California’s AB5 law, which took effect on January 1, 2020, changed the default assumption about worker classification. Under AB5, a worker is presumed to be an employee unless the hiring business can satisfy all three parts of the ABC test. This applies to most working relationships in California, and it directly affects how you pay people, what taxes you owe, and how those payments show up in your books.

The ABC test has three requirements that must all be met for a worker to qualify as an independent contractor. Part A says the worker must be free from the control and direction of the hiring business, both in the contract and in practice. Part B says the worker must perform work that is outside the usual course of your business. Part C says the worker must be engaged in an independently established trade or business of the same nature as the work they’re doing for you.

Part B is where most small businesses get tripped up. If you run a web development company and hire a freelance developer to help with a project, that developer is doing work within the usual course of your business. Under the ABC test, that person would likely be classified as an employee regardless of what your contract says. But if you hire a bookkeeper to manage your finances, that work is outside your core business, so Part B is easier to satisfy.

AB5 does include exemptions for certain professions and business-to-business relationships. Licensed professionals such as lawyers, accountants, real estate agents, and certain creative professionals may fall under the older Borello test, which is more flexible. B2B exemptions exist too, but they come with their own checklist of conditions. Don’t assume you’re exempt without actually reviewing the requirements.

The financial risk of getting this wrong is real. If the EDD reclassifies your contractors as employees, you could owe back payroll taxes, unemployment insurance contributions, penalties, and interest going back several years. On top of that, there’s potential exposure for unpaid overtime, meal and rest period violations, and workers’ comp coverage gaps. These costs add up fast and can seriously hurt a small business.

From a bookkeeping standpoint, classification determines how payments are recorded and what filing obligations you have. Contractor payments get reported on 1099 forms at year end. Employee wages require payroll tax withholding, quarterly filings, and W-2s. If workers are misclassified in your books, the problem compounds every pay period. Having a QuickBooks ProAdvisor in Long Beach who understands these distinctions helps make sure your records reflect the correct treatment from the start.

If you regularly work with contractors, review each relationship against the ABC test. Keep documentation showing how the contractor operates independently, the scope of work, and evidence that they serve other clients or have their own business presence. A written agreement calling someone an independent contractor is not enough on its own. California looks at the actual working relationship, not just the paperwork.

When it comes time to file, accurate classification makes 1099 preparation straightforward. But if your classifications are wrong, those 1099s become evidence of a problem rather than proof of compliance. Get the classification right first, and the bookkeeping and tax reporting will follow naturally.