Once you have your files together for each independent contractor or if you have 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 should gather about five people that are your best sources for 1099 information and create a reference sheet for the tax auditor to reach out and contact them.
The reaction that you are going to get from the tax auditor will 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.
Helping the EDD auditor is good for business
The EDD tax auditor will often ask for contact information and a lot of people do not have it readily available for a payroll tax audit. If you show up to the audit and you have five people, you can say, "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 contacts if you would like.”
The auditor is stuck in position here. The usual process is for them 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 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 the magic number. Put together information on the five you choose. This way you know which five will be interviewed. Make sure these are your five best contractors as it will really help your case during the course of your audit.
Although the auditor may be on the defensive because you have seemingly curated a list of names for them, it more often becomes low hanging fruit. 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. The analogy is tempting Eve with an apple here.
Independent contractor preliminary interviews
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. Unless you are rock solid about what these people are going to say, it's a good idea to call them and do preliminary interviews.
In our firm, we'll have a senior attorney do a basic interview about their employee's role 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 — this could become really big problem if you are caught doing this — make it a casual conversation. The interview should flow something like this.
"Hi Contractor. 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, and we'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.”
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 the 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 reticent when they talk to you. You want them to be candid and honest.
You're trying to facilitate that to have a dialogue.
"The company is going through an audit. We just wanted to ask you some questions that the auditor is likely to ask you, but we wanted to clarify your role further. Would you mind answering some questions for us?" They say, "Yes." You say, "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 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. It usually 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 come up, at least you'll have a reference point and will not walk into any ambushes later on in the payroll tax audit process.
If you are going through or have gotten notice that you're about to go through a California payroll tax audit, it's smart idea to get professional tax counsel. Setting up a consultation with Brotman Law is easy to do and could save you hours of anxiety, sleeplessness and frustration, not to mention a lot of money. Give us a call at 619-378-3138 today.