How to Handle a Misclassification Audit

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Any company that utilizes both W-2 employees and 1099 independent contractors must be vigilant in classifying them correctly for tax purposes; as an employer, you are responsible for withholding and remitting employment taxes for the former group, but not the latter.

Failure to properly classify your workers into their correct groups may result in penalties for your company, such as back wages, taxes, and interest due. As a California employer, you may also be subject to the Employment Development Department (EDD) audit — sometimes 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.

If you are facing an EDD audit due to suspected misclassification, here’s what you need to know in order to navigate the audit process.

The Difference Between Independent Contractors and Employees

One significant difference between independent contractors and employees is that contractors are in business for themselves. Contractors typically perform work outside of the scope of a company’s regular business, and they typically work from home or at a third location. Furthermore, while employers may dictate regular work hours and enforce company discipline for their employees, a contractor is not subject to these rules.

Many agencies, including the EDD and the California Department of Labor Standards Enforcement, have their own tests to determine if a worker is a contractor or employee. Generally speaking, the more control a company has over an individual’s work, the more likely that individual is an employee.

What Triggers a Misclassification (EDD) Audit

If you’ve misclassified an employee as a 1099 independent contractor, and that employee files a claim for unemployment, workers’ compensation, or disability, the IRS will take notice — as independent contractors are not eligible for such benefits.

The IRS will also notice if a person receives both a W-2 and a 1099 form in the same year. Although companies can convert a contractor to an employee if they are performing the same type of work, the IRS may question why that person was not classified as an employee for the entire year.

The IRS or Department of Labor may also become aware of misclassification if a worker (or an anonymous tipster) registers a complaint. Typically, these complaints are with regards to social security and Medicare taxes (payroll taxes), for which independent contractors are responsible to pay higher amounts than employees.

The EDD Audit Process

Prior to any EDD audit, an auditor performs an interview to explain the purpose and process of the audit, as well as to gather basic information and answer general questions. During the audit, the auditor will review the employer’s records. An EDD audit spans the 12 most recently completed financial quarters, though an audit can stretch further back if your company hasn’t filed returns.

Commonly audited records include: check registers, bank statements, general ledgers/journals, annual financial statements, ownership verification, tax returns, 1099 forms, payroll records, and employment tax records. An employer may be selected for a complete audit, wherein the auditor will verify the correct reporting of gross and taxable wages and withholding and reporting of income tax.

After the audit is completed, the auditor will inform you that one of four results has occurred: no differences found; an overpayment has been made (credit or refund issued to you); an underpayment has been made (assessment due from you); or both underpayments and overpayments have occurred. The EDD will share any audit information with the IRS.

Fines, Penalties, and Liabilities

The consequences of an underpayment or misclassification will depend on whether the auditor finds the discrepancies to have occurred intentionally or unintentionally.

Unintentional misclassifications may result in a $50 penalty for each W-2 form that was not filed for an employer classified as a contractor. The employer also faces penalties of: 1.5% of employee wages to compensate for income tax withholding, 40% of employee payroll taxes, 100% of matching employer payroll taxes plus interest on each of these penalties, and a Failure to Pay Taxes penalty of 0.5% of the unpaid tax liability for each month delinquent.

Intentional and fraudulent misclassifications may result in additional penalties, such as 20% of all wages paid and 100% of payroll taxes — employer and employee share alike. Criminal penalties, including a $1,000 fine per misclassified worker and up to one year in prison, may also be imposed. California employers can see total fines of up to $25,000 per misclassification violation.

Navigating an Audit

If the EDD finds that you owe an assessment, you have a right to appeal the results of the audit. To move forward with an appeal, you should seek the help of a professional tax attorney who understands the nuances of the appeals process and can represent your best interests. If you don’t feel confident handling your EDD audit alone, reach out to a tax attorney from the beginning — a professional with expertise in tax audits can help you navigate communicating with the EDD and providing the required records, to help the audit go as smoothly as possible.

The foremost prevention technique, of course, is to properly classify your workers in the first place. If you’re unsure of the correct category for some of your workers, the IRS can assist with Form SS-8, which is designed to determine worker classification. Those workers who are not contractors (i.e. all W-2 employees) must have the proper income taxes and payroll taxes withheld and remitted. In the event of an audit, a professional tax attorney is your greatest ally.

If you need help preparing for or navigating an audit from the IRS or state of California, contact our expert team at Milikowsky Tax Law.