You may be familiar with or have heard of a twelve-factor test or a three-factor test or a lot of different tests that the EDD supposedly uses to classify independent contractors. Through my years of professional experience and time spent in a lot of California payroll tax audits, I will just tell you that a lot of this stuff is bogus. Audits of independent contractors essentially come down to two things: revenue generation and control.
Question One: is the person involved with the businesses at 1099 essential to the revenue generation activities of the business? If you employ somebody as a 1099 independent contractor, is what they're doing directly generating revenue for you? If they are associated with the revenue-generating activities of the business, then the California payroll tax auditor is probably going to try and classify them as an employee. For example, we can look to the famous Uber case in California. You have all of these Uber drivers that are driving around and that are integral to Uber’s ability to generate revenue. Therefore, California comes in and views them a W2 employee versus 1099 independent contractor.
Question Two: What is the nature of the control that the employer has over the 1099 worker and the level of independence that the 1099 worker has? In a California payroll tax audit, you will need to establish workers as independent businesses. Evidence of a business license, evidence of business card, evidence of a website, or other marketing materials that are going to establish that the worker is marketing their services out independently. Independence speaks to lack of control and lack of control speaks to them being an independent contractor.
The California payroll tax auditor is going to look at the relationship between the worker and the employer in detail. The auditor will look to see how much dominance the employer has, whether the negotiating platform is equal or whether it is tilted towards the employer. You must keep in mind that the independent contractor rules are put into place in order to, it protect employees who are being classified, or misclassified as 1099 workers to avoid payroll taxes. If there is a level of control that the employer has over the worker, then they're also going to be classified as a W2 employee versus a 1099 contractor. Knowing all this going in, you can start to build your case. Here is essentially how we build an argument in a California payroll tax audit.
First, you want to take all of your 1099 workers in the business, you want to put them into buckets based on their job category, and determine which buckets that the EDD is most likely to come after. Second, you want to offer up testimony and/or provide contact information for your best fact pattern within the bucket. We usually take our workers, we usually put them into buckets and then we give them five stars, four stars, three stars. Anything below three stars, we do not want any contact with the auditor.
Thus, if you start having people that you feel less than confident about in a bucket, you may just want to go ahead and concede the bucket which will give you some credibility at the audit level. The EDD is going to be looking at each job category and they are going to try and make a determination in the job category rather than by individual worker. The more you bolster you case for each job category and the more job categories look independent, the more success you are going to have in your California payroll tax audit. You want to figure out what your best facts are and you are going to try and present those facts and minimize your bad facts. Presenting your arguments in terms of the two-factor test that we just discussed is going to maximize your success in the audit.