Businesses with operations in California have begun to identify options and implement strategies for compliance with Assembly Bill (AB) 5, which imposes the ABC test for identifying whether a worker is an independent contractor or an employee for not only employment law purposes, but also for state tax purposes beginning January 1, 2020.¹

One compliance option is to simply convert all contractors to employees. For employers with multi-state operations, however, another idea has emerged. Because the legal landscape in California is so significantly different from that of other states, some business have considered treating a particular category of workers as employees in California, while continuing to classify those doing the same tasks in other states as independent contractors.

There might be obvious workplace morale issues that arise from such an approach.  Contractors in a neighboring state might react negatively if they learn that workers in California—who are doing the same jobs—are being treated as employees.  Of course, the opposite is possible, as the converted employees may resent losing the freedom and independence that comes from not being beholden to an employer or a boss while those in other states do not.²

Another set of issues involving income tax may be more daunting for businesses that choose to classify California workers as employees, while leaving workers in other states as contractors.  

Primarily, employers must consider section 530 of the Revenue Act of 1978.  Section 530 is a safe-harbor provision that prevents the IRS from retroactively reclassifying “independent contractors” as employees and subjecting the principal to federal employment taxes, penalties and interest for such misclassification. In order for an employer to qualify for section 530 relief, it must have:

(1) Consistently treated the workers (and similarly situated workers) as independent contractors;

(2) Complied with the Form 1099 reporting requirements with respect to the compensation paid the workers for the tax years at issue; and

(3) Had a reasonable basis for treating the workers as independent contractors.  

Choosing to classify workers in California as employees, while treating those doing the same task in other states as contractors, could jeopardize an employer’s ability to take advantage of the safe harbor that section 530 provides.  If that protection is lost, businesses could face the specter of retroactive reclassification of all contractors (in all states) as employees for federal tax purposes. 

One option is to “put a box” around California by creating a legal entity that operates only in California using employees who remain completely separated from the company’s operations in other states where contractors are engaged. Caution should be taken to ensure that the two entities really are separate and operate independently of each other.

A second option is to treat workers in California as employees for state tax purposes, but still classify them as independent contractors for federal tax purposes.  This may be an administrative nightmare, and could subject the entity to heightened scrutiny. 

This is but one example of the possible tax consequences of business restructuring in the wake of AB 5.  Companies doing business in the Golden State must evaluate a multitude of factors when considering a modification of their operations to address the challenges of this new law.  Businesses should not neglect consideration of the possible tax ramifications of any such changes.