One of the most common—and most expensive—mistakes California business owners make is treating a worker as an independent contractor when the law treats them as an employee.

Many owners assume that calling someone a “1099 contractor,” having them sign an independent contractor agreement, or letting them set their own hours settles the question. In California, it doesn’t come close. Under Assembly Bill 5 (AB 5), the state applies the strict ABC Test, which starts from the presumption that every worker is an employee. The burden is on your business to prove otherwise—and if you can’t, the worker is an employee no matter what the paperwork says.

The good news: with some planning up front, these problems are largely preventable.

The ABC Test: California’s Default Standard

California adopted the ABC Test in the Supreme Court’s Dynamex decision (2018) and codified it in AB 5, effective January 1, 2020 (now found at Labor Code  2775 et seq., as amended by AB 2257). It presumes a worker is an employee unless the hiring business proves all three of the following:

1. Control. The worker is free from your control and direction in performing the work—both under the contract and in actual practice.
2. Outside your usual business. The worker performs work that falls outside the usual course of your business.
3. Independent trade. The worker is customarily engaged in an independently established trade, occupation, or business of the same kind as the work performed.

Miss even one prong and the worker is an employee. Prong B is where most businesses stumble: if the worker does the very thing your company sells, it’s hard to argue their work falls outside your usual course of business. A bakery that brings on cake decorators, or a cleaning company that dispatches cleaners, will almost always fail Prong B—no matter how the relationship is documented.

A Signed Agreement Isn’t Enough

One of the biggest misconceptions is that a signed independent contractor agreement settles the issue. In California, it doesn’t. Because the ABC Test presumes employee status and puts the burden on you, agencies and courts look at the operational reality of the relationship, not the title on the contract or the 1099 form. A well-drafted agreement matters, but it can’t turn an employee into a contractor.

Exempt Occupations Still Have to Clear the Borello Test

AB 5 and its follow-up, AB 2257, carve out a long list of occupations and relationships where the ABC Test doesn’t apply—among them licensed professionals (doctors, lawyers, architects, accountants, engineers), certain professional-services roles (marketing, HR administration, graphic design, grant writers, freelance writers and photographers, subject to conditions), bona fide business-to-business contracting, and referral-agency arrangements.

Two points matter here. First, being on the exemption list does not automatically make someone a contractor—it simply swaps in the older, multi-factor Borello test, which still centers on how much control you have over the work. Second, most exemptions come with their own detailed conditions that have to be satisfied before Borello even applies. Assuming you qualify without checking each requirement is a common and costly error.

The Financial Consequences Can Be Severe

When a worker is misclassified in California, the cost usually goes well beyond correcting payroll. It can include:

• Unpaid payroll taxes, plus interest and penalties
• Unpaid overtime and minimum wage
• Meal and rest period premiums
• Unreimbursed business expenses
• Workers’ compensation liability (with potential criminal exposure)
• Unemployment insurance and State Disability Insurance (SDI) contributions
• Wage statement violations and waiting time penalties
• Civil penalties for willful misclassification under Labor Code § 226.8—$5,000 to $15,000 per violation, rising to as much as $25,000 per violation where there’s a pattern or practice
• Attorneys’ fees and litigation costs

Because wage claims can reach back years, these liabilities pile up fast—especially when several workers have been classified the same way.

One Investigation Can Quickly Expand

Many owners are surprised how fast a single complaint spreads. A claim filed with one California agency can trigger inquiries from others—the Employment Development Department (EDD) for payroll tax and unemployment, the Labor Commissioner’s Office (DLSE) for wage claims, the Division of Workers’ Compensation, and the Franchise Tax Board—plus the IRS at the federal level. Enforcement budgets have grown, and audit risk is especially elevated in industries like cleaning, trucking, healthcare staffing, and gig work. What starts as one worker’s complaint often becomes a full audit of the company’s employment practices.

Misclassification Also Fuels Lawsuits—Including PAGA

Misclassification claims often surface after the working relationship ends. A terminated contractor may later claim they were really an employee and seek unpaid overtime, missed meal and rest break premiums, expense reimbursement, benefits, interest, statutory penalties, and attorneys’ fees.

California adds another layer: the Private Attorneys General Act (PAGA) lets an aggrieved worker sue on behalf of the state for civil penalties, which can turn a single misclassification into a claim reaching well into six figures. Even when the business ultimately wins, defending these claims takes real time, money, and attention.

Getting It Right from the Start Costs Less

Many businesses wait for a complaint or audit notice before seeking legal guidance, and by then the options have narrowed. It’s far better to address classification before hiring by:

• Running each role through the ABC Test—or the applicable exemption and Borello analysis—before you engage anyone.
• Preparing an agreement that reflects the intended relationship and includes California-required terms.
• Structuring the working relationship so it actually matches the classification on paper.
• Keeping documentation that supports the classification decision.
• Revisiting classifications as the business grows or job duties change, since a relationship that qualified years ago may not today.

A small investment in preventive planning almost always beats the cost of an EDD audit, a Labor Commissioner claim, or a PAGA lawsuit.

The Bottom Line

In California, worker classification is far more than a payroll decision—it’s a legal determination governed by the ABC Test, with real tax, wage, and liability consequences. Get it wrong and a business can face years of back taxes, wage claims, penalties, and litigation. Take the time to evaluate each relationship under the ABC Test up front and you substantially reduce that risk.

If you’re hiring your first worker—or you’re not sure your current contractors would survive the ABC Test—review your practices before a problem arises. A proactive assessment today can head off a costly dispute tomorrow.

This article is intended for general informational purposes only and does not constitute legal, tax, or financial advice. California worker classification law is fact-specific and continues to evolve, and the appropriate analysis depends on the particular circumstances. Business owners should consult qualified legal and tax professionals regarding their specific situation.