In California, a single sentence can cost a small business $50,000 or more: “Oh, don’t worry, they’re just a 1099 contractor.”
This common phrase—and the misunderstanding behind it—is the single biggest compliance “nightmare” facing Los Angeles business owners. Assembly Bill 5 (AB 5) fundamentally changed the rules. The old “if-they-say-they’re-a-contractor-it’s-fine”-test is long gone. Now, the burden of proof is 100% on you, the business owner.
Misclassifying a worker doesn’t just mean a small fine. It means you are on the hook for back payroll taxes, unpaid overtime, meal break penalties, workers’ comp premiums, and civil penalties that can add up to $25,000 per violation.
This guide will walk you through the two-part test every LA business owner must know to stay compliant and protected.
The $50,000 Mistake: What “Willful Misclassification” Costs
The state of California does not take this lightly. They see misclassification as a form of fraud that robs workers of rights and the state of tax revenue.
If you are found to have “willfully misclassified” a worker (which can simply mean you should have known better), the penalties from agencies like the EDD, CSLB, and IRS are severe:
- Civil Penalties: $5,000 to $25,000 per violation (per worker).
- Back Wages & Overtime: You can be forced to pay 2-3 years of back overtime, often with interest.
- Meal & Rest Break Penalties: You’ll owe one hour of pay for every day a meal break was missed.
- Tax Liability: You will be responsible for the employer and employee side of payroll taxes (FICA) you failed to withhold, plus state unemployment (SUI/ETT).
- Public Shaming: Violators can be ordered to post a public notice on their website and business premises stating they were found guilty of misclassification.
The First Hurdle: Contractor vs. Employee (The AB 5 “ABC Test”)
This is the main gate. By default, California law presumes every worker is an employee. To classify them as an independent contractor, you must be able to prove ALL THREE of the following conditions (this is the “ABC Test”).
A. The worker is free from the Control and direction of the hiring entity.
- What it means: You cannot control how, when, or where they do their work. You can only control the result.
- Fail Condition: You require them to work 9-5 in your office, use your equipment, and follow your specific process.
B. The worker performs work that is Outside the usual course of the hiring entity’s business.
- What it means: This is the toughest part. The worker’s job cannot be core to what your business does.
- Fail Condition: A bakery hiring a baker. A plumbing company hiring a plumber. A marketing agency hiring a graphic designer. All of these are employees under this test.
- Pass Condition: A bakery hiring a plumber to fix a sink. A plumbing company hiring an accountant (like Key Forecasts!) to do their books.
C. The worker is Customarily Engaged in an independently established trade or business.
- What it means: The worker must be a legitimate, independent business on their own.
- Pass Condition: They have their own business license, an LLC, other clients, their own liability insurance, and they market their services to the public.
- Fail Condition: A worker who only works for you and has no other business infrastructure.
The Hard Truth: If you cannot prove “YES” to all three of these, the worker is an employee. Period. There is no partial credit.
The Second Hurdle: Exempt vs. Non-Exempt (For Employees Only)
If your worker is an employee (and most are), you have one more classification to make. By default, all employees in California are Non-Exempt.
- Non-Exempt Employees: Are paid hourly and are protected by all wage and hour laws. You must pay them overtime, track their hours, and provide mandatory meal and rest breaks. This is 90% of your workforce.
- Exempt Employees: Are paid a fixed salary and are not eligible for overtime. This is a rare exception, not a loophole.
To classify an employee as “exempt” (from overtime), you must prove ALL THREE of the following conditions:
- The Salary Basis Test: You must pay them a fixed salary, not an hourly wage.
- The Salary Threshold Test: As of January 1, 2026, their salary must be at least $70,304 per year. This is 2x the California state minimum wage ($16.90/hr). Note: This is the state minimum; it can be higher in some localities.
- The Duties Test: The employee’s primary job (more than 50% of their time) must actually be in an executive, administrative, or professional role. This means they must genuinely manage the business, run major office operations, or be a licensed professional (like a lawyer or doctor).
Warning: You cannot just call a “Manager” exempt. If their primary duty is stocking shelves or running a cash register, they are Non-Exempt and you owe them overtime, regardless of their title.
Find Your Classification: A 2-Minute Worksheet
This is a complex, fact-specific decision. To help you get a preliminary idea of your risk, we created a simple classification worksheet based on the “ABC” and “Exempt” tests.
[Click Here to Download Our Free Worker Classification Worksheet (.xlsx)]
Disclaimer: This tool is for informational purposes only and does not constitute legal or financial advice. Your specific situation must be reviewed by a qualified California employment attorney and your accounting professional.
Conclusion: Stop Guessing and Get Compliant
In Los Angeles, “winging it” on worker classification is a gamble you can’t afford to lose. The state has given a clear message: the burden of proof is on you, and the penalties are severe.
Getting this right isn’t just about avoiding fines—it’s about building a stable, scalable, and legal business.
🚀 Stop Risking Your Business. Get Clarity Now.
Stop guessing and risking your business. At Key Forecasts, we help Los Angeles businesses set up compliant payroll systems from day one. We’ll work with you to analyze your workforce, ensure your classifications are correct, and set up the accounting framework you need to stay protected and profitable.
Don’t wait for an EDD audit. Contact us today for a free, confidential compliance consultation.