California's AB5 law has been in effect for several years now, but its impact on contractors and construction businesses continues to generate confusion — and expensive mistakes. Combine that with the IRS and FTB's ongoing focus on 1099 compliance, and it's clear that worker classification isn't something you can afford to get wrong in 2026.
Whether you're a general contractor running a crew, a specialty subcontractor, or a solo operator who hires help on a per-project basis, this guide covers what you need to know to stay compliant and avoid penalties.
Why AB5 Matters for Contractors
Assembly Bill 5, which took effect January 1, 2020, established a new legal standard for determining whether a worker is an employee or an independent contractor in California. The law created a presumption that workers are employees — and put the burden on the hiring business to prove otherwise using a strict three-part test.
For the construction industry, AB5's implications are significant. Many contractors have long relied on a flexible workforce of subcontractors and day laborers paid as 1099 workers. That model isn't inherently illegal — but it requires meeting a higher bar than most business owners realize.
Important: Misclassifying an employee as an independent contractor exposes you to back payroll taxes, interest, penalties, workers' compensation liability, and potential lawsuits from affected workers. The EDD and FTB actively audit contractors for this.
The ABC Test: California's Three-Part Standard
Under AB5, a worker is presumed to be an employee unless the hiring business can satisfy all three prongs of the ABC test:
The ABC Test for Independent Contractor Status
Free from Control
The worker is free from the control and direction of the hiring entity in the performance of the work, both under contract and in fact. You cannot dictate when, where, or how they work.
Outside the Usual Course of Business
The worker performs work that is outside the usual course of the hiring entity's business. This is the hardest prong for contractors. If you're a licensed general contractor hiring a framer, the framing is arguably within your usual course of business.
Independently Established Business
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. They should have their own contractor's license, insurance, clients, and business presence.
The B Prong Problem for General Contractors
The "B" prong is where most general contractors run into trouble. Courts have interpreted it strictly: if the work being performed is the same type of work your company does, the worker is likely an employee, not a subcontractor. This doesn't mean you can never use subcontractors — but they need to be licensed, insured, and operating as genuinely independent businesses.
A subcontractor who works exclusively for you, doesn't carry their own workers' comp, and uses your tools and equipment is going to look a lot like a misclassified employee to an EDD auditor.
1099 Filing: What You're Required to Do
For workers who do qualify as independent contractors, federal and California law require you to issue 1099-NEC forms for any individual or unincorporated entity paid $600 or more during the calendar year. Here's the compliance checklist:
1099 Compliance Checklist
California's DE 542: The Form Most Contractors Miss
Most out-of-state resources don't mention California's DE 542 form — but the EDD takes it seriously. Any business that pays an independent contractor $600 or more must report that contractor to the EDD within 20 days of signing a contract with them or making the first payment, whichever is earlier.
The DE 542 was designed to help California track workers who owe child support. Failing to file it can result in a $24 penalty per contractor — which sounds minor until you've hired 50 subs over the course of a year.
Penalties for Non-Compliance
| Violation | Penalty Range |
|---|---|
| Failure to file 1099-NEC on time (IRS) | $60–$660 per form, depending on how late |
| Intentional failure to file 1099 (IRS) | $660 per form, no cap |
| Failure to file DE 542 with EDD | $24 per contractor per occurrence |
| Employee misclassification (EDD audit) | Back taxes + 10% penalty + interest + potential workers' comp liability |
| Failure to withhold (if worker should have been an employee) | Full amount of tax that should have been withheld + penalties |
Subcontractor Best Practices
If you work with subcontractors, protect yourself by maintaining documentation that demonstrates legitimate independent contractor relationships:
- Require a copy of their California contractor's license and verify it's current on the CSLB website
- Require proof of general liability insurance and workers' compensation coverage (or a legitimate exemption)
- Use written subcontractor agreements that specify scope, timeline, and payment — and avoid language that implies control over how the work is done
- Ensure they work for other clients, not just you
- Do not provide tools, equipment, or training that employees would receive
- Pay them by project or milestone, not by the hour
What to Do If You've Been Misclassifying Workers
If you suspect you've been classifying workers incorrectly, the worst thing you can do is nothing. The IRS offers a Voluntary Classification Settlement Program (VCSP) that allows businesses to voluntarily reclassify workers and pay a reduced amount of employment taxes — avoiding the full penalties of an audit-triggered reclassification.
The program isn't right for everyone, and it has its own requirements and tradeoffs. But it's worth evaluating before the EDD finds you first.
Working with a CPA on Contractor Compliance
AB5 compliance and 1099 filing aren't just accounting issues — they sit at the intersection of tax law, employment law, and California-specific regulation. At Aberny CPA, we work with contractors across the Inland Empire, Los Angeles County, and beyond to build compliance systems that protect them from audit exposure and keep their crews running efficiently.
If you're not confident your worker classification practices will hold up to scrutiny, let's talk before you're forced to have that conversation with the EDD.
Not Sure If Your Workers Are Properly Classified?
An ounce of prevention here is worth a lot more than an audit defense. Schedule a free consultation and we'll review your current setup.
Book a Free Consultation →