How to Handle a Misclassification Audit
Any business that employs both W-2 workers and 1099 independent contractors must be precise in classifying those workers correctly. As an employer, you are responsible for withholding and remitting employment taxes for W-2 employees but not for independent contractors.
Incorrect classification, whether intentional or not, can result in substantial liabilities, including back taxes, penalties, and interest. In California, employers may also face an Employment Development Department (EDD) audit, commonly referred to as a misclassification audit. According to the Department of Labor, between 10–30% of audited employers are found to have misclassified their employees.
This article explains the difference between contractors and employees, what triggers an EDD audit, how the audit process works, and what penalties businesses may face.
Independent Contractors vs. Employees
The primary distinction between an independent contractor and an employee lies in control and independence.
- Employees are subject to company rules regarding work hours, methods, and discipline. Employers must withhold income taxes, Social Security, and Medicare contributions.
- Independent contractors are in business for themselves. They typically work outside of a company’s core operations, often from their own location, and are not subject to company discipline or schedules.
The EDD, California Department of Labor Standards Enforcement, and the IRS each have their own classification tests. In general, the greater the control an employer has over how work is performed, the more likely the worker is an employee.
What Triggers an EDD Misclassification Audit
An EDD audit may be triggered in several ways:
- Unemployment or benefits claims: If a misclassified worker files for unemployment, disability, or workers’ compensation, EDD will take notice because independent contractors are not eligible for these benefits.
- Dual reporting: If an individual receives both a W-2 and a 1099 from the same company in a single year, EDD or the IRS may question the classification.
- Complaints: A worker, or even a third party, may file a complaint regarding payroll taxes or benefits eligibility.
- Random audits: EDD also conducts random audits to ensure compliance. Even businesses confident in their practices can be selected.
Preparing for an Audit
Audits begin when EDD mails a notification of audit. This notice includes:
- The purpose of the audit
- A list of required records and documents
- A questionnaire about your business and workers
Employers should begin collecting the requested information immediately. Commonly reviewed records include:
- Payroll records and tax filings
- Bank statements, ledgers, and journals
- 1099 forms and W-2s
- Financial statements and ownership records
EDD auditors typically review the prior three years of payroll tax records, though this period may be extended if necessary.
At the outset, auditors often conduct an interview to understand your business operations and employment practices. During the audit, provide the requested information, no more and no less. Offering incomplete information may delay the process, while providing unnecessary details may raise additional questions.
The EDD Audit Process
The audit generally covers the twelve most recently completed quarters but can expand further if returns were not filed. The auditor’s role is to verify whether workers are properly classified and whether payroll taxes were correctly reported and paid.
After reviewing your records, the auditor will issue one of four determinations:
- No differences foun
- Overpayment (credit or refund issued)
- Underpayment (assessment owed)
- Both underpayments and overpayments identified
EDD shares its audit findings with the IRS, so liabilities can extend beyond the state level.
Penalties for Misclassification
The consequences of misclassification depend on whether the conduct is determined to be unintentional or intentional.
Unintentional Misclassification
- $50 for each W-2 not filed for a misclassified worker
- 1.5% of wages for income tax withholding
- 40% of employee payroll taxes
- 100% of employer payroll taxes
- Interest and a Failure to Pay penalty of 0.5% of the unpaid tax liability per month
Intentional or Fraudulent Misclassification
- 20% of wages paid
- 100% of both employer and employee payroll taxes
- Criminal penalties, including up to $1,000 per misclassified worker and up to one year in prison
- In California, fines of up to $25,000 per violation
Navigating an Audit
If EDD determines that you owe an assessment, you have the right to appeal. An experienced tax attorney can guide you through the appeals process, represent your business, and ensure your interests are protected.
The best strategy, however, is prevention. Ensure your workers are correctly classified. If you are uncertain, the IRS provides Form SS-8 to assist in determining worker status.
1099 Worker Misclassifications Can Be Costly
Worker classification is a critical compliance responsibility. Missteps can lead to costly penalties, extended audits, and reputational damage. If you receive notice of an EDD audit, or if you want to confirm that your classifications are correct, seek professional legal guidance.
At Milikowsky Tax Law, we represent California businesses through EDD and IRS audits with the goal of achieving the most favorable outcome possible. Our team understands the complexities of worker classification and audit procedures, and we advocate for your business at every step.
If you need support preparing for or navigating an EDD audit, contact Milikowsky Tax Law.
