Employment Development Department
California’s Employment Development Department (the EDD) has the right to audit California businesses to ensure that employee payroll taxes are being paid for the right personnel and in the right amounts. Businesses that hire independent contractors are especially vulnerable to EDD audits right now, in light of a California Supreme Court decision in April 2018 that expanded the definition of employees. Companies do not have to pay employer payroll taxes and with hold employee income taxes for independent contractors; they do for employees. Therefore, if the EDD suspects that your business may have misclassified employees as independent contractors, you may be liable for substantial taxes and penalties.
If the EDD mails your company a Notice of Audit, and the audit is a “Request Audit,” that means your business is on the EDD’s radar. How did this happen? Most commonly it happens because your workers have applied to the EDD for unemployment or workers’ compensation and the requests were denied because they were classified as independent contractors. (Note: a “Verification Audit” is likely less problematic as it is usually a more routine audit to verify certain details.)
The Notice of Audit will contain Form DE231A, which includes document requests, and a list of questions. The documents the EDD requests usually include tax returns, financial statements, bank statements, payroll records, and documentation of EDD quarterly contributions. It will also contain a response deadline. If that deadline is too soon, because your business is short-handed and needs time to gather all the documents, or because you want to hire counsel, or both, you may call the EDD and request an extension. If you do contact the EDD at this stage, it is best to keep the conversation to the deadline or other logistical question(s) you have. As in a traffic stop, anything you say can and will be used against you, so be cautious. An attempt to plead your case to whomever answers the phone at the EDD will almost certainly not help and may cause harm to your business.
It is best practice, at this stage, to hire a tax professional or accountant to advise you regarding the sufficiency of tax payments, and, especially if you have independent contractors on your payroll, to hire an experienced employment attorney to advise you. Misclassification of employees as contractors is a complex and rapidly-changing area of law, and is often misinterpreted by non lawyers.
For example, if you believe you have properly classified your workers as independent contractors because both you and they prefer that arrangement, that is not enough under the law. Neither employers nor employees may avoid paying taxes (and complying with California’s labor laws) by mutual agreement. Until April 2018, the test governing whether an independent contractor was properly classified involved weighing numerous factors including the degree of control the business had over how the contractor performed the work. However, on April 30, 2018, the California Supreme Court decided Dynamex Operations West v. Superior Court, 4 Cal. 5th 903 (2018), dramatically limiting the employees that could properly qualify as independent contractors.
Dynamex provided same-day courier and delivery services and had converted all its drivers from employees to independent contractors. As independent contractors, Dynamex drivers had to provide their own vehicles and vehicle insurance, as well as to pay for their own gas, tolls, vehicle maintenance, and workers’ compensation insurance. Dynamex continued to find and make arrangements with customers, set the rates for delivery, and assign drivers to routes. A group of Dynamex drivers sued the company in a class action, alleging they should have been classified as employees and given the protections afforded to employees under the Labor Code.
The California Supreme Court in Dynamex established a new test to determine whether independent contractors were correctly classified, called the “ABC” test. “A” is the level of control the company has over the workers. The more control the company actually exercises over how, when, and where the work is done, the more likely it is that the contractor should be an employee. “B” is whether the worker is working in the same business as the hiring company. Dynamex was a delivery company and its “contractors” were delivery drivers. Because the company and the “contractors” were in the same line of work, Factor B would treat them as employees. “C” is whether the worker is engaged in an independent trade or business. Whether the contractor had a previously-existing business license, or also worked on contract for other companies, would be relevant to this factor. All three “ABC” factors must favor independent contractor status, otherwise the company could be liable for misclassifying employees.
Although the Dynamex case was a wage and hour lawsuit, there are at least some indications that the EDD is relying on the new “ABC” test in its tax audits. Laura Curtis, a policy advocate with the California Chamber of Commerce, claimed the EDD has been performing audits and filing cases against companies for misclassifying employees as independent contractors using the “ABC” standard. Kevin Smith, “Ruling on independent contractors leaves entrepreneurs in limbo.” San Gabriel Valley Tribune, Oct 25, 2018,
In light of the complexity and shifting nature of the law regarding classification of workers in California, it is best to be cautious when facing an audit and to hire counsel.
However, whether or not you choose to hire an attorney, it is critical to be honest and respectful in responding to the initial document request and questionnaire with the Notice of Audit. Generally, you can and should produce the documents requested. In fact, you are required by law to keep certain documents – such as 3 years’ worth of employee payroll records – so claiming not to have them could open the door to further problems.
On the other hand, it is also generally advisable not to “overshare” by answering questions that are not asked or producing documents not requested. For example, if the EDD requests certain documents for a 2-year time period, do not provide documents for a 5-year time period. Likewise, there may be some documents the EDD requests to which they are not legally entitled. Your attorney can assist you in preparing objections to these requests.
After your company produces the requested documents, there will be an in-person meeting with the auditor. The auditor will review the records produced, hear arguments, and make a decision regarding whether the correct taxes were paid and whether your company’s workers were properly classified.
If the EDD determines that your company underpaid taxes, payment will be due in 30 days plus interest and penalties. If the owed taxes are not paid in 30 days, 10% interest will accrue going forward.
Your company will have the right to appeal an unfavorable decision by the EDD.
Regardless of whether you are just starting a brand new company, run a ‘mom & pop’ business, or you already have a large established corporate enterprise with hundreds of locations across California, we are able to grow with you and meet your legal needs.