AB5 vs IRS Worker Classification, Small Business Payroll Tax Crisis

Author : Christy Evangeline Christy Evangeline | Published On : 10 Nov 2026

Small businesses in California may benefit from independent contractors to manage labor expenses, tap into niche expertise, and ensure flexibility in their operations. But there's more to deciding to hire workers as 1099 independent contractors rather than W-2 employees than simply picking a way to pay. Business owners are required to meet the federal IRS worker classification rules as well as the even more stringent rules set by the California Assembly Bill 5 (AB 5).

The lack of understanding can result in costly payroll tax assessments, penalties, interest, and even multiple agency audits. Look for an expert (like an EDD lawyer in San Diego) who will help you manage your tax burden.

It is Important to Grasp the Federal IRS Classification Rules

IRS decides if a person is an employee or an independent contractor based on common-law principles. It explores the three general types:

Behavioral control: Do the worker's actions in the workplace, including where, how, and when they work, fall within the control of the business?
Financial control: Does the worker have his own business expenses, investment, and profit/loss opportunities?
Relationship between the parties: Does the contract, benefits, permanency, and relationship of the parties suggest employment?

These are sometimes presented as a 20-factor test, but at present, the IRS approaches its analysis through these three groups.

Federal requirements for an independent contractor do not necessarily meet California's expectations for an independent contractor. Hiring a professional (like an EDD appeal attorney)

California AB 5 Introduces New Risks for Businesses

The ABC test is generally applied by California AB 5 to identify if a worker is considered an employee or independent contractor for employment-related matters in California.

A business would have to meet three criteria under this test:

Freedom from control: The worker is free of control and direction by the hiring entity, both contractually and in practice.
Outside the usual business of the hiring entity: The worker is doing work outside the hiring entity's normal business.
Independent business: The individual works in an occupation that is customarily a separate trade, occupation, or business.

The second requirement is particularly challenging. For instance, a construction company that hires a freelance graphic designer may have a better claim to independent contractor status than a delivery driver who performs the construction company's primary delivery services.

There are also a number of statutory exemptions and alternative classification tests for qualifying occupations and business relationships in California. An exemption does not automatically make an individual a contractor, and the requirements must be met. Get in touch with a professional (like an attorney for IRS problems) who will help you in tax matters.

The IRS-EDD Double-Audit Problem

Misclassification can lead to a costly compliance chain. A business could be liable for the following if the California Employment Development Department (EDD) finds that the contractors should have been employees:

Unpaid state payroll taxes and work contributions.
Unemployment insurance and employment training tax burdens.
Disability insurance and income tax withholding.
Interest and applicable penalties.
More required paperwork and inspections.

An EDD determination can also generate information that's subject to federal investigation. The IRS will conduct its own worker classification review and apply unpaid federal employment taxes, such as Social Security, Medicare, and federal unemployment taxes.

But an audit by a state does not necessarily mean an audit by the IRS, nor does it mean that misclassification is a federal crime.