The California Employment Development Department (EDD) conducts audits to determine if businesses are:
- Correctly classifying their contractors and employees, and
- Paying the full taxes due under California law
It’s important to note that EDD is actively targeting independent contractor misclassification, which could result in a six-figure penalty per employee for business owners.
Let’s discuss independent contractor classification as well as review some common misconceptions about 1099 workers that can lead to misclassification. Additionally, we’ll cover what to do in the event of an EDD audit.
What is an Independent Contractor?
A 1099 independent contractor is a worker who provides skills and services outside of the hiring business’s usual services. They maintain control of their work and performance, such as:
- Setting their rates
- Working with multiple clients
- Choosing when and where they work
- Providing their own resources (i.e. tools)
Examples of independent contractors might include electricians, plumbers, carpenters, bricklayers, painters, hair stylists, wedding planners, auto mechanics, florists, and more.
Further, business owners should familiarize themselves with AB-5 law to correctly classify independent contractors and W-2 employees.
What is AB-5 Law?
Assembly Bill 5, commonly referred to as AB-5, is legislation that extends employee classification status to some independent contractors. AB-5 requires that hiring entities reclassify these workers as employees based on the strict criteria outlined in the ABC test.
What is the ABC Test?
The ABC test is a set of requirements a worker must meet to be classified as a 1099 independent contractor instead of a W-2 employee.
The worker must meet all three criteria of the ABC test to be correctly classified as an independent contractor:
- The worker is free from the control and direction of the hiring entity in connection to the performance of the work.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
If the employee fails to meet any of the criteria in the ABC test, they are automatically classified as a W-2 employee instead.
Read our Ultimate Guide to Assembly Bill 5 (AB-5) for more information.
Common Misconceptions About Independent Contractors
Misconceptions about independent contractors are common, especially with the addition of the stricter guidelines of AB-5 Law and the ABC test.
Below are some of the most common misconceptions:
- Hiring workers as independent contractors are less expensive than hiring them as employees.
- If the worker performs similar work for other businesses, they are an independent contractor.
- You can hire a worker as an independent contractor on a trial basis before hiring them as a W-2 employee.
- Your company can sign a written contract to make the worker an independent contractor.
- Your worker has a license so they must be an independent contractor.
Business owners should understand why these misconceptions are inaccurate to correctly classify independent contractors and avoid penalties following an EDD audit.
Read on to learn more about these independent contractor misconceptions.
Which Industries Are More Likely to Misclassify Employees?
According to EDD, industries that run a higher risk of misclassifying workers include:
- Healthcare, and
- Seasonal Industries
Business owners in these industries should be aware of the risks associated with employee misclassification and take the time to fully understand AB-5.
How Do Business Owners Correctly Classify Independent Contractors?
Business owners can avoid employee misclassification by reviewing the arrangement they have with the worker concerning the guidelines described in the ABC test and AB-5 law.
What Happens During an EDD Audit?
The EDD conducts tax audits to determine if business owners are meeting their state tax obligations. Typically, they cover the 12 most-recent calendar quarters. Audits, however, may extend further if necessary.
EDD will examine the relationship between the employer and their 1099 worker to determine if the worker is correctly classified.
EDD will ask questions such as:
- Does the independent contractor have their own business?
- How does the independent contractor provide services for your company?
- How much control does the contractor have over providing these services?
As previously discussed, several factors weigh into employee classification. Employers can turn to the ABC test to ensure they are complying with AB-5.
What To Do If You’re Under EDD Investigation
Here are some steps to take if you find out your business is being audited by EDD.
Understand the Type of Audit
Don’t panic – some forms of audits occur with no assumption of wrongdoing or are triggered by random sweeps. The first step you should take when your business is under EDD investigation is to determine the form of the audit.
Verification audits are not based on an assumption of wrongdoing but are random checks based on factors such as:
- Business size
- Size of payroll, or
- Other factors determined by EDD
Request audits are based upon evidence collected by California EDD from former employees or people closely associated with your business.
Organize Your Information
Whether you are undergoing a verification audit or request audit, you will need to have specific information prepared for EDD.
Prepare for an audit by organizing the following documents:
- Cash payment records
- Verification of ownership
- Any applicable licenses or written agreements
- Federal and state tax returns
- Any 1099 forms
- General ledger
- Bank statements for the past three years
- Check registers
- Any check stubs or canceled checks
- Annual financial statements (i.e. balance sheets and expense statements)
To verify payroll, you will also need to prepare payroll records, as well as federal and state tax reports, inclusive of quarterly tax reports, unemployment insurance withholding, and employee withholding.
Read on for a full list of forms you need to prepare for an audit.
Consider Milikowsky Tax Law
Once you are aware your business is being investigated, it’s important to contact a qualified tax attorney to represent you.
At Milikowsky Tax Law, our tax attorneys are former business owners and managers, which gives us incredible insight and experience to understand your business from the inside out and provide relentless, effective representation in all tax matters.
All employers in California have certain state tax requirements on top of their federal tax obligations.
Read on to understand your EDD obligations as a California employer or to learn more about California EDD audits.