Risk Management · Employment

California AB 5 and the ABC Test: How to Avoid a Six-Figure Worker Misclassification Mistake

By Chris Scott-Dixon, Esq. · CSD Business Law · July 13, 2026

You can call someone an independent contractor. You can pay them on a 1099. You can even both agree, in writing, that that's what they are. And under California law, none of that decides the question. The state does — using a test that assumes your worker is an employee until you prove otherwise.

For a lot of California business owners — especially agencies, studios, and anyone who runs on freelance talent — that's an uncomfortable sentence. It should be. Worker misclassification is one of the most common and most expensive legal mistakes we see, and it almost always comes from owners who thought they were doing everything right.

Here's how AB 5 actually works, why creative businesses get caught more than most, what a misclassification finding really costs, and how to check your own exposure before the state does it for you.

What AB 5 actually changed

For decades, California decided who was an employee and who was a contractor using a flexible, multi-factor standard from a case called S. G. Borello & Sons, Inc. v. Department of Industrial Relations (1989). It weighed a dozen factors and gave businesses a lot of room to argue.

That changed. In 2018, the California Supreme Court decided Dynamex Operations West, Inc. v. Superior Court, adopting a much stricter standard known as the ABC test. In 2019 the Legislature passed Assembly Bill 5 (AB 5), which took effect January 1, 2020, writing the ABC test into the Labor Code for most purposes. It was later amended by AB 2257 and is codified today at Labor Code section 2775 and following.

The headline: under the ABC test, a worker is presumed to be an employee. The burden is on the hiring business to prove otherwise.

The ABC test, in plain English

To classify a worker as an independent contractor, you have to satisfy all three of these. Miss one, and the worker is an employee.

Why agencies and freelancers get caught (prong B)

Read prong B again: the worker has to do work outside the usual course of your business.

Now picture a marketing agency. Its business is producing marketing. So when it hires a freelance copywriter to write copy, a designer to design, or an editor to edit, those workers are doing the exact thing the agency sells. That's squarely inside the usual course of business — and prong B fails.

This is why the "we're all freelancers here" model is so legally fragile for agencies, studios, and production shops. The people delivering your core service are the people the ABC test is most likely to treat as employees.

"But there are exemptions" — yes, and they're narrower than you think

AB 5 and AB 2257 carved out a long list of exemptions. Two matter most to creative businesses:

• The professional-services exemption (Labor Code § 2778) lists certain occupations — including some marketing, human-resources, graphic-design, grant-writing, fine-art, freelance-writing, photography, and content-contributor roles — that can be evaluated under the older, more flexible Borello standard if a set of conditions is met (maintaining their own business location, setting their own rates, holding a business license where required, and being able to work for others).
• The business-to-business exemption (Labor Code § 2776) can apply when a legitimate, separate business contracts with another business — but only if roughly a dozen specific conditions are all satisfied.

Two things to understand about these exemptions. First, they don't automatically make anyone a contractor — they only change which test applies. You still have to pass Borello. Second, the conditions are strict and fact-specific. Missing one condition collapses the exemption. This is exactly the kind of analysis worth running with an attorney before you rely on it, not after an audit notice arrives.

What misclassification actually costs

This is the part that turns an accounting shortcut into a business emergency. When California finds that a worker was misclassified, the exposure stacks:

1. Willful-misclassification civil penalties. Under Labor Code § 226.8, willfully misclassifying an employee as an independent contractor carries civil penalties of $5,000 to $25,000 per violation.
2. Unpaid wages and overtime. Back pay for minimum wage, overtime, and missed meal and rest breaks the worker should have received as an employee.
3. Payroll tax exposure. If the EDD finds negligent or intentional disregard of the rules, it may add a penalty of 15% of the tax deficiency under Unemployment Insurance Code § 1127(a), on top of the unpaid taxes and interest.
4. Unemployment and workers' comp. Unpaid unemployment-insurance contributions and potential workers'-compensation liability, including uninsured-employer penalties.
5. PAGA lawsuits. Under the Private Attorneys General Act, a worker can bring a representative action for Labor Code violations without the state getting involved first, after a required notice period.

How to audit your own classifications before the state does

You don't need to wait for a notice. A straightforward self-review catches most problems:

1. List every 1099. Write down everyone you pay as a contractor and what they actually do.
2. Run prong B first. For each person, ask: is this work the thing my business sells? If yes, treat classification as high-risk until proven otherwise.
3. Check control in practice. Do you set their hours, require your tools or processes, or direct how the work gets done? That cuts against contractor status regardless of what the contract says.
4. Test prong C honestly. Do they have other clients, their own entity, their own marketing? Or do they effectively work only for you?
5. Don't lean on an exemption you haven't verified. If you're relying on § 2778 or § 2776, confirm every condition is met — in writing.
6. Fix forward. Reclassifying going forward, tightening agreements, or restructuring relationships is far cheaper than defending a claim later.

The bottom line

AB 5 didn't ban independent contractors. Plenty of genuinely independent professionals still qualify. What it did was flip the default: in California, your worker is an employee unless you can prove all three prongs of the ABC test — and for businesses whose contractors deliver their core service, that proof is hard to make.

The good news is that this is a preventable problem. Classification is decided at setup — in how the relationship is structured, documented, and run — not in a courtroom later. The least expensive version of this work is the version you do before anything goes wrong.