Rightly or wrongly, some independent contractors in California are being told by clients that if they want to keep getting work, they must form a corporation or LLC, short for limited liability company.
The reason given is AB5, the state’s ludicrously complex worker-classification law, which took effect Jan. 1. The law requires hiring entities to treat every California worker as an employee — not an independent contractor — unless the worker meets three requirements, known as the ABC test, or qualifies for one of numerous exemptions. Workers who qualify for an exemption must still must be treated as employees unless they pass an older, multifactor test known as Borello, which is less strict.
“Nothing in the law says you have to form an LLC” or corporation to be treated as an independent contractor, said Stephen Fishman, a lawyer and author of Nolo’s “Working for Yourself.” It could help with the “C” part of the ABC test, which requires the worker to be “engaged in an independently established trade, occupation, or business.” But “it’s not a cure-all, not a panacea.”
It’s not clear why some firms are requiring California contractors to form LLCs and corporations. “I think it’s overly conservative, but they are worried about the repercussions and want more things to point to,” said Oakland attorney Ramey Barnett. “Or they could be confused.”
To pass the ABC test, an independent contractor must be: (A) free from control and direction of the hiring firm, (B) performing work outside the hiring entity’s usual business, and (C) engaged in an independent business.
The law exempts some professions from the ABC test, but they must still pass the Borello test to be classified as independent contractors. These include doctors, dentists, lawyers, accountants, engineers, architects, real estate agents, fishermen and a few others.
There are other exemptions for other categories of workers, but they must pass Borello and satisfy a list of other factors, which varies by type of business.
One exemption is for people who provide 11 types of “professional services,” such as travel agents, graphic designers, grant writers, fine artists and enrolled agents. This category also includes freelance writers, editors, newspaper cartoonists and photographers who provide no more than 35 “submissions” a year to that client. No other profession has such a limit. Lorena Gonzalez, who authored AB5, proposed abolishing that cap Thursday after a lawsuit challenged it.
A wide range of independent contractors could qualify for what’s known as the business-to-business exemption. It exempts “bona fide” businesses — including sole proprietorships — that provide a service directly to the hiring firm, not its clients, as long as they meet 11 other requirements and pass the Borello test. An example would be a developer who builds a website for a law firm, not the law firm’s clients, said Oakland attorney Heather Conger.
None of these exemptions, nor the ABC test itself, require the independent contractor to be a corporation or an LLC, although most require a business license.
Having an LLC “doesn’t make you an independent contractor. You still have to fall under an exemption or meet the ABC test,” Conger said.
Independent contractors can do many things, short of forming an LLC, to establish themselves as a bona fide business.
• At a minimum, you should have a business license in the city or unincorporated county where you operate.
• Adopt a name other than your own for your business and file for a fictitious business name in your county.
• Open a business checking account and a separate credit card for your business and keep all transactions separate from your personal expenses.
• Consider getting an employer identification number from the Internal Revenue Service and use it — instead of your Social Security number — along with your business name when you sign contracts. Sole proprietors and single-member LLCs with no employees are not required to get one, but it’s free and could help protect you from identity theft, Fishman said. (Most other businesses must have one.)
• Have a separate office or business location.
• Set up a business website, advertise and have multiple clients.
If a client still requires you to form a corporation or LLC, you may have no choice if you want to keep that client.
For a business with one owner who has been operating as a sole proprietor, forming a single-member LLC is usually the simplest route.
You must pick a business name that’s not already in use, file Form LLC-1 (Articles of Organization) with the California secretary of state’s office and pay a $70 fee. Within 90 days of registration, and every two years thereafter, file Form LLC-12 (Statement of Information) and pay $20.
The main drawback of forming an LLC in California is that you will owe an $800 state tax every year until you dissolve it. This fee is paid annually to the Franchise Tax Board with Form FTB 3522.
Gov. Gavin Newsom’s 2020-21 budget proposed waiving the $800 annual tax paid by LLCs, limited partnerships and limited liability partnerships during their first year, but this has not been approved yet.
If your gross revenue exceeds $250,000 a year, you will also owe an annual fee that starts at $900 for gross revenue from $250,000 to $500,000 and goes up from there. This fee is paid with Form FTB 3536.
The $800 tax is deductible as a business expense for federal but not California income taxes. The gross receipts fee that starts at $900 is tax deductible for both, said San Francisco CPA Richard Pon.
An LLC will provide some liability protection, but “it’s not nearly as great as most people think,” Fishman said.
If your LLC signs a contract — such as a loan or lease — and later defaults on it, the other party can only pursue your business assets, not your personal assets, for the unpaid amount, as long as you didn’t personally secure it. However, most companies won’t lend money or rent to a small business unless the owner co-signs. That lets them go after the owner’s personal assets if the business fails.
If you have employees, the LLC will generally limit your personal liability for anything your employees do, such as killing someone while driving a company car, Fishman said.
However, it won’t protect your personal assets from claims arising from personal injury, libel or malpractice caused by you, the owner, Barnett said.
An LLC may not provide any protection at all “if you used the entity to defraud someone, or if the entity was a sham, or if it was undercapitalized,” said Chas Rampenthal, general counsel for LegalZoom. That’s why it’s important to do everything by the book and keep your business and personal finances separate.
The best way to protect your assets is by purchasing business insurance. This could include general liability insurance, which covers claims arising from accidental bodily injury or property damage caused by you or an employee, said Geoff Herman, vice president of commercial with Riskguard Insurance Solutions Inc.
A service business may also need professional liability insurance, which covers claims arising from mistakes you or your employees make. For doctors, it’s called malpractice insurance. For writers, lawyers, accountants and such, it’s called an errors and omissions policy.
Your homeowners insurance will not cover business claims, although some companies may offer an endorsement “on a home-based office, for certain uses,” Herman said.
You don’t need to be an LLC or corporation to buy business insurance, he added.
Bear in mind that an LLC is a legal entity, not a tax entity. For income tax purposes, a single-member LLC will be treated as a sole proprietorship, unless it opts to be taxed as a corporation. Its income and expenses are reported on Schedule C, attached to the owner’s Form 1040, and profits are taxed at the owner’s individual rate.
If the single-member LLC opts to be treated as a corporation, different tax rules apply. There are some tax advantages to forming an S corporation, but it’s more complicated and costly. The tax savings may not outweigh the added costs, especially if your income is coming almost entirely from services you provide yourself, said Nathan Rigney, lead tax research analyst with H&R Block.