Chapter 02

California Payroll Audit Strategies for the Independent Contractor

In looking at your buckets that you have created, we want to highlight a few other things, which will help defend you in an independent contractor audit. This is based on a few tips and tricks that we have learned over the years based on our experience in EDD audits.

Use EDD Fact Sheets to Your Advantage

First, when we as a firm are dealing with a client that has independent contractors that we feel are questionable, we will check the EDD's website to see if there have been any information sheets or internal guidance published on the industry that we are dealing with.

For example, for casual labor, we know that there is guidance on the issue because we have run into it quite a bit in our practice. What we mean by this is that the state of California has put out a fact sheet on the definition of what casual labor is, and not surprisingly, they classify most of these people as employees. However, you can read through this fact sheet and know what position the EDD auditor is going to take in advance and where the cracks are.

So, if you get a situation where you have a lot of casual labor, you first go to the EDD fact sheet, because that's what the auditor is going to refer to, and then you run a test on those people against what the fact sheet says. That will basically allow you to do a mock audit to see if you think that you have a reasonable position against what the EDD's internal guidance says.

Identify California Statutory Employee Issues and Issues for Family Businesses

The next thing you're looking for is you're looking for situations where people are statutory employees. You'll get instances where people are truck drivers or in other occupations where they are considered statutory employees.

You want to make sure you know that going in, because if somebody has been classified as a 1099 and they’re actually a statutory employee, the tax auditor is going to make you look pretty foolish there.

When you've got a lot of related parties in a business, that is a huge red flag to the EDD like in situations where you have related family members who are operating a business together. It is a cause for concern for the tax auditor because of past abuses in that space. 

Not just like one or two people, like a husband and a wife, although that can be a red flag in and of itself, particularly when you have a lot of personal expenses, but when you have got multiple family members in a business. 

So, take for example when you have got dad and son running the business and uncles working for it or a couple of cousins in the business. Maybe just smoke and no fire, but be on the lookout for any problems with those relationships.

Look at the Case History for Heavily Disputed or Targeted Industries

Guess what? You are neither the first nor last person to go through a California payroll tax audit. The benefit of this is that many of the issues that you are facing have been fought before, usually many times. 

When we start with a client, if we are rusty on the challenges surrounding a particular industry or are dealing with a new issue, we will look for case law or guidance that has been issues in the past. 

We are looking for things or worker classification issues that are “hot button” in order to gain insight or to hopefully get some background information on some of the other cases that have occurred in those industries.

What are the hot button issues? Well, we have been through the ropes on most things EDD at this point in our practice, so we are usually on the lookout for newer issues, but for non-tax people, I can go ahead and give you three off the top of my head. 

The EDD frequently targets anything involving salespeople, anything involving the construction industry, anything involving the restaurant and hotel industry. Chances are if you are in an industry with a large unskilled labor pool, there is probably an EDD fact sheet on the issue.

So, make sure you look at those issues. Look at some of the case law surrounding those issues and go from there. If you are still asking the question, "Well, how do I know if I have a business with a hot button issue?" Just run through the list of EDD information sheets and if the industry appears on that information sheets, you will find a situation where there is litigation on the case or there's been some sort of internal guidance, and chances are that it may be on-point to your particular situation.

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Reimbursement Issues

Once you have cleared any 1099 issues or at least gotten them out on the table, the next thing you want to do is confirm whether or not you need to deal with reimbursement issues. Understand what the reimbursement policy for the organization is and start pulling records with respect to reimbursements. 

If you have got large scale reimbursements, you want to make sure everything is properly documented. If it is not properly documented, you know that you're going to have an issue working on the audit. You need to minimize that issue or you need to start figuring out your strategy and what you're going to do to deal with it.

How do I beat the EDD at their own game?

Beating the EDD at their own game is very tough because the passage of AB5 has essentially regulated independent contractors in California. 

In order to be in a true independent contractor relationship, you need to either fall under the definition of AB5 or be engaged in a true business-to-business relationship where the person is not involved in being integral to the generation of your revenue.

The reality of the situation is if you come under a payroll tax audit and you have independent contractors in California, which is the subject matter for most payroll tax audits, it is going to be difficult to beat the EDD because the EDD is locked on this issue and they know exactly what they are looking for.

With that said, there are some tactics that you can use during the course of the audit to help you out. The first thing that I would recommend is that from your independent contractors that you separate people by job category and by what they do. This may be a situation where you just have one class of workers and if so, this strategy will not work for you.

To the extent that you employ multiple independent contractors who do multiple things, you want to try and put them in different buckets. Then with each bucket, you want them to relate your level of risk.

Certain buckets are probably not going to be able to get past the auditor. These are people who look like employees; they are students or they may be lower-skilled workers. There are certain buckets that are probably going to be on the fence.

Then there may be other buckets that are completely and totally an independent contractor relationship, if you hire a law firm or an accounting firm or something like that. By segregating these workers into buckets, you are going to look at what your exposure is in different categories.

The key to beating the EDD at their own game is not necessarily to get out of the audit unscathed, but to get out with as little liability as possible. There is no harm in conceding that the independent contractors you know are going to get reclassified ahead of time. If you offer that to the auditor, it will make things a lot easier.

Then when it comes to the independent contractors who are on the fence, you want to do anything that you can do to establish those people as true independent contractors.

Can you see their LinkedIn profiles? Do they have insurance? Do they have a business card? Do they maintain their own websites? Do they advertise themselves? What do these independent contractors do to maintain their own business? All of that is very, very important.

The other way to beat the EDD is through the application of penalties. The EDD is very severe when it comes to the penalty structure for misclassifying workers or for not filing the appropriate payroll tax returns, even informational returns.

We have seen situations in our firm where we will have an amount of tax that is due and the penalties will be five times or more in excess of the amount of tax. It is really important that when you go into these audits that you focus on beating the penalties as much as you do beating the tax.

By developing a narrative at the beginning of the audit, by defeating willfulness, and by removing yourself from some of these harsher penalties, you will do a lot better for yourself.

The actual tax itself, when you look at it from a payroll tax perspective in California, is not that much. Even businesses with a pretty high payroll are not paying that much in actual tax, particularly if they have workers who are filing their own returns and paying their personal income tax because then you can debate it.

The long and the short of it is that is how you beat the EDD at their own game. You go in strategically and try to mitigate your risk and any penalties that are associated with that. That is how you can be successful in an EDD audit.

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