The EDD has stepped up unemployment tax audits to police independent contractor misclassification. Many believe the EDD is pursuing these investigations to bolster its balance sheets due to its tax losses during the pandemic.
The EDD investigations are directed at companies that paid “independent contractors” on a 1099 basis in the last three years. The EDD commences these investigations by sending targeted businesses a “Inquiry Regarding Records” letter and/or a “Preaudit Questionnaire” and an “Information Sheet: Employment Tax Audit Process.” The investigation is focused on whether a company misclassified an employee as an independent contractor in a manner that the company owes contributions and taxes for the misclassified employees. If you receive one of the above-mentioned communications immediately contact your business legal counsel and your accountant.
Employers must withhold certain sums for employee contributions and taxes. However, for a worker classified as an independent contractor, no such contributions or taxes are withheld by the employer. The goal of these investigations, according to the EDD, is “to ensure that employers properly report all workers, wages, and contributions for Unemployment Insurance, State Disability Insurance, Employment Training Tax, and California Personal Income Tax withholding.”
The Preaudit Questionnaire requests a broad scope of data and information to “expedite the examination of [the Company’s] books and records.” It contains inquiries related to whom the company contracts with, what types of services they provide, the types of accounting system maintained, contact information for bookkeepers, etc., and a response to the questionnaire is required no later than 14 days after receipt.
After the EDD’s receipt of the completed Preaudit Questionnaire, it will conduct a telephone investigation of the company and its bookkeepers. The EDD will ask about the operation and organization of the business and accounting records. The EDD auditor will then review the company’s books and records to: (1) verify the business ownership and type of entity (sole proprietorship, partnership, corporation, etc.); (2) verify that all individuals paid for services have been properly classified as either employees or independent contractors in accordance with the provisions of the California Unemployment Insurance Code (“CUIC”) and the common law test as applied by the State Supreme Court; and (3) discuss any questionable payments made for personal services and the nature of the working relationship(s) between the company and the worker(s). With additional input from the company and discussion(s) with the worker(s), the auditor will determine whether the worker(s) are employees or independent contractors.
After review of the company’s records, the EDD will send interview requests to workers paid as independent contractors to assist the EDD investigation to determine whether the company misclassified workers as independent contractors.
If the company is selected for a “complete audit” – something that is presently more likely than not – the following “tests” will be conducted by the EDD: (1) verification that the company’s acknowledged gross wages and taxable wages have been properly reported; and (2) verification that the company has correctly withheld and reported personal income tax for wages paid to employees.
Thereafter, the EDD auditor will arrange for an exit interview to review the audit findings and to attempt to resolve any disputed issues. If a company does not reach an agreement with the auditor, it may then request a pre-assessment conference with the supervisor of the auditor.
The audit can result in no action, a credit paid to the employer, or an “assessment” for underpayments.
A company may appeal an assessment under the Employer’s Bill of Rights. The company may petition the California Unemployment Insurance Appeals Board for a hearing before an Administrative Law Judge.
It is presently uncertain whether the EDD has or will refer investigations to the Labor Commissioner for enforcement action based on employee misclassifications.
If your company receives an “Inquiry Regarding Records,” a “Preaudit Questionnaire,” or an “Information Sheet: Employment Tax Audit” from the EDD, immediately contact your business counsel and come up with a response plan. However, the time to act is before you receive an “Inquiry Regarding Records,” a “Preaudit Questionnaire,” or an “Information Sheet: Employment Tax Audit”. Contact business counsel now to review your records now to determine whether any workers may be at risk of having been misclassified. The company should ensure it has a signed contractor agreement with each independent contractor, and that the independent contractor is a bona fide entity, not an
individual. Work with your legal counsel to calculate and pay any potential withholdings and taxes to avoid penalties in an assessment, in addition to reclassifying as employees those independent contractors who are determined to be misclassified.
The company should periodically conduct a misclassification audit to determine whether independent contractors are misclassified with the assistance of legal counsel, so the audit is subject to the attorney-client and attorney work product privileges. Don’t wait. The EDD has drastically stepped-up enforcement.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
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