The EDD is aggressively pursuing unemployment tax audits aimed at evaluating potential independent contractor misclassification. Presumably due to the overwhelming financial burden the pandemic imposed, the EDD is pursuing these investigations to bolster its balance sheets. The EDD is investigating companies that paid “independent contractors” on a 1099 basis in the last three years. The EDD sends targets of these investigations an “Inquiry Regarding Records” and/or a “Preaudit Questionnaire” and an “Information Sheet: Employment Tax Audit Process.” The goal of the EDD investigations is to determine whether a company misclassified an employee as an independent contractor such that the company would owe contributions and taxes for the misclassified employees. If you receive one of the above-mentioned communications from the EDD, you should consult with counsel immediately [and before responding].

By way of background, employers are obligated to withhold certain sums for employee contributions and taxes. When a company classifies a worker as an independent contractor, no such contributions or taxes are withheld. [For a refresher on the proper classification of employees following AB5, please click here.] The EDD describes the goal of these investigations as “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.”  

In the Preaudit Questionnaire, the EDD asks employers for a broad scope of data and information to “expedite the examination of [the Company’s] books and records.” Such questionnaire includes inquiries related to whom the company contracts withs, what types of services they provide, the types of accounting system maintained, contact information for bookkeepers, etc. The EDD requires a response to the questionnaire in just 14 days.

Following the Preaudit Questionnaire, the EDD will conduct a telephone investigation of the company and its bookkeepers. During these calls, 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) with you and the worker(s).

Based on the facts obtained from the records, input from you, and discussion(s) with the worker(s), the auditor will determine whether the worker(s) are employees or independent contractors.

Notably, after evaluating a company’s accounting records, the EDD will send interview requests to workers (usually by email). That is, the EDD will speak with individuals whom the company paid as contractors to assist in their investigation to determine whether the company misclassified workers as contractors.

If your account is selected for a “complete audit” [it likely will be], the following “tests” will be conducted by the EDD: (1) verification that your acknowledged gross wages and taxable wages have been properly reported; and (2) verification that you have correctly withheld and reported personal income tax for wages paid to your employees.

As the final leg of the audit, the auditor will arrange for an exit interview, either in person or by phone, to review the audit findings and to attempt to resolve disputed issues, if any. If a company does not reach an agreement with the auditor, it may 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—most likely—an “assessment” for underpayments (i.e. the EDD instructs the company it owes money).

If an assessment is issued, a company may appeal the assessment under the Employer’s Bill of Rights (DE 195). The company may petition an independent third party, the California Unemployment Insurance Appeals Board, for a hearing before an Administrative Law Judge.

It remains to be seen whether or not the EDD will refer investigations to the Labor Commissioner for enforcement action on any purported employee misclassifications.

Practical Tips:

If you receive an “Inquiry Regarding Records,” a “Preaudit Questionnaire,” or an “Information Sheet: Employment Tax Audit” from the EDD, contact counsel immediately. You need a plan!

To be proactive, review your records now to determine whether any workers may be at risk of being considered misclassified. Make sure each one has a signed contractor agreement on file, and that the engaged contractor is a bona fide (registered) entity, not an individual. If risks are uncovered, work with counsel to consider calculating and paying any potential withholdings and taxes to avoid penalties in an assessment, in addition to reclassifying them as employees.

On a going-forward basis, conduct a misclassification audit to determine whether independent contractors are misclassified. Once again, involve counsel so the audit never become discoverable.