Business owners hire independent contractors to help with specialized or contracted work. But, as a business owner, if you find yourself engaging in what may be considered an ‘employer-employee relationship’ with your independent contractor hires, you may be contacted by the Employment Development Department (EDD) and/or the Internal Revenue Service (IRS) for a potential misclassification audit.
Misclassification is one of the reasons EDD may conduct an audit of your business. These audits might result in:
- Back taxes owed
- Potential criminal liability.
How Do You Know if You Should Hire Someone as a W-2 Worker or a 1099 Independent Contractor?
Choosing to hire a worker as either a W-2 worker or a 1099 independent contractor requires knowing the criteria for classification and how the worker’s services dovetail with your current company offerings. When you consider the correct worker classification, consider who holds the right of control. The right of control looks at these three criteria to aid in determining classification:
- Behavioral Control: Are you in charge of the manner in which workers perform their duties?
- Financial Control: Do you pay regular wages and have the ability to fire the employee?
- Relationship to business: Is the employee an essential part of helping your business run?
A W-2 worker is someone hired for a specific job, is given set work hours, receives benefits, works for one specific employer, and has taxes deducted from payroll.
1099 independent contractors, on the other hand, are hired on a contractual basis for a specific task, are paid a set fee, do not receive benefits, do not have taxes deducted from payroll, and have more work flexibility overall. 1099 independent contractors can work for multiple employers simultaneously.
For example, an administrative assistant hired as a W-2 would show up during regular set work hours and complete set tasks for the job in their scope of work. They receive benefits, are taxed on payroll, and report to a higher authority.
An administrative assistant hired as a 1099 would have his or her own business entity, set their own scope of work, invoice the company for work performed, and would work for other employers simultaneously. Once the scope of work is completed, they no longer work for the company.
Before hiring someone as a W-2 or a 1099, make sure they fit the new strict Assembly Bill 5 (AB-5) classification requirements to avoid triggering a government audit of your business.
What is AB-5?
AB-5 is a California law put into effect January 1, 2020 that changed previous worker classifications. Before AB-5, EDD classified employees through the Borello test. This test had looser, less clear requirements for classification. Now, the agency set forth clearer rules and regulations, called the ABC test, regarding classification between W-2s and 1099s.
What Are the ABCs of Contractor Classification?
The ABC test under California’s AB-5 regulation explains that all workers are considered W-2 employees who receive benefits and payroll taxes unless all three of the following criteria are met:
- “The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.”
Why Does the Government Care about Correct Worker Classification?
When workers are misclassified, the government does not receive the correct payroll taxes. Incorrectly classifying W-2 employees as 1099 independent contractors also strips the worker of benefits they would receive as W-2 employees.
Companies who incorrectly classify employees as contractors save money in workers’ compensation, payroll taxes, paid time off, benefits, and retirement accounts. Because of these savings, they may be able to undercut the competition at the sacrifice of their workers.
Businesses who adhere to the W-2 classification criteria might report other companies for this kind of misclassification because it creates an unfair playing field for businesses who adhere to regulations.
Not every business that uses 1099 contractors is predatory or wrong in their classification. Many businesses use 1099 contractors correctly. When working with independent contractors, there are a few pitfalls to be aware of so you don’t accidentally treat your independent contractors like your employees.
Common Mistakes When Working with Independent Contractors
Here are a few behavior scenarios that could lead to potential issues when working with independent contractors:
1. Not Renewing Scope of Work
Contractors are normally hired to work on a per-job or project basis. They submit a Scope of Work with clear Key Performance Indicators (KPIs) and report on the hiring entity’s Return on Investment (ROI).
Even if the relationship lasts years, the 1099 worker or outsourced company will invoice the business using their services and maintain a contract and billing records. 1099s also have tax records to show that they pay their own income taxes on the money paid to them by the hiring entity.
2. Dictating the Use of Equipment or Software
Contractors determine the tools and equipment to use for their job. A contractor who provides a service that requires the use of your internal software is not automatically a W-2. It is important to be clear in the proposal that they will provide their own schedule, deliverables and likely will use other software to service other clients.
3. Setting a Schedule for Contractors
While contractors can be required to be on calls at set times, you cannot suggest or direct when a contractor takes breaks or even what time of day they need to start work.
By establishing a schedule for your contractor outside of assignment deadlines and scheduled agreed-upon calls, you could be seen as engaging in an employer-employee relationship.
4. Making Contractors Work in the Office
If contractors are working in your offices or place of business, this may cause some labeling issues when determining if they are a contractor or an employee. If a contractor is working out of an office alongside full-time or part-time employees, they might be confused or misclassified as an employee, especially if they are working similar hours and performing similar tasks.
5. Paying Wages and Expenses Incorrectly
Salary or hourly wages are reflective of employee behavior. To avoid any confusion, it’s best practice to pay contractors by project or retainer. Contractors pay for their own resources and supplies. While they may work in your CRM (in the case of an outsourced marketing agency), they will have their own project management software to manage their internal workflows.)
6. Requiring the Contractor to Only Work with Your Business
Unlike W-2 employees, independent contractors have the flexibility to work with multiple employers at once. At any given time, they may choose to only take on your business alone, but this is at their discretion. If they choose to work with seven different businesses at once, they have the right to do so.
By asking them to sign a non-compete agreement, you treat them as an employee rather than a contractor. This means they must receive the benefits that employees receive. Instead, your business can communicate with the independent contractor about a confidentiality agreement to keep your business’s information secure.
7. Not Verifying Contractor Status
In order for an independent contractor to be properly licensed and classified, they should have the following criteria:
- Verified website or social media accounts
- Client base
- EIN number
- Business license
If they are missing any criteria, the best practice is to communicate with the contractor so they can provide any missing information.
What Triggers EDD Audits?
Although the government agency performs random misclassification audits of businesses, they do audit businesses when they are flagged. Triggering an EDD audit can come in many forms, but they all have the same outcome – an audit of your business.
Be aware of the top four EDD audit triggers to help your business steer clear of an audit. Remember there isn’t a foolproof plan to avoid an audit, but staying away from the common triggers can help set your business up for success.
- Having an independent contractor who files for unemployment
- Employee complaints
- Filing your business taxes late
- Randomized verification audits
Read on for more about why each instance triggers an audit and how you can prepare.
The Employment Development Department is meticulous with the audit process and takes misclassifications seriously. Misclassifying even one worker can trigger an EDD audit of your business. These audits are serious and can result in fines and penalties of thousands, if not hundreds of thousands of dollars.
If your business is undergoing an EDD audit, learn more about what to expect in an EDD audit here.