The Employment Development Department in California has been particularly aggressive in the area of independent contractor reclassification audits. In the eyes of the Employment Development Department, California businesses have been abusing the system by treating workers who should be classified as employees as independent contractors. In doing so they shift the burden for payroll taxes onto the worker and avoid their own contributions to the payroll tax and unemployment insurance system. As a result, the Employment Development Department has been particularly vigilant in auditing businesses for perceived abused of the system. Often these independent contractor reclassification audits can be costly for businesses.
As a tax attorney, I have seen independent contractor reclassification audits can be triggered by any number of actions, be it a 3rd party report, a random sweep (the Employment Development Department in connection with other state agencies is known for performing surprise inspections), or through perceived underreporting of payroll tax. However, usually these audits are triggered when an “independent contractor” filing for benefits generally owed to employees and lists their former employer on the benefit form. This includes unemployment benefits. In addition, the Employment Development Department targets businesses with a high likelihood of workers being left off the payroll or those that may pay employees in cash. These include construction businesses, retail stores, bars/restaurants, businesses that utilize seasonal employees, or those that are likely to pay employees in cash.
Employment Development Department independent contractor reclassification audits are potentially costly for businesses. The reclassification of a worker leads to the assessment of all past due payroll taxes owed by the business, plus interest and any applicable penalties. In addition, if a worker from a certain class of employees is reclassified, the Employment Development Department will likely move to reclassify the entire class of employees as independent contractors. This can equate to tens or hundreds of thousands of dollars in potential liability. As a result, Employment Development Department independent contractor reclassification audits are quite a lucrative source of revenue for the state of California.
Many businesses make serious mistakes during an independent contractor reclassification audits. First, they assume that having an independent contractor agreement will protect them in the audit. This categorically false. Having a independent contractor agreement can be a positive, especially when defending your business against the claims of the Employment Development Department, but is by no means dispositive. Independent contractor audits hinge on a multi-factor test that was adopted from the same test that the IRS uses for its independent contractor reclassification audits. As with the IRS, just because there is an agreement in place between two parties does not mean that the Employment Development Department needs to honor that agreement.
If you are selected for audit, I highly recommend that you seek the advice of a payroll tax attorney. The stakes are often simply too great to attempt representation by yourself. Employment Development lawyers and auditors are experts at making arguments toward employee classification and you need often need an experienced lawyer to handle the matter.