COVID-19 vs. California’s Worker Classification Law

Kathleen K. Wright

Kathleen K. Wright is the director of the state and local tax program in the School of Taxation at Golden Gate University, San Francisco. She frequently presents seminars on SALT issues for the California CPA Education Foundation.

In this installment of States of Mind, Wright reviews the status of A.B. 5 and how the gig economy in California is responding to the new law and the COVID-19 pandemic.

As a result of COVID-19 and shelter-in-place orders in the state, California has seen skyrocketing unemployment claims¹ and budget cuts for state agencies in the May revision of the 2020-2021 budget. With so many people out of work, freelance-type work becomes an attractive option. But employers in some industries (like delivery services) are concerned that they might be forced to classify these workers as employees — a costly undertaking that is stifling a growing need in the economy. Shelter-in-place orders imposed to curb the spread of COVID-19 have left us more reliant than ever on gig economy workers. Many of us are now ordering everything from household items to grocery deliveries, and the need for delivery workers and truckers has spiraled. But faced with the cost of treating drivers as employees, will companies that provide these services be willing to move forward with hiring plans to satisfy the demand?

This article discusses the status of A.B. 5 regarding the statutory effective date of various parts of the legislation, executive orders that have affected rights of employees, and litigation. The article concludes with a discussion of how the gig economy is responding to the fight for its survival against the double threat of COVID-19 and A.B. 5.

Statutory Developments: A.B. 5 Effective Dates

A.B. 5 adopted the result in a landmark case, Dynamex Operations.² In that case, the court held that most workers are employees and the burden of proof for classifying individuals as independent contractors belongs to the hiring entity. A.B. 5 entitles workers classified as employees to receive benefits such as a minimum wage, sick leave, and unemployment and workers’ compensation benefits.

A.B. 5 established a three-part test to determine whether to classify workers as employees or independent contractors. The test assumes that workers are employees unless the company that hires them can prove the worker:

• is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;

• performs work that is outside the usual course of the hiring entity’s business; and

• is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.³

A.B. 5 became effective January 1, with the delayed implementation of one significant component of the bill — workers’ compensation. On July 1, A.B. 5 became effective for purposes of workers’ compensation coverage — just in time for the impact of this benefit to be brought into the roiling debate over employer liability in the workplace if a worker contracts COVID-19.

Gov. Gavin Newsom (D) issued Executive Order N-62-20 May 5. It changes all existing California workers’ compensation policies so that COVID-19 related illnesses of employees who worked outside their homes from March 19, 2020, through July 5, 2020, will be presumed to have contracted the virus in the course of employment and are covered under workers’ compensation.

As parts of the California economy are allowed to reopen, workers are being called back to their old jobs. Almost any worker who is now back at the employer’s location and not working from home could be an example of the COVID-19 risk facing employers. Take schools and colleges as an example: Even if the teachers are working from home, the presumption applies to staff members, custodians, and others who have been required to work at school sites. For healthcare providers, the presumption has broader application than just medical personnel — it applies to administrative, custodial, and other employees. Employees in the food and beverage industry, many of whom are trying to cope with outdoor operations, are another good example.

Although Newsom has not yet extended Executive Order N-62-20 there are several bills that, if passed, could extend and expand the presumption. The most promising of the pending bills is S.B. 1159, which was recently amended in the State Assembly, and essentially codifies the order’s rebuttable presumption, which would remain in effect until January 1, 2024.⁴ Workers’ compensation is not a government-funded program; employers are required to carry workers’ compensation insurance. Unless legislation changes the entire structure of the workers’ compensation system, the only way to cover the cost of increased payout of benefits is with increased premiums paid by employers. Executive Order N-62-20 states that insurance carriers should adjust the cost of their policies as necessary to account for the increased liability. Therefore, the already sky-high workers’ compensation rates in California will likely increase even more. This development might not be enough to preclude employers from rehiring employees as nonessential businesses slowly reopen, but it might be enough of an impediment to hiring new employees — not exactly what we need when the state is already trying to deal with the staggering demands related to unemployment.

Litigation Developments: The Exceptions to A.B. 5

A.B. 5 includes a laundry list of exceptions, which doesn’t seem to follow any criteria. In other words, the industries selected to warrant an exception seem to be randomly applied to some professions and not others. If the business qualifies for an exception, then employee classification is analyzed under the right-to-control test set forth in an older California Supreme Court decision,⁵ which applies a 13-factor test called the common law test. This test evaluates each factor to determine its relevance to the facts of the case. Results are subjective and hard to predict, which led the California Supreme Court to adopt the simpler and easier to apply ABC test in the Dynamex decision.⁶ The result is that every profession in California wants to be an exception, either through legislation or litigation. This section discusses litigation spawned by A.B. 5.

California Truckers Association

Litigation so far has not been friendly to employers with the California Truckers Association being the single plaintiff walking away with a victory.⁷ In this case the question was whether a person driving a truck for another party or entity is an independent contractor or employee under the Labor Code, Industrial Welfare Commission wage orders, and the Unemployment Insurance Code. A federal judge in San Diego issued a preliminary injunction against the enforcement by the state of A.B. 5 against independent truckers. The ruling means the state cannot implement the law as it pertains to the trucking industry.

The basis for this decision was unique, in that the argument of the truckers focused on the Federal Aviation Administration Authorization Act of 1994 (FAAAA), which prevents states from enacting punitive laws that affect a motor carrier’s prices, routes, and services. A.B. 5 directly conflicts with this federal statute by requiring drivers to be classified as employees (rather than independent contractors). When a federal law conflicts with a state law generally the state law will be struck down as unconstitutional under the supremacy clause of the U.S. Constitution.⁸

In his order the judge wrote: “There is little question that the State of California has encroached on Congress’ territory by eliminating motor carriers’ choice to use independent contractor drivers, a choice at the very heart of interstate trucking. In so doing, California disregards Congress’ intent to deregulate interstate trucking, instead adopting a law that produces the patchwork of state regulations Congress sought to prevent. With A.B. 5, California runs off the road and into the preemption ditch of the FAAAA.” The state attorney general has appealed.

American Society of Journalists and Authors

In American Society of Journalists⁹ the U.S. District Court denied a motion for a preliminary injunction against the enforcement of A.B. 5 for photographers, photojournalists, freelance writers, editors, and newspaper cartoonists. Although these professions are granted an exemption under A.B. 5 as professional services,¹⁰ the exception applies only if the worker limits the number of annual content submissions to a publisher to 35 per client. Also, the exception does not apply to freelance videographers. The complaint alleged that the law subjected some categories of speech (such as journalism and photojournalism) to harsher restrictions than other professional services. These restrictions raised equal protection and First Amendment rights issues, but the court disagreed and held that the plaintiffs had failed to demonstrate the likelihood of irreparable harm, that the balance of hardship tips in their favor and advancement of the public interest. The case has been appealed by the plaintiffs to the California Court of Appeal.

One of the primary complaints of these workers is that publishers will go out of state to find writers and journalists who are not burdened with the compliance issues related to employment of writers and journalists who live and work in California. A.B. 5 applies to all workers in California — regardless of where the employer is based — but does not apply to workers outside California even if the employer is in the state.

Uber Technologies

Uber has been litigating the issue of worker status for several years in California and other states, and has been losing this battle with claims filed by state agencies and the drivers themselves. Now it plans to turn directly to the people of California, through Proposition 22 on the November ballot.

Uber had not fared all that well under the prior law on worker classification, and then came A.B. 5, which seems directed at Uber and other ride-hailing services. Although Uber’s litigation history is voluminous, this article addresses the decision in the most recent case involving A.B. 5, California v. Uber.¹¹ The complaint asserts that both Uber and Lyft have misclassified their drivers as independent contractors rather than employees in violation of A.B. 5. The state argues that Uber and Lyft are depriving workers of the right to a minimum wage, overtime, access to paid sick leave, disability insurance, and unemployment insurance. The complaint asks for a preliminary injunction enjoining defendants from classifying their drivers as independent contractors and from continuing to violate provisions of the Labor Code, the Unemployment Insurance Code, and wage orders of the Industrial Welfare Commission.

Uber and Lyft maintain that an injunction would require them to restructure their businesses in such a significant way that it would prevent them from continuing to employ drivers on either a full- or part-time basis. Despite the devastating impact reclassification of workers as employees will have on both companies, the judge granted the injunction and made it effective August 20.

Uber and Lyft have appealed, asking for the decision to be deferred until the Ninth Circuit rules on Uber’s pending constitutional challenge to A.B. 5; until the November election, when the voters will consider Proposition 22; or until the final disposition of numerous lawsuits and arbitrations in which similar claims have been raised. Both companies have said that they will have to temporarily shut down to comply. On August 20, the appellate court granted the companies a temporary reprieve and provided new deadlines. On September 4 the companies must submit sworn statements with implementation plans for complying with the law within 30 days if the appellate court upholds the injunction order issued by the lower court and if Proposition 22 does not pass. Oral arguments for this proceeding are scheduled for October 13.

Proposition 22

California Proposition 22 — the App-Based Drivers as Contractors and Labor Policies Initiative — would establish drivers as independent contractors and not employees or agents. If enacted, the measure would override A.B. 5 regarding whether app-based drivers are employees or independent contractors. The ballot measure defines app-based drivers as workers who:

• provide delivery services on an on-demand basis through a business’s online-enabled application or platform; or

• use a personal vehicle to provide prearranged transportation services for compensation via a business’s online-enabled application or platform.

Uber, Lyft, and DoorDash have each placed $30 million in campaign accounts to fund the ballot initiative campaign. They were later joined by Instacart and Postmates, which have each contributed $10 million toward the effort.

Proposition 22 does more than retain the status of independent contractor for app-based drivers. It creates a third category of worker classification — an idea put forth by Uber CEO Dara Khosrowshahi in a recent New York Times op-ed piece.¹² This work category would be an independent contractor with some guaranteed benefits, such as a minimum level of pay and healthcare subsidies. Khosrowshahi has said that if Uber is forced to reclassify workers immediately as employees, it would have to lay off a significant number of workers and shut down temporarily while it tries to reorganize to face the reality of employment and its related costs.

Proposition 22 creates that third worker category. Although it classifies app-based drivers as independent contractors, that does not mean they would not have some employment benefits, they just would not be covered under existing state laws. These workers would, however, have minimum earnings, healthcare coverage, and insurance.

Proposition 22 includes¹³:

• paying the difference between a worker’s net earnings, excluding tips, and a net earnings floor based on 120 percent of the minimum wage applied to a driver’s engaged time and 30 cents per mile, adjusted for inflation after 2021;

• prohibiting app-based drivers from working more than 12 hours during a 24-hour period, unless the driver has been logged off for an uninterrupted six hours;

• requiring companies to provide healthcare subsidies equal to 82 percent of the average California covered premium for each month for drivers who average at least 25 hours per week of engaged time during a calendar quarter;

• requiring companies to provide healthcare subsidies equal to 41 percent of the average California covered premium for each month for drivers who average between 15 and 25 hours per week of engaged time during a calendar quarter;

• requiring companies to provide or make available occupational accident insurance to cover at least $1 million in medical expenses and lost income resulting from injuries suffered while a driver is online (defined as when the driver is using the app and can receive service requests) but not engaged in personal activities;

• requiring companies to provide or make available accidental death insurance for the benefit of a driver’s spouse, children, or other dependents in case the driver dies while using the app.

A driver’s engaged time is the time between accepting a delivery or rideshare request and completing the request. Proposition 22 would also require the companies to develop anti-discrimination and anti-sexual harassment policies.

The Tax Consequences

The tax consequences are numerous. Regardless of what happens to Uber and Lyft, many workers have already been reclassified as employees under A.B. 5. That means that the number of instances when a worker is an independent contractor for federal tax purposes and an employee for state tax purposes has also increased. The Franchise Tax Board has posted a Q&A on its website that addresses issues raised by this dilemma.¹⁴ In essence, the federal tax return will have to be completely redone for state tax purposes.

Proposition 22

If Proposition 22 passes, then hiring entities will be required to provide health insurance, occupational accident insurance, and accidental death insurance. Payments that are required to be made to someone classified as an employee, such as sick leave, state disability, or fringe benefits that are excluded from an employee’s income under California law, may be considered taxable by the federal government. As an example, under IRC section 106(a), the exclusion for employer-provided accident or health plan coverage (and the amounts received under an employer’s accident or health plans) applies only to employees. An employee is defined under the employment tax rules (that is, under the common law multifactor test).

A.B. 5

A worker classified as an independent contractor for federal tax purposes would likely receive a Form 1099-K or a Form 1099-MISC. A worker classified as an employee for California tax purposes would receive a Form W-2. As a result, the income reported on forms 1099-K or 1099-MISC may be different from the amount on a Form W-2 because the items of income and how that income is reported may be different.

A worker who is an independent contractor for federal purposes would be entitled to deduct their business expenses. However as a California employee, the worker would be limited to unreimbursed business expenses. If a worker uses a vehicle in her business, she may be able to depreciate the vehicle and deduct maintenance against her business income for federal purposes. However, for California tax purposes, she would not be entitled to those deductions.

Also, hiring entities that are considered employers in California would be required to pay the state disability insurance tax and California personal income tax withholding, however they would not be required to pay a portion of the worker’s Social Security and Medicare taxes. For federal purposes, the worker would be required to pay the self-employment tax without any contribution from the hiring entity and would be able to claim a deduction for half of the payment. No deduction would be allowed for state purposes.

Payments that must be made to a worker under California’s classification as an employee, such as sick leave or disability, or fringe benefits that are excluded from an employee’s income, may be considered taxable by the federal government. State disability insurance and state income tax payments made by employees in California could be deductible on the federal tax return as state taxes.

Conclusion

The earthquake-like jolt of A.B. 5 would have been enough of a game changer for the gig economy without the setbacks caused by COVID-19. San Francisco has been virtually closed since March 20. The result is an increasing number of For Lease signs appearing in shop windows and a continued increase in unemployment claims. Now add ride-hailing companies to the list of businesses that will probably have to lay off a significant number of workers (now classified as employees), and you can only wonder how much more the fragile economy can take.

A reasonable alternative could be S.B. 990, which would repeal A.B. 5 for two years to allow for the California economy to recover from the pandemic and the enormous $54 billion state budget deficit. It would also grant time for lawmakers to create compromise legislation that would address the economic challenges California will face because of the pandemic and its aftermath. Although a good idea, the bill is still in the Senate Committee on Labor, Public Employment and Retirement, where it was voted down and is being held for a rehearing.