What Happens If You Misclassified a Worker?

What does the employment classification of workers have to do with payroll tax audits?

Everything.

When the Employment Development Department of the State of California decides to audit, the classification of your workers is the auditor’s sole concern. Additionally, the IRS often adopts the results of the EDD audit to use in assessing federal penalties.

For this reason, it is critical to classify your workers properly and supply only the information the auditor asks for, nothing more.

Quick Overview of Employee vs. Independent Contractor

Previously, we have posted about the difference between employees and independent contractors in the eyes of the IRS and the EDD. Here is a quick reminder.

A very basic definition of an employee is someone for whom you must withhold payroll taxes and comply with employment laws. An independent contractor pays his or her own taxes, and there are fewer employment laws to comply with.

At heart, the determination of whether a worker is an employee or an independent contractor comes down to the issue of control:

• Who controls how the work is done
• Who controls where the work is done
• Who controls the person performing the work

There is an entire list of factors the EDD (and the IRS) use to determine whether or not someone is an employee. No single factor can be used to make the determination.

Causes of Misclassification

The most common problem and the one that can be the most expensive if you have made an error is classifying a worker as an independent contractor when that worker is actually an employee.

Misclassification occurs through ignorance or misapplication of the legal standards. It can also happen if there is a work arrangement that has been in place for years and is never reviewed to make sure the original classification still applies.

Misclassification can also be intentional. Someone in the company fails to follow company policy or directives regarding employment classification or the employer just decides to take the risk in order to avoid paying payroll taxes and save money.

New Guidelines and Changes in Statute of Limitations

Complicating matters is the publication and implementation of new guidelines from the Federal Department of Labor. Issued in July 2015, the DOL broadened the scope of the classification of “employment” used in determining whether a worker is an employee or an independent contractor.

The DOL added a “suffer or permit to work” standard and an economic realities test. The new guidelines may make employees out of most workers. Each employer must make changes accordingly.

Employee misclassification is a high priority target for federal and state tax enforcement, and penalties can be substantial. Employers can see penalties of anywhere from $5,000 to $25,000 per violation. The employer will also receive a one year “scarlet letter” posting.

Recently, the IRS lengthened the time period for the statute of limitations as well.

EDD Audit Triggers

The key to an EDD audit is only to submit relevant documentation, meaning only records about employment related issues. Also, do not volunteer any information beyond what the auditor asks for. Any admission you make can count against you.

An audit is often triggered by a former worker applying for unemployment insurance, which is taken as an assertion that the person was an employee of your company and entitled to unemployment payments.

Instead of conducting a complete examination of the individual claim, the EDD will look into the status of all the independent contractors your company is using.

Audits can also be triggered by filing or paying late, making errors in time records or other statements or documents, or digital failures that cancel or delay payroll.

The Audit Process

An audit begins with a formal notification of audit through postal mail. The auditor will send a list of requested documentation and a pre-audit questionnaire.

A minimum documentation request includes:

• Verification of business ownership
• Check registers and stubs
• Bank statements and canceled checks
• General ledger and journal
• Annual financial statements
• Vouchers and pay-out slips
• Forms 1099

The pre-audit questionnaire is designed to elicit admissions and give the auditor enough information to develop an audit plan. You must carefully plan your responses to avoid problems later. If you have not yet consulted a skilled tax attorney, this would be a good time to do so. A tax attorney can help you minimize admissions that could cause problems down the road.

An audit typically covers a three-year period unless circumstances arise that cause the auditor to go back further.

When it comes to employment classification, the auditor has the discretion to define and apply a list of factors to determine whether a worker is an employee or an independent contractor, which brings us around to the relationship between employment classification and payroll tax audits.

The EDD auditors always assess the factors, used to determine employment classification (which are highly subjective) in their favor; therefore, it is more difficult to convince them that a contractor is not an employee.

One more thing, a worker can be an independent contractor according to the IRS and yet be an employee in the eyes of the EDD.

Potential Audit Results and Penalties

An audit can result in one of four outcomes:

• No change, meaning no differences were found
• Overpayment, in which a refund or credit is issued
• Underpayment, meaning the difference will be assessed and charged to you
• Both underpayment and overpayment

Demand for payment of penalties, interest, and back taxes within 30 days is usually made. If you cannot pay this in full within the time allotted, a 10% penalty will be added. Penalties often drive EDD audits because the penalties can exceed the taxes owed in certain conditions.

As you can see, an adverse audit decision can cause substantial payroll tax liabilities for your business. To add to the issue, the IRS generally adopts the conclusion of the EDD auditor and assesses federal payroll taxes, interest, and penalties. Filing for bankruptcy will not resolve the problem with the EDD.

You may not avoid all audits, but you can greatly minimize the chances of a payroll tax audit by the Employment Development Department by classifying all your workers correctly, especially those you treat as independent contractors. If you are unsure how to apply the legal statutes and factors, or if you receive notification of an audit, contact a tax attorney experienced in California payroll tax law to help you do the right thing and to protect your rights as an employer.