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Misclassification rules on franchising and the impact on franchisees

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Legislation that impacts franchises can be an ever-changing landscape. Just as franchising continues to adapt to new markets and ideas, legislation changes in ways that frequently alters how franchises operate.

In 2019, legislators in California discussed a bill concerning employee classification and how to tell the difference between employees and independent contractors. Later that year, legislators passed the bill (AB5), and the governor signed it into law. The legislation took effect in January 2020.

From the time the governor signed the bill until now, lobbyists and other concerned parties raised issues with the content of the rules and how they could impact franchising. Here’s what you should know about AB-5 and the impact that it has on franchising in California.

Overview of employee classification

In many situations, determining what type of employee someone is can be relatively simple and intuitive. As the gig economy has expanded and franchises have continued to flourish, it seemed more employees were misclassified as independent contractors.

Employers have a clear benefit to classifying people as independent contractors because retaining independent contractors comes with less overhead and fewer rules. While employees are entitled to benefits like paid time off and health insurance, independent contractors do not require the same things.

How did the rule change?

Before AB-5, several court cases addressed how employers should classify employees. Since there was some ambiguity about what rules applied and when, employers who could make an argument, either way, tended to classify employees as independent contractors when they could.

The new rule codifies what was was recently decided in Dynamex Operations West, Inc. v. The Superior Court of Los Angeles County, that defined the distinctions between employees and independent contractors. Also called the ABC rule, the new legislations give the following three part test for distinguishing independent contractors from employees:

  • Work is outside the control of the hiring entity both in performance and in fact
  • Hiring entity brings on the worker for tasks outside the typical course of business
  • The work has an independently established trade or occupation consistent with the work being completed for the hiring entity

These factors for deciding who is an employee and who is an independent contractor are intended to clarify roles to avoid future misclassification.

What does the codified rule mean for franchises?

There has been a unique relationship between franchisors and franchisees. The purpose behind investing in a franchise opportunity is for the franchisee to be an independent business owner running the business under the franchisor’s trademark and controls. The franchisee is typically not interested in being an employee of the franchisor.

While the test can be effective in a traditional employment situation where there needs to be a distinction between employees and independent contractors, applying the ABC test to franchises can present challenges. For example, the franchise may prescribe branding and marketing for the franchisee’s location. Still, the franchisee can hire employees and coordinate their schedules. AB-5 would shift the classification of the franchisee to one of a traditional employee.

When it comes time to apply the ABC test to the franchisee/franchisor relationship, the franchisee is likely to be misclassified as an employee. Although the franchisee tends to have more autonomy than a traditional employee, the franchisor still has control over how the franchisee performs their tasks and operates the business. Also, a franchisee does work that is directly related to the business. Finally, the franchisee does not have an independently established trade or occupation; instead, they are working within the confines of the franchise. Therefore, under the ABC test, a franchisee is likely to be considered an employee of the franchisor.

What is the issue for franchisees?

Before AB-5, franchisees were able to have a contractual relationship with franchisors and be considered independent business owners operating under the brand and controls of a franchise system. The new legislation, in many cases, classifies franchisees as employees, adding a long list of other rules that would apply to the franchisee/franchisor relationship, including:

  • Overtime pay
  • Reimbursement of expenses
  • Paid sick time and family leave
  • Employee benefits and discrimination rules
  • Meal and rest breaks
  • Paid time off

These rules often apply to employees that franchisees hire but should not apply to the franchisees themselves.

AB-5 includes some fields of employment where the legislation will not apply, but currently, franchising is not among those listed.

The risks to franchising

When franchisees are classified as employees, it defeats the purpose of franchising since a franchisee is, by definition, an independent business owner operating under someone else’s trademark and business system. As a franchisee, this type of business offers the opportunity to limit some risk while having some of the freedoms of owning your own business.

The franchise relationship tends to be a commercial and contractual one. Although there are times when franchisees have similar duties and obligations as employees, the freedom in the relationship allows both franchisors and franchisees to own and operate a franchise without some of the commitments of traditional employment.

Actions against AB-5

Franchises are an essential part of the American and California economy, so legislation that takes such a broad and impactful stance could cause problems for franchisees and franchisors. Currently, California franchise owners and the International Franchise Association (IFA), have filed a lawsuit to challenge AB-5 stating that “overly broad language” in the legislation will cause problems for franchising in California.

In an effort to take on the matter on multiple fronts, the IFA has also made lobbying efforts to amend the languageto exclude franchises from the legislation that attempts to classify franchisees as employees.

Moving forward

Some of the first changes to the gig economy motivated some businesses to change where they were willing to do business. In franchising, there could be significant impacts to all affected franchises if franchisees must be classified as employees.

The real concern, aside from the impact in California of AB5, is that the ABC test for classification of independent contractors and employees has been included in the Protecting the Right to Organize (PRO) Act and could become federal law.  If this were to happen, without a carve-out for franchising, it could jeopardize the entire franchise community by misclassifying franchisees as employees of their franchisors.