This article intends to provide a historical context of the changes to the legal definition of an independent contractor for process serving agencies and process servers and the impact of AB5.
At the time of writing this, several large process serving agencies are warning independent contractor process servers that they will only contract with those who incorporate and will no longer continue business relationships with individuals operating otherwise. Whether you are a process server, or a process serving agency owner, you should start planning.
Each process server and process serving agency should consult with a lawyer and accountant and decide whether to change their business structure, convert servers to employees, or continue to contract with independent contractors. Each company need to evaluate that which is best suited for their unique situation. This law is new, and there will be considerable risks and costs associated with the decisions made about this issue. Solutions suggested in this article may not be appropriate in each circumstance.
What AB5 Does
Assembly Bill 5 (AB5) was signed by Governor Newsom and amends and adds California Labor Code §§ 3351 and 2750.3 and Unemployment Insurance Code §§ 606.5 and 621. It codified the holding in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (2018) 4 Cal.5th 903 (Dynamex). It creates a presumption that a worker who performs services for a hirer is an employee for purposes of claims for wages and benefits arising under wage orders issued by the Industrial Welfare Commission. In essence, the laws redefine an independent contractor in California.
By amending the California Labor and Unemployment Insurance Codes, it expands the application of Dynamex, which was based on a wage-order claim, and applies it to all workers.
The seminal case defining independent contractor status of a worker, prior to Dynamex, was set forth in S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989) 48 Cal.3d 341 (Borello). That decision instituted a multi-factor test, and opined, inter alia, that a worker is an independent contractor who is free from the control and direction of the hiring entity in connection with the performance of the work,
Process Server Industry Specific Tax Regulation
In 1995, after several tax audits had targeted process serving agencies, the California Employment Development Department (EDD) promulgated an industry-specific tax regulation for the process serving industry. It recognized, with significant CAPPS’ input, that process serving agencies customarily operated using individual process servers as independent contractors. The regulation considered 15 factors and assigned a certain weight to each, evidencing whether the worker would be considered an employee or an independent contractor. (Title 22, CPR. Section 4304-11)
The tax regulation tracked the specifically unique features of the process serving business in light of the holding in Borello. The legal status of this specific tax regulation is unknown at this point because Dynamex rejected the Borello decision for a more worker-friendly standard. This regulation is no longer a guide for process serving agencies and individual process servers. It may offer a reliance defense if Dynamex is deemed to be applied retroactively.
The Dynamex Decision
The Dynamex decision redefined an independent contractor with what is referred to as the three-pronged “ABC Test”.
- The worker is 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;
- that the worker performs work that is outside the usual course of the hiring entity’s business; and
- that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed
The hirer, the contracting entity, is obligated to show, based on these three factors, that the worker was not an employee but a bone fide independent contractor.
Part B of this “ABC Test” is the most difficult hurdle for a process serving agency because an individual independent contractor process server, heretofore allowed under Borello and the aforementioned tax regulation, would now not be performing work “outside the usual course of the hiring entity’s business.” They will now be presumed to be an employee.
In May 2019, the U.S. Court of Appeals, Ninth Circuit ruled that Dynamex should be applied retroactively. (Vazquez v. Jan-Pro Franchising Int’l, Inc., 923 F.3d 575, 586-90 (9th Cir. 2019)) However, in July the court suspended its decision, granted the defendant’s petition for rehearing, and certified the question of retroactivity to the California Supreme Court to decide the question.
The California Supreme Court is currently considering that issue which was not addressed in the 2018 Dynamex decision. You can view the progress of that case here.
Legislation – AB5
There was a cluster of State Senate and Assembly bills introduced to overturn or alternatively, codify Dynamex. AB5 was the bill that ultimately prevailed.
The law codified Dynamex and created exemptions for over fifty professions and types of businesses which allowed operation under the previous Borello decision. These exempt occupations would include, among others, licensed insurance agents, certain licensed health care professionals, registered securities broker-dealers or investment advisers, direct sales salespersons, private investigators, real estate licensees, commercial fishermen, workers providing licensed barber or cosmetology services, and others performing work under a contract for professional services, with another business entity, or pursuant to a subcontract in the construction industry.
Since the process serving industry did not receive a specific exemption, they are affected by the new law which changed the definition of an independent contractor. This also affects other businesses that operate in California and use independent contractors such as UBER, LYFT, the construction industry, etc.
This legislation is also a reaction to a changing reality of the workforce. In 2017, a report from the U.S. Bureau of Labor Statistics estimated that nationally, 35 percent of workers participate in some form in the “gig economy.”
This will have an enormous impact on the California economy. Businesses might just leave California to avoid it. Those that stay will be paying more in taxes. Workers will lose the flexibility to set their own hours and control when and how they work.
On the other hand, workers will be protected from work-related injuries, and the worker and the state will not be subsidizing uncovered medical costs. Furthermore, the state and local governments will be receiving more tax money.
The law also authorizes the California Attorney city attorneys and local prosecutors to sue companies for non-compliance. That might be bad news for offending businesses because enforcement may originate locally.
Business to Business Exemption
The law also provides an exemption for business to business contracting relationships and sets forth specific guidelines. Those are codified in new Labor Code § 2750.3(e):
(e) Subdivision (a) and the holding in Dynamex do not apply to a bona fide business-to-business contracting relationship, as defined below, under the following conditions:
(1) If a business entity formed as a sole proprietorship, partnership, limited liability company, limited liability partnership, or corporation (“business service provider”) contracts to provide services to another such business (“contracting business”), the determination of employee or independent contractor status of the business services provider shall be governed by Borello, if the contracting business demonstrates that all of the following criteria are satisfied:
(A) The business service provider is free from the control and direction of the contracting business entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
(B) The business service provider is providing services directly to the contracting business rather than to customers of the contracting business.
(C) The contract with the business service provider is in writing.
(D) If the work is performed in a jurisdiction that requires the business service provider to have a business license or business tax registration, the business service provider has the required business license or business tax registration.
(E) The business service provider maintains a business location that is separate from the business or work location of the contracting business.
(F) The business service provider is customarily engaged in an independently established business of the same nature as that involved in the work performed.
(G) The business service provider actually contracts with other businesses to provide the same or similar services and maintains a clientele without restrictions from the hiring entity.
(H) The business service provider advertises and holds itself out to the public as available to provide the same or similar services.
(I) The business service provider provides its own tools, vehicles, and equipment to perform the services.
(J) The business service provider can negotiate its own rates.
(K) Consistent with the nature of the work, the business service provider can set its own hours and location of work.
(L) The business service provider is not performing the type of work for which a license from the Contractor’s State License Board is required, pursuant to Chapter 9 (commencing with Section 7000) of Division 3 of the Business and Professions Code.
The following is a summary of this section. If a process serving agency contracts with a legitimate business that operates in accord with Labor Code § 2750.3(e), they may operate under Borello. Under the law, the burden is on the contracting business to show:
- The process serving business must be legitimate, minimally operating as a sole proprietorship
- The process serving business is free from the control of the manner and means of the contracting business
- The process serving business is providing service to the contracting business and not directly to its customers
- There is a contract evidenced with a writing
- If the work is performed in a jurisdiction requiring a business registration or license, it has obtained one
- The process serving business maintains a separate location from that the contracting business
- The process serving business is customarily operating as an independently established business of the same nature as the contracting business
- The process serving business contracts similar services to the other businesses and maintains clientele without restriction from the hiring entity
- The process serving business advertises and holds itself to the public to provide the same or similar service
- The process serving business provides its own tools, vehicles, and equipment to provide the services
- The business can negotiate its own rates
- Consistent with the nature of the work, the business sets it own hours and location of work
If a process server is truly in business, then a process serving agency will be contracting with another business.
This, however, can make it harder to take on a new person who is looking for a job or wants to become a process server. A person who makes more than ten services of process must register as a process server. Taking on a new person to provide service assignments will force a business to treat them first as an employee. Only if they eventually form a business under the directives in Labor Code § 2750.3(e) can they contract as a bona fide business. “Converting” employees to independent contractors is a red flag for EDD auditors.
Individual Independent Contractors
Labor Code § 2750.3(e)(2) addresses individuals who have not formed a business and are retained by a contracting business for services. Those individual workers are deemed to be employees under the Labor Code.
(2) This subdivision does not apply to an individual worker, as opposed to a business entity, who performs labor or services for a contracting business.
This presents an apparent ambiguity in the law. An individual has always been able to and may continue to operate as a sole proprietorship without filing a fictitious business name, as long as they operate as a business. (See link for a summary discussion of a sole proprietorship.) According to the description on the California Franchise Board’s website, the key is that a sole proprietor must pick a name for tax reporting purposes, and obtain all the appropriate licenses, zoning, or permits required.,
Furthermore, operating a business from a home is also not an indicator that negates the status of a bona fide business. The IRS recognizes a proportional deduction for using a home for business purposes.
The following subsection, Labor Code § 2750.3(e)(2) reads as follows:
(3) The determination of whether an individual working for a business service provider is an employee or independent contractor of the business service provider is governed by paragraph (1) of subdivision (a).
That means that if the individual independent contractor complies with the business to business requirements, they are truly an independent contractor and not an employee.
The problem will arise when a contracting agency files a form 1099 reflecting payments of $600 or more to an individual independent contractor who does not have a business name. That would be a red flag to the EDD and could lead to an audit for suspected misclassification of the worker. The issue would be determining whether the person is truly a business or an individual worker. Again, the burden of proof is now on the contracting agency.
Costs for Misclassification
The costs for misclassification of a worker can be devastating to a business. If an EDD auditor contacts the business and demands to see all of the 1099 forms, they may demand records from the prior four years. If they determine that some or all of the workers were suspected of misclassification, they can make an assessment for unpaid taxes on the full amount paid to the worker, which would also include penalties and interest.
If the workers are determined to be employees and not independent contractors, the employer will be responsible for paying both the employee and employers’ contribution of Social Security and payroll taxes, unemployment insurance and employment taxes.
The employee contribution amounts may be offset by obtaining affidavits from the employee stating that they filed their taxes predicated on the previous amounts reported on the 1099 form they received from the business. They must provide separate affidavits for each yearly quarter at issue.
Nevertheless, the amounts a business may be obligated to pay can be substantial.
Furthermore, misclassified workers would likely be reported to another agency to audit a determination of whether worker’s compensation insurance was paid and add yet another round of assessments to the business.
These audits don’t always come directly from the agencies. A worker, disgruntled or not, may make a claim to the California Labor Commission alleging they did not make minimum wage, or were given appropriate breaks, or were underpaid for overtime hours. An independent contractor might make a claim to the EDD for unemployment benefits, and if they prevail, the case could ripen into a tax audit and a tax case. That happened to me 30 years ago.
As mentioned earlier, some process serving agencies are urging process servers to incorporate or form a limited liability company. They will ensure compliance with the law in two ways because a) they are operating under the business-to-business exemption under Borello and, most importantly, b) they do not have to send a corporation or LLC a 1099 form. On the other hand, this abrupt change in employment status could trigger a wrongful discharge suit.
Costs for Forming a Corporation
Costs for forming a corporation or LLC vary, but the filing fee is about $100 and the filing of a Statement of information is $25. It can be done without a lawyer, or an estimate of about $500 through Legalzoom.com. One lawyer estimated that forming through a lawyer would run about $1500.
Additionally, there are more operating costs by forming as a corporation.
- There is a minimum yearly tax of $800, credited toward any taxes owed.
- Yearly documentation to operate (estimated $500 per year for a lawyer to maintain proper records)
- Maintain books and records which include shareholders, corporate minutes, accounting ledgers, opening and annual meeting minutes
- Record all corporate decisions and actions of the corporation
- Corporate resolutions to authorize corporate expenditures
- Obtain an EIN and pay employees (including officers or managing members)
- 2 tax returns to file by the business and owner: corporate and individual
- Annual registration and annual fees
Finally, now is the time for process serving agencies to begin thinking about how to operate starting January 1, 2020.
A business will be taking on a greater burden by converting independent contractors as employees. If the law changes again making it more advantageous to operate with independent contractors, converting back to treating employees as independent contractors, whether it is the same employee or those performing the same function as an employee will surely trigger an audit. The presumption is that if the employee did perform or current performs the same job as an employee, all similarly situated workers would be deemed an employee.
There is not only tax liability. There is also tort liability. As an employer, a business is vicariously liable for the damages incurred by or to an employee. If the employee is involved in an accident on the job, the employer is also responsible. If the employee process server gets into a fistfight with the person being served, the damages incurred by that person is also the employer’s responsibility. If the employee is injured involving these scenarios, the employer’s workers’ compensation policy will be there to compensate the employee for his or her injuries.
I will be notifying the few independent contractor process servers that, based upon a legitimate business decision, that I intend to contract only with businesses.
I will then form a checklist, predicated on the business-to-business directive, asking for the items on the list. If the server wants to be in business, we’ll do business. I now have a duty to show that the business is a bone fide business,
- Form of Business
- Business address
- confirmation of process server registration.
- Confirmation of a business license.
- Employer Identification Number (EIN).
- Price List and negotiate it.
You get the idea.