AB5, signed in 2019 and effective January 1, 2020, codified Dynamex and extended the ABC test beyond wage orders to nearly all California Labor Code, Unemployment Insurance Code, and wage-order claims. AB 2257, signed in September 2020, then carved out and expanded a long list of exemptions in response to industry pushback. Finally, Proposition 22 — passed by California voters in November 2020 and upheld by the California Supreme Court — created a narrow carve-out for app-based rideshare and delivery drivers (Uber, Lyft, DoorDash, Instacart, and similar platforms).
The net result: the ABC test is now the default rule in California. Borello applies only when a statutory exemption removes a relationship from the ABC test entirely.
The ABC Test, Prong by Prong
To classify a worker as an independent contractor under AB5, the hiring entity must prove all three of the following. If even one prong fails, the worker is an employee.
Prong A — Freedom From Control and Direction
The worker must be "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." This is the closest prong to old-school Borello, but it is now a threshold requirement, not a balancing factor.
In practice, Prong A fails when the hiring entity sets the worker's schedule, dictates the method of work, requires attendance at staff meetings, supplies the tools, or sets fixed performance benchmarks beyond a deliverable. A graphic designer who chooses her own hours, picks her own software, and turns in finished work generally passes. A "contract" delivery driver who is told what route to drive, what uniform to wear, and what hours to work generally fails.
Prong B — Outside the Usual Course of Business
The worker must perform work "outside the usual course of the hiring entity's business." This is the prong that surprises most California businesses. It is not enough that the worker is independent or skilled — the work itself must fall outside what the company actually does.
A bakery that hires a plumber to fix a sink passes Prong B easily — plumbing is outside the usual course of a bakery's business. The same bakery that hires "independent" bakers to bake bread fails Prong B even if the bakers are otherwise autonomous. A law firm hiring contract attorneys to handle the firm's caseload almost certainly fails Prong B. A law firm hiring an outside graphic designer to redesign its website almost certainly passes.
This single prong has reshaped entire industries — from trucking to journalism to ride-share — because it asks a question that has nothing to do with the worker's independence.
Prong C — Customarily Engaged in an Independent Business
The worker must be "customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed." Translation: the worker should look like a real, ongoing business, not just a person with a 1099 from one client.
Strong indicators include having multiple clients, advertising services publicly, holding the required business licenses, maintaining a separate workspace, carrying business insurance, and having a recognizable business name with its own invoices, tax IDs, and contracts. A web developer with a website, an LLC, three other clients, and a portfolio passes Prong C. A "contractor" who has worked exclusively for one company for two years and has never marketed to anyone else fails.
The Exemptions: When the ABC Test Does Not Apply
AB5 and AB 2257 created roughly fifty exemptions and carve-outs. Falling into one does not automatically make a worker an independent contractor — it simply means the older, more forgiving Borello multi-factor test applies. You still have to pass Borello. The main exemption categories include:
- Specified occupations. Licensed insurance agents, physicians and surgeons, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, private investigators, accountants, securities broker-dealers, investment advisers, and direct sales salespersons (paid on commission).
- Professional services. Marketing professionals, human resources administrators, travel agents, graphic designers, grant writers, fine artists, certain photographers and photojournalists, freelance writers, editors, content contributors, illustrators, copy editors, translators, payment processing agents, and certain enrolled agents.
- Real estate and repossession agents. Licensed real estate professionals and licensed repossession agents.
- Bona fide business-to-business contracts. Discussed below.
- Referral agencies. Discussed below.
- Construction subcontractors. Construction industry subcontractors with proper licensure, in writing, with separate workers' compensation, and with customary indicia of an independent business.
- Motor club services, freelance translators, registered foresters, and various niche categories added by AB 2257.
Exemptions have detailed sub-requirements. The "freelance writer" exemption, for instance, used to cap submissions at 35 per outlet per year — AB 2257 removed that cap but added other conditions. Read the statute carefully or have counsel do it before relying on any exemption.
The Business-to-Business Exemption Trap
The B2B exemption is the most misunderstood relief valve in AB5. To qualify, the relationship must meet twelve separate conditions, including:
- The business service provider is free from the contracting business's control and direction in fact and by contract.
- The business service provider provides services directly to the contracting business, not to its customers.
- The contract is in writing.
- The business service provider has all required business licenses and tax registrations.
- The business service provider maintains a business location separate from the contracting business.
- The business service provider is "customarily engaged" in an independent business of the same nature as the work performed.
- The business service provider actually contracts with other businesses and holds itself out to the public.
- The business service provider advertises and provides services to the public or other potential customers.
- The business service provider provides its own tools, vehicles, and equipment.
- The business service provider negotiates its own rates.
- Consistent with the nature of the work, the business service provider sets its own hours and place of work.
- The business service provider is not performing work for which a license is required from the Contractors State License Board.
Even when all twelve conditions are met, you still drop back to Borello — not automatic exemption. The B2B exemption is narrow by design.
Penalties That Should Make Every Owner Read the Contract Twice
California's misclassification penalties are designed to be punitive. They stack across agencies, and most assessments hit the company first because the worker rarely had any real choice in classification.
- Labor Code § 226.8 willful misclassification penalty: $5,000 to $15,000 per violation; $10,000 to $25,000 per violation if part of a pattern or practice.
- EDD payroll tax assessments: Back unemployment insurance, employment training tax, state disability insurance, and personal income tax withholding for up to three years (eight years for fraud).
- EDD audit penalties: A 10% failure-to-file penalty, a 10% negligence penalty, up to 50% for intentional misclassification, and up to 50% for fraud — these stack on top of the underlying tax.
- IRS payroll tax assessments: Federal income tax withholding, FICA, FUTA, plus penalties and interest. Trust Fund Recovery Penalties under IRC § 6672 can pierce the corporate veil and reach officers and responsible parties personally.
- Wage and hour exposure: Minimum wage, overtime, meal and rest breaks, expense reimbursement under Labor Code § 2802, waiting time penalties, paid sick leave, and PAGA representative actions.
- Workers' compensation: Premium recovery plus penalties for uninsured periods; criminal exposure for chronic non-coverage.
EDD audits frequently begin with something innocuous: a single former contractor files for unemployment, the EDD denies it because the employer reported no wages, and the auditor opens a file. By the time the auditor finishes, every contractor in the company is on the table.
A Practical Compliance Workflow
If you operate in California, the following process — adapted for your industry — usually closes the largest gaps.
- Inventory every contractor. Pull a list from your accounts payable system of every individual or sole-proprietor LLC you paid in the last three years. Group by relationship.
- Run each through the ABC test. Document Prong A, B, and C analysis in writing. Where any prong is shaky, flag the relationship.
- For flagged relationships, look for an exemption. Map the relationship against the AB5/AB 2257 exemption list. If you find one, document the Borello analysis as well.
- Tighten contracts. Independent contractor agreements should describe deliverables, not hours; should disclaim control over manner and means; should require contractor-owned tools and licenses; and should permit the contractor to work for others.
- Check business indicia. Ask each contractor for a business license, professional license (if applicable), a copy of their general liability insurance, a marketing site or portfolio, and confirmation of at least one other paying client.
- Re-classify where needed. When a relationship fails the ABC test and no exemption applies, convert to W-2 — preferably before the EDD comes calling. Voluntary reclassification is far cheaper than an audit.
- Track expenses, payroll taxes, and reimbursements correctly. Misclassified workers often signal sloppy bookkeeping, which compounds penalties under both California and federal law.
Bookkeeping Decisions That Make or Break a Classification Audit
When EDD auditors arrive, they ask for general ledgers, accounts payable detail, 1099 summaries, payroll registers, and contractor agreements. They also ask for emails, scheduling software exports, and Slack archives. A surprising amount of misclassification gets proven not through the contract — which usually says all the right things — but through how money moved, who paid for what, and whether the contractor was actually treated like a vendor.
Clean books help in three ways. First, they let you reconstruct the actual relationship quickly when the auditor asks. Second, they prove that contractors carried their own expenses, set their own rates, and invoiced like real businesses — strong evidence under Prong C and the B2B exemption. Third, they limit the auditor's "estimated" assessments. When records are weak, EDD auditors estimate aggressively, and the burden flips back onto the company to disprove the estimate.
Plain-text, version-controlled accounting is particularly useful here, because every transaction has a date, a counterparty, an amount, and a category that you can search and prove. If you are running a small services business in California — agency, consultancy, studio, dev shop, healthcare practice, restaurant group — the discipline of keeping clean monthly books and clearly separating "vendor" payments from "employee" wages is one of the cheapest forms of audit insurance you can buy.
Common Mistakes Worth Avoiding
- Treating an LLC the same as a "real" business. A single-member LLC owned by a former employee, paid by only your company, with no other clients, is not a business for AB5 purposes — it is an employee with a tax ID.
- Relying on an old contractor agreement. Pre-2018 contracts almost never satisfy the ABC test. Update template language.
- Ignoring Prong B. Most companies fail Prong B and never realize it because they fixated on freedom from control.
- Confusing federal and California rules. The IRS uses a multi-factor common-law test similar to Borello. Passing IRS scrutiny does not mean you pass AB5.
- Forgetting Form DE 542 (Report of Independent Contractor). California requires employers to report any contractor paid $600 or more within 20 days. Skipping it is a fast way to put yourself on the EDD's radar.
- Letting one "contractor" answer your customer service line. That single fact often makes Prong B impossible to win.
Keep Your Worker Classification — and Your Books — Audit-Ready
AB5 is procedural at heart. Win on documentation: clean contracts, clean invoices, clean general ledgers, and a defensible written analysis of the ABC test for every long-term contractor. Beancount.io offers plain-text, version-controlled accounting that gives you complete transparency over how every dollar moves — invaluable when an EDD auditor wants three years of detail in a week. Get started for free and pair tight bookkeeping with tight worker classification, so the next audit is just paperwork — not a six-figure surprise.