Man in carThis article originally appeared on October 18, 2019 in Law360.

Law360 (October 18, 2019, 1:51 PM EDT) — California's recent decision to reclassify a large swath of independent contractors as employees for state tax purposes has the potential to greatly increase tax liabilities and compliance burdens for workers and companies alike.

Democratic Gov. Gavin Newsom signed A.B. 5 on Sept. 18 and many of its labor code provisions take effect Jan. 1. The new law reclassifies vast numbers of independent contractors meeting certain criteria as employees and will result in employers suddenly withholding state income and employment taxes for large groups of workers for whom there was previously no obligation to do so.

But the law, which primarily targets gig economy employers, could also create confusion for both employers and workers as an entire class of workers will be treated as employees for state purposes but remain independent contractors for federal tax purposes.

“There are going to be a lot of questions over the next few months,” as employers and employees prepare for the tax year that begins Jan. 1, said Annette Nellen, tax professor and director of the graduate tax program at San Jose State University.

Among those questions, Nellen noted, are whether a California employee is still a contractor for federal tax purposes, whether California should come up with its own version of a W-2 wage and tax reporting form for all these new employees and what the broader effect will be on California's employment numbers and overall fiscal situation.

Nellen wondered whether an employer would agree to take on a contractor with a low number of hours as an employee. She noted the tax gap for gig workers could be lowered if employers do, as improved reporting reduces the amount of tax left unpaid. But there is no guarantee, she said.

“Some employers may just decide, ‘I am going to stay away from California workers,’” Nellen said. Big gig-economy companies, such as ride-hailing companies Uber and Lyft, plainly do not want to make those kinds of decisions. They lobbied intensely against the passage of A.B. 5 and continue to urge lawmakers to make substantial revisions, such as exempting more workers. A.B. 5 already exempts certain workers such as those in insurance and financial services.

There are many reasons companies wouldn't want to convert their contractors to employees. They would have to withhold income taxes and pay the employer's portion of Federal Insurance Contributions Act taxes. Employers would also face having to pay unemployment taxes, reimburse business expenses and provide any number of other benefits traditionally offered to employees, among other considerations.

“I think that's why from an employer standpoint, it's easier to have independent contractors,” said John Hayashi, managing director of tax at BPM. “All you have to pay is the amount you agree to pay your contractor.”

On the employee side, no longer being a contractor may eliminate some hassles, such as having to make quarterly estimated tax payments and pay health insurance premiums. But substantial risks include employers paying less, due to increased tax and benefit responsibilities, or deciding they don't want to keep more expensive workers at all.

Many employers face making those decisions now or risk being out of compliance in the near future. Many employers are likely to take the less desirable but easier route of treating workers as employees for both federal and California purposes, predicted Justin Miller, a tax professional with BNY Mellon Wealth Management.

“It might be easier for the employer to treat them as employees for both federal and state purposes,” Miller said. “Employers don't want to risk liability for failure to withhold for federal income tax purposes.”

Another layer of complexity emerges when contractors work in multiple jurisdictions. Because the ride-hailing companies have been so vocal in their opposition to A.B. 5, Uber and Lyft drivers are most frequently mentioned as contractors who would become employees. But in California, the law may have a significant impact on a completely different industry.

Workers in the movie industry are frequently freelancers, moving to sets and locations where and when they are needed. For a few months, it may be California. Then it may be Nevada. Then it may be Oregon or elsewhere.

If the test for being an employee generally remains as it is, then a worker would be a contractor in other states, but an employee when returning to California. Most companies do not know how to handle that situation, said Brad Marsh, a tax professional at Greenberg Traurig LLP.

“Companies don't have systems to treat people differently in different states,” Marsh said. “The amount of compliance necessary here is underappreciated.”

Marsh and others also noted that California, as the nation's most populous state, often sets the stage for state labor and tax policy. Massachusetts already has a similar law, and New York may be about to follow suit. State Sen. Diane Savino, D-Staten Island, has sponsored a bill similar to California's.

If Massachusetts, California and New York all reclassify workers as employees, employers may decide that they have little choice but to treat all workers as employees for both federal and state tax purposes, said Shail Shah of Reed Smith LLP.

“Having two systems doesn't make a lot of business sense,” Shah said. “I definitely think you are going to see the dominoes fall, even if other states don't implement a bill. Employers may throw their hands up and say, let's go with a uniform approach, even if it may not be the right answer.”