What do employers need to know about independent contractors and California EDD payroll tax audits?

What do employers need to know about independent contractors and California EDD payroll tax audits?

In California, employers are responsible for payroll taxes and contributions, and filing quarterly and yearly reports with the California Employment Development Department (or the “EDD”) on behalf of its employees. There are four kinds of payroll taxes administered by the EDD: Unemployment Insurance, Employment Training Taxes, State Disability Insurance, and Personal Income Taxes.

If there is a legally valid relationship, independent contractors operate as separately established businesses and payments to them are treated the same as payments to other companies. To qualify as an independent contractor, the contractor’s business and the parties’ services arrangement must either satisfy all three components of the ABC Test or fall within one of the exceptions to the ABC Test and meet the requirements of California’s common law test, the Borello standard.

If the ABC Test or one of its exceptions are not satisfied, the contractor will be deemed an employee, and the contracting company will be held liable for payroll taxes and contributions as the contractor’s employer.

In California, the EDD is responsible for administering and enforcing payroll tax laws. Enforcement is primarily accomplished through tax audits conducted by EDD auditors. In a tax audit, the auditor will scrutinize the employer’s compliance with state payroll tax requirements, with a focus on whether contractors were paid “wages” for which payroll taxes are owed.

Most EDD audits are triggered by a claim for unemployment benefits by an individual treated as an independent contractor, also known as an “obstructed claim.” If the EDD concludes the individual was an employee, the EDD will frequently initiate a company-wide audit to determine if it treated other similar workers as independent contractors. The EDD also targets companies in industries it considers part of the “underground economy”, characterized by a high incidence of unreported (“under the table”) payments.

If payments to contractors are determined to be wages, the EDD issues an assessment making the “employer” liable for payroll taxes, penalties, and interest. 

A company has the right to challenge an EDD assessment and to dispute the employment finding, but it is critical to act quickly because the challenge must be filed within 30 days or the assessment will become final.

Companies with independent contractors should take steps to ensure the relationships are valid under California law. This includes evaluating the legal validity of the independent contractor classification prior to contracting, ensuring the interactions between employees and independent contractors do not infringe on the contractor’s right to control the performance of the contracted for services, and periodically reexamining the arrangement to ensure continuing validity. Finally, if contacted by the EDD for an audit, consider involving counsel, especially if the company has multiple independent contractor arrangements in California that it wishes to maintain.