Employee Misclassification and EDD Audits
Jan and Neil discuss the impact of the Supreme Court decision in Dynamex and the resulting issues associated with independent contractors, 1099 workers and the new “A-B-C Test” established by the Court’s decision.
Jan also discusses the role of California’s Powerful Employment Development Department or EDD and the taxes it is responsible for collecting and auditing. The podcast also reviews a hot topic and something which is becoming much more common – an EDD verification audit. While the EDD reviews and audits every California employer’s payroll every three years the EDD has an added incentive to review the classification of workers. The new presumption in California is that every worker is classified as an employee, and if not, it is the legal burden of the provider of work to prove why the worker is not to be classified as an employee.
Jan
Welcome to our podcast on employee misclassification and EDD audits. I’m Jonathan Allen.
Neil
So Jan, as we start our conversation about employee misclassification and EDD audits, let’s talk about the California employment development department or EDD itself. What is this agency responsible for from an employer’s perspective?
Jan
The EDD is responsible for ensuring that the appropriate amount of personal income tax, unemployment insurance, SDI, or state disability insurance, and the California employee training tax is appropriately calculated and paid.
Neil
So one of the things we’re often asked about is a verification EDD audit. What is a verification audit?
Jan
The EDD reviews and audits a taxpayer’s payroll every three years. And in that three year audit, they will go back and they will cover three years. But essentially what they’re doing is they’re looking to ensure that the employees have been properly classified. They’ve been properly paid. The proper amount of withholding has been made. And of course, the appropriate amount of employers taxes, whether it’s unemployment insurance, SDI, or the employment training tax has been paid.
Neil
So, Jan, how is a verification audit different than an EDD payroll tax audit? And how often do those usually occur?
Jan
Generally during an EDD audit, they will be going through a verification process as well. But the verification audit is generally created when a number of 1099s have been filed on behalf of a company. And when there are a number of 1099s that been filed, that triggers a response in the EDD to go back and review those 1099s to ensure that those that are being paid as a 1099 contractor, shouldn’t be reclassed as an employee. So there’s an overlap in both payroll tax audits that the employers see on every three year basis, but they can be initiated on their own typically based on the number of 1099s that a company may file on a yearly basis.
Neil
And so that’s the result of what I consider to be massive changes in California law regarding the classification of independent contractors. How has that changed over the past few years?
Jan
Well, you’re right. In terms of the changes, the changes have been coming for a long time, particularly in the state of California, that resulted in a tax court’s Supreme court tax decision called the Dynamex decision and what the Dynamex decision did was it changed essentially the way that we categorize or the way that we think of a contractor before dynam contractors or dynamics contractors could be hired by virtually any company. There was a set of protocols and there were a set of guidelines that were established by the internal revenue service, 21 of them to be, be precise that were utilized in making the determination as to whether or not an individual was a contractor or an employee under Dynamax. Most of those guidelines were swept away. And the initial indication of the distinction between an employee and an outside contractor is if the individual that’s doing work for the company contributes to the revenue stream of the company, then that person will be deemed an employee and not a contractor.
Neil
Wow. So this decision, as I understand, it changed the basic presumption that all workers in California are presumed to be employees and that it’s up to the employer to prove otherwise, is that correct?
Jan
That’s a pretty fair statement. There has been quite a shift and we’ve seen it in a number of cases that have arisen coming from the dynamics decision, such as in Uber and Microsoft were the two largest cases that challenge the dynamics decision.
Neil
So the Dynamex decision created what’s called a new ABC test. That must be applied to justify to prove that a worker is actually an independent contractor. Can you take me through the three elements of this ABC test?
Jan
Well, essentially the ABC test is a holdover from the guidelines under the old format, but what the EDD is looking for is that the worker is free from the control and direction of the hiring entity, that the worker performs work, that’s outside the usual course of the hiring entity’s business. And that’s where the revenue stream concept really comes in and that the workers customarily engaged in an independently established trade or business. So what the EDD and the state are looking for are individuals that are truly, really self-employed that they’re doing these services for more than one company, and that they do that on their own. And that the income that’s earned becomes their self-employment income and not revenue for the company.
Neil
So, Jan, what are the penalties for misclassification of employees as independent contractor?
Jan
The penalties for the misclassification of independent contractors can run from $5,000 at a minimum to $25,000 per misclassification. When there’s more than a, just a few instances that occur.
Neil
And then what other types of fees or costs are they trying to recover?
Jan
Well during the audit, of course, the state is interested in recouping the unemployment insurance, the employee training tax, and the SDI that go back to fill coffers, which they pay out to employees on an as needed basis. So what you find in an audit, they generally go back three years. If the EDD determines that there is gross misrepresentation, they could go back seven. But essentially what they’re doing is they’re looking to pick up the unpaid SDI and the California unemployment training taxes as a result of these audits.
Neil
So, Jan, what are we able to do for our clients? In these cases,
Jan
Our firm has handled several misclassification audits and it’s been our experience at least shortly after the Dynamex decision that audits can be settled for the back payment of unemployment tax and SDI over a period of three years, her reclassification of the outside contractor. I think the further we get along from the dynamics decision, the longer that the Dynamex decision remains in place and the continued legal challenges to that decision and the determination of any changes that may be made to that decision, we may see a far more harsh penalty regime coming from the EDD simply because the longer the law is in place, the more punitive they become because the employers have had a longer period of time to become accustomed to the regulations that have come forth from the Dynamex decision
Neil
And the standards that are expected.
Jan
Exactly.
Neil
So we get through that portion of the audit, but the next knock on, on the door may be the one that has even more financial punch it’s the employer and their plaintiff’s attorney.
Jan
Well, I would say the next punch comes from the IRS because essentially what occurs is once there’s been a settlement with the state, the state will go back and share that information with the internal revenue service. And to the extent that there are contractors that have been reclassed as employees, the next knock on the door is likely to be the internal revenue service now wanting their share of the pie as well.
Neil
So, Jan, how does the EDD find out about independent contractors and how does this become an audit issue in the first place?
Jan
Well, typically the EDD will go back and assess the number of 1099s that are issued by a company during a given year. And particularly if the dollar amount is being paid for the 1099s is a large one in relation, say for an instance to payroll. So the first and foremost telltale sign is a number of 1099s, and the amount that’s being dispersed under 1099 accounts. The second is for example, an independent contractor, uh, you may lay that particular employee off or contractor off, and they go down to the state and they want to claim unemployment insurance. And that really becomes the first time that they’re aware that they’re not entitled to unemployment insurance because of their employee status. So it’s at that point that a disgruntled employee can go back and file a claim or make a claim with the EDD relating to their status as a contractor, as opposed to an employee it’s, then that the EDD will come in and generally initiate an audit, looking for additional potential misclassifications within the workers of that particular company. And finally, there are just disgruntled workers that will go down and make a claim simply because they’re aware of how to manipulate the legal system. And a lot of them do so quite competently.
Neil
So in our experience with our clients that you see coming in, who does this hit hardest, and what are we seeing the most of in the real world?
Jan
I think what we’re seeing over a period of time is the distinction between small companies, generally those with 25 or fewer employees, because the rules for both the feds and the states are different for those for small companies, deemed small companies and those for large employers. And I think the crossover that we’re seeing is for those employers that have started out as small, but are now moving into the realm where they have 25 or more employees. And don’t realize that the rules for them have changed. And that’s really where we’re beginning to see the crossover in terms of these reclassification audits and the changes in the rules at both the federal and the state level as they apply to these now larger employees or employers.
Neil
So Jan, if a company is contacted by the EDD for a verification audit or a payroll audit, do they need Allen Barron?
Jan
Absolutely. They need professional assistance in getting through the audit process and doing it efficiently and economically.
Neil
And there’s a strategy to how you provide information and for how you structure responses back to the EDD
Jan
Absolutely the information that’s requested is not necessarily always the information that’s provided. And I think the employer needs to be aware that the EDD is not going to look just to the employer for information. Oftentimes they reach out to the contractors themselves, and it’s important to understand how to deal with the communication with those contractors prior to the auditors making their communication.
Neil
So there’s just a world of risk associated with these audits.
Jan
Absolutely. Any payroll audit is risky, but the reclassification audits probably have the most liability relating to potential penalties, interest and taxes,
Neil
The biggest check coming out of hip pocket national bank.
Jan
Absolutely.
Neil
So Jan, another of the issues that really matters in this specific situation is you’re an attorney. What difference does the fact that you’re an attorney make when these conversations begin
Jan
Well again, what arises is the attorney client privilege and the ability to go back and really explain to the attorney what’s happening and being assured that that information is not going to be passed on to any particular authority.
Neil
So Jan, in these situations, employers are facing great risks and that protections of the attorney client privilege can really come into play versus having the same discussions with a CPA or a bookkeeper.
Jan
Yes, the attorney client privilege is extended only to the attorney and the client. The protection doesn’t include a client and their CPA or a client in an enrolled agent or even a client in their own controller or CFO. So the attorney client privilege allows an employer to speak freely and understand that the information that’s being given to the attorney will not be disclosed to the taxing authorities.
Neil
So in effect, if they have the same conversations with the CPA bookkeeper or internal officer, the EDD could ask for work papers, emails, notes, and they would have to provide them to the agency
Jan
They’re required to yes, an attorney’s work papers are not necessarily disclosable, but again, it comes down to the professional and the information that’s being asked by the auditor and the distinction of how that information should be presented. And when it should be presented that the employer can rely on the discretion of the attorney.
Neil
So Jan, we’ve had this major change in California law, and yet they haven’t gone out the entire state and said, okay, all of you, all your independent contractors are now employees. How do you see this playing out? How has it played out so far and where are we going with this in the future?
Jan
Well, there was a real pull prior to the pandemic to go back and essentially reclass everyone that was working particularly in California as an employee. And I think as a result of the pandemic, what we’ve seen is not even the contractors that were outside contractors, that don’t receive some of the benefits that an employee does necessarily want to be classified as an employee, because there are losses in terms of flexibility and time when it is that a person can work, how much they can work that may be lost if the individual is reclassified as an employee. So I think for the near term, there will be additional challenges to Dynamex. I think there’ll be this tug of war between individuals that want to maintain their independent contractor status and those that want the benefits and the protections that being classified as an employee will provide those individuals. So I don’t think the matter is settled in any form or fashion. I think it’ll be a while longer, but I do see us moving towards a more inclusive employee classification definition as opposed to the maintenance of the outside contractors.
Neil
Thanks Jan.
Jan
Thanks Neil.
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