Once you have gotten your files together for each independent contractor or if you have got strong evidence that these people are independent contractors, the next phase is preparing your contractors to be contacted and potentially interviewed by the EDD auditor. You need to be careful here, very careful, because you are walking a fine line. However, best practices in California dictate that you are going to want to try and gather about five people that are your best sources and create a reference sheet for the tax auditor to reach out and contact them. The reaction that you are going to get when from the tax auditor is going to be a mixed bag. Some auditors appreciate the help and some will buck a little because it appears that you might be trying to control how you are running their audit. So, again, you are walking a thin line.
The tax auditor will often ask for contact information and a lot of people do not have it readily available for the payroll tax audit. Say if you show up to the audit and you have five people, you say to the auditor, "Look, hey, I thought you're going to want to talk to our people, so I went ahead and asked a few of them if they would be willing to speak with you. We would be happy to get you more if you would like.”
The auditor is stuck in position here. The auditor’s usual process is to mail out note cards to all of your contractors based on the information that they have on file through the 1099s. Half the time, this scares people away (who freely wants to talk to the government?), so the auditor is forced to call or follow up with them in some other way. This is time consuming and aggravating for the auditor because it takes up a lot of time for them and they are used to striking out.
Five is about the magic number. So, if you can put together information on the five and control which five that they interview, oh, and by the way, these are your five best ones, it's really going to help your case during the course of your audit.
Although the auditor may be naturally on the defensive because you have seemingly curated a list of names for them, it is low hanging fruit for them. They have to perform interviews or at least fully strike out trying to get ahold of people in order to complete their audit report. This is especially true of individuals who are highly compensated independent contractors. So, you might be able to tempt Eve with the apple here.
On the subject of independent contractors. I mentioned that you have to go into the audit meeting with about five references that the auditor is going to interview. It is a very good idea, unless you are rock solid about what these people are going to say, to call them and do preliminary interviews with them. In our firm, we'll have a senior attorney go through and just do kind of a basic interview about their position and what makes them an independent contractor.
Although you want to be careful to not come across like you are trying to influence their testimony to the tax auditor (big, big problem if you get caught doing this), a casual conversation. The interview should flow something like this.
"Hi Contractor, so the reason for my call is that I wanted to give you a heads up that the company is going through a payroll tax audit right now, or they're being questioned by the Employment Development Department regarding some of our independent contractor relationships. This does not have any bearing on you (i.e. don’t freak out).”
Note: You want to stress to the third party in question, the independent contractor, that this is totally routine because you want them to drop their guard. You don't want them guarded when they talk to you. You want them to be candid and honest.
Continuing the conversation….“We don't mean to make you nervous. This isn't going to have any blow back on you, but company is going through a payroll tax audit right now, or they're being questioned by the employment development department regarding some of their employer relationships."
Again, you want to stress to the third party in question, the independent contractor, that this is totally routine because you want them to drop their guard. You don't want them guarded when they talk to you. You want them to be candid and honest.
So, you're trying to facilitate that to have a dialogue, "Company is going through an audit. We just wanted to ask you some questions that probably the auditor is going to ask you, but we wanted to kind of clarify your role further. Would you mind answering some questions for us?" They say, "Yes," "Okay, great….
Can you tell us how you found out about the job?
Can you tell us how many other 1099s you received that year, where you received them from?
Who are some of the other people you work for?
Can you tell me whether or not you have your own business?
Can you tell me what the nature of your work for or with the client is?
How much do you earn per month? How are you paid?
Does it vary on a month to month basis?
These are some our examples from our interview template. Obviously, since you might know these people, the conversation might flow somewhat differently. However, we want to stress that, even if you know the answers to these questions, you want to make sure that the information of the independent contractor is matching your story. Plus, it allows you the opportunity to clarify the answers that they are eventually going to give to the auditor and to subtlety synchronize their story to your narrative.
We want to caution you. By the time the tax auditor is speaking and interviewing your independent contractors, they could have their mind made up about the case and could use the interview to bolster the position that they have already concluded. We have had situations in the past where independent contractors will complain to our client that they felt like the auditor tried to put words into their mouth or was twisting things to get them to tell a narrative that was different.
So these are the reasons that you do these interviews. Takes no more than an hour to conduct four or five independent contractors' interviews. These don't have to be long interviews, they can just be 10 minutes. Get the contractor to open up a little bit about their background. Get them talking and kind of go from there. That's a very good step to take when going through this. Hopefully, you've gone through and done all these steps. If there are any issues that have come up during the steps, then you at least have a reference point and do not walk into any ambushes later on in the California payroll tax audit process.