California's Assembly Bill 5 drastically affects gig economy companies like Uber and DoorDash. This is what an independent contractor actually is, and how it's classified under the new law.

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• California lawmakers passed Assembly Bill 5, adopting a narrow definition of independent contractor that could force Uber and other gig economy businesses to choose between reclassifying workers as employees or risking significant liability for misclassification.
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• The move serves as a reminder to businesses to be careful when classifying workers as contractors.
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• Classifying independent contractors falls into two main categories: the "right to control" test (often called the "IRS test") and the tougher "ABC test" recently adopted in California's AB5.
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• Uber, Lyft, and DoorDash are now planning a $90 million push for a 2020 ballot proposal.
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• Click here for more BI Prime stories.

Last month, California passed Assembly Bill 5 ("AB5"), setting a high bar for businesses aiming to classify workers as independent contractors. Under AB5 (effective January 1, 2020), a business' workers are employees unless their services fall outside the business' "usual course or type of business." This legislation is widely seen as a direct challenge to the model of gig economy companies such as Uber and Lyft, which rely on independent contractors. Still, Uber says it is confident its drivers are correctly classified - even under AB5's stringent test.

Businesses that misclassify workers as independent contractors can face significant liability under both state and federal law. This can include tax penalties as well as claims for unpaid wages and overtime, workers' compensation, and unemployment benefits. Additionally, once found to have misclassified workers, the business must reclassify the workers as employees. The resulting costs could be a huge - potentially fatal - blow to Uber, Lyft, and their gig economy compatriots. One estimate puts Uber and Lyft's increased costs at $290 million in California alone.

The legal tests for determining independent contractor status (such as the one adopted in AB5) rely on the facts of the relationship between the business and the worker. These tests generally rely on a traditional understanding of employment. Gig economy businesses like Uber do not neatly fit a conventional model, though.

Independent contractors are non-employee workers hired to perform services. Generally, contractors are not covered by labor and employment laws such as wage and hour laws (for example, overtime, minimum wage), leave laws (for example, the Family and Medical Leave Act), and anti-discrimination laws (for example, the Americans with Disabilities Act). Contractors are usually ineligible for benefits and have no collective bargaining rights. They are responsible for their own taxes - in fact, the contractor tax form, "1099," is often used as shorthand distinguishing them from employees ("W-2s").

Saying a worker is an independent contractor does not make it so. State and federal laws and regulations define who can be an independent contractor. These tests generally fall into two main categories: the "right to control" test (often called the "IRS test") and the tougher "ABC test" recently adopted in California's AB5. The federal government uses the IRS test, as do most states (for at least some analyses). But Massachusetts, New Jersey, and now California have fully adopted the ABC test, and many states use it for certain situations, such as determining workers' compensation eligibility.

The IRS test relies on one general rule: A worker is an independent contractor if the business paying them has the right to control only the results of the work, not what and how work will be done. To figure out who has the right to control, the test considers multiple factors in three categories, non-exhaustively summarized as follows:

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• Behavioral Control: Type and degree of instruction given, such as when and where to work and what supplies to use; performance evaluations and discipline
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• Financial Control: Opportunity for profit or loss; investment in equipment; freedom to provide services to other clients; and method of payment (for example, salary versus by the job)
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• Relationship: Contract; permanence of relationship; extent to which services are central to the business; and benefits

The ABC test, while simpler, is tougher. To be an independent contractor under the ABC test, all three of the following must be met:

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1. The worker is "free from the control and direction" of the business while performing their work.
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2. The work falls "outside the hiring entity's usual course or type of business."
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3. The worker has their own independent business beyond the job at hand.

Uber's main product is a mobile app through which users request rides from local drivers. When a user requests a ride, the app pairs the user with an available driver.

Applying the IRS Test, some factors indicate drivers are contractors, and others indicate an employment relationship.

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• Behavioral control: Drivers control their schedules and hours, and driver evaluations mostly come from user ratings, not Uber. On the other hand, Uber has community guidelines governing drivers' behavior; violations can lead to account suspension or deactivation in Uber's sole discretion. To reactivate, drivers must complete a "quality improvement course" selected by Uber.
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• Financial control: Drivers are paid by the ride and are responsible for expenses, including vehicle, maintenance, gas, insurance, phone, and data. Driver contracts are not exclusive - they can (and usually do) also drive for competitors such as Lyft. Many drivers also work for black car services or taxi companies. That said, when they are driving for Uber, the company unilaterally controls fares.
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• Relationship: Drivers' contracts state that they are independent contractors, and they do not receive benefits. At the same time, the relationship is indefinite, and drivers' services seem crucial to Uber's business.

Applying the ABC Test (now law in California), on the other hand, Uber drivers seem more like employees.

Part one mirrors the IRS Test's "behavioral control" portion. As discussed above, there are facts on both sides here: Drivers are largely free from Uber's control and direction but can be suspended or banned for violating Uber's terms.

Likewise, part three sticks closely with the IRS Test's consideration of "financial control." As mentioned, drivers are free to (and often do) drive for competitors and other ride services.

The core difference between the tests - and the reason for the fuss over AB5 - is part two, which requires that contractors' work be "outside the hiring entity's usual course or type of business." To meet this element, Uber must - and has been trying to - show that drivers' services are outside of its usual course or type of business.

So, what is Uber's business? The most obvious answer (at least to its users) is that it's a transportation service. If it is, Uber cannot logically argue that drivers' work is not crucial to its core business.

Uber claims it's not a transportation business, though. Instead, Uber argues its business is "serving as a technology platform for several different types of digital marketplaces," connecting independent drivers with passengers. But Uber is not selling software or making ad revenue from its (free) app. It solely makes money through fares and delivery fees. If a business is defined by its revenue source, then Uber might have a hard time winning under the ABC test. And, as users know, the app is useless when no drivers are available.

In response to AB5, Uber, Lyft, and delivery service DoorDash have pledged to devote a combined $90 million to lobbying for a ballot initiative in California that would permit them to continue classifying workers as non-employee contractors. The proposed measure would provide drivers with minimum hourly earnings, workplace injury coverage, and paid sick and family leaves.

If Uber and Lyft end up reclassifying drivers as employees, drivers will likely have to choose between working for one or the other, and increased labor costs will likely be passed on to riders.

Regardless of what happens to Uber, employers in the US - especially California - should closely evaluate their classification of independent contractors and speak with employment counsel about any concerns.