Chapter 11

What Happens During a California Independent Contractor Audit?

Establishing a Pattern or Routine of Worker Misclassification

Understand that the EDD auditor is looking to make a worker misclassification determination  and that the auditor’s first goal in an independent contractor audit is establishing a system and a pattern of routine for the business’s operations. For example, if we have a retail store and the retail store has two locations, in each location, we have anywhere between five and seven employees at a time.

The EDD auditor will use that information to develop a pattern within the business on who the key members of the business are. Essentially, who are the key members of the business and what services do those individuals perform.

The auditor here is establishing a pattern of who the business’s workers are who function as employees. The reason for the auditor doing that obviously is to compare the employees to any independent contractors that the business may have. The EDD wants to look at the key functions that each employee performs.

The EDD auditor is going to take those functions and then compare and contrast those functions to those performed by independent contractors. They are going to see if there are similarities between the two and, if so, you could be in for big trouble.

For example, you might have a situation where you have a business with both salespeople who are W2 salaried employees and who were issued 1099s. If the functions of the 1099 worker and the employee are the same, the Employment Development Department is going to seek to reclassify the 1099 worker as an employee (and hold the employer liable for all the past due employment taxes) absent sufficient justification from the employer they should be treated as a contractor.

The initial scope of those questions is to establish background on the business, create a framework for who the employees are in the business and what they do.

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Reviewing Forms and Entities in an Independent Contractor Audit

Additionally, the Employment Development Department is going to look at forms of entities as well. During the independent contractor audit, the auditor is going to look to see if there are maybe multiple payroll tax accounts associated with the business.

For example, you often have time where you have a sole-proprietor business that will incorporate during some time in the audit period in question, so the EDD auditor will go back and look at both accounts, to try and trace the accounts to establish some sort of normalcy.

They will look for consistent treatment between the employees and the independent contractors over the life of the business’s operations.

In some situations, during an independent contractor audit, you may encounter a situation where you have a business that may be associated with some bad behavior in the past. The new owner, prior to the audit, decides to scrap the entity and create a new entity. The EDD is going to be looking for similarities there, too.

The auditor will be looking for who is calling the shots at the business. Who is really directing control? Who is managing operations? Who is signing checks? Who is really the responsible party?

This is important not only from an officer compensation standpoint, but from a business continuity standpoint. Evidence that there was deliberate action to defeat the collection of payroll tax will be treated potentially as fraud.

The Employment Development Department also is going to want to know who the officers are in the company and how they are getting paid. However, the EDD auditor is seeking to also establish who has some level of control over the business.

That way, if there is a payroll tax assessment later against the business and the business decides to shut down, the EDD will have information on who the responsible parties are. The EDD can use that information to pursue an assessment against those responsible parties.

Finally, the EDD is also going to examine reasonable compensation issues. The auditor is looking at the salaries of each officer and the relationship/ratio of K-1 distribution income associated with each officer.

The reason for this is that the EDD auditor is making sure that officer compensation paid through W-2 salary is not set arbitrarily low and/or that there is a fair balance between salary and profit distributions based of: 1) their position, 2) their job duties and responsibilities and 3) the fair value of their service contributions to the business.

California Independent Contractor Audit – Step by Step Through the Interview

The initial compliance interview serves a couple of different purposes.

Number one, it is to get background information on the client.

Number two, it is to get answers in place for different questions in case there are any problems or factual disputes that come up later.

For example, one of the questions they ask you is “How many locations do you have?” That way, if they later get information on a location that you did not disclose, you could potentially dig yourself into a hole.

The initial compliance interview lays the framework for the tax auditor’s line of questioning. A lot of the time in independent contractor audits, like with most audits, these auditors are basically writing a form audit report.

The tax auditors are going through and they are completing their due diligence in the beginning of the audit. They are recording your answers in the initial compliance interview and then are going to take your answers and incorporate them into their report later.

At the EDD independent contractor audit level, here are the questions that you are going to be asked in the independent contractor audit interview:

  • When did business operations commence?
  • What is the nature of the business?
  • What are the hours of operation?
  • How many employees do you have and what are their job titles/functions?
  • How many independent contractors do you have?
  • What services are performed by the independent contractors?
  • Are they full-time, seasonal or part time workers?
  • Is the business incorporated, did the business have a different entity form either before or after the audit period?
  • How many locations does the business have?
  • How many workers at each location?
  • Can you please list all of your officers, including names, job titles and responsibilities?
  • Who manages and directs the business’s operations?
  • Who are the authorized check signers on the bank account?
  • Who prepares and files payroll tax returns?
  • Who prepares and files income tax returns?
  • What is the frequency of payroll?
  • How often do people get paid?
  • Who provided the business with any guidance for any 1099s that they have issued?
  • What’s the business mailing address?
  • What are the personal mailing addresses for the officers?
  • What is the business’s total revenue for the last year?
  • What is the business’s total revenue year-to-date?
  • What is the salary amount for each officer?
  • What is the K1 amount for each officer?

Those are the questions that are going to establish the background information for your EDD independent contractor audit.

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