One of the most common reasons why the Employment Development Department (EDD) may choose to audit your business is if they suspect that you have misclassified your workers. When hiring workers, it’s imperative that you correctly classify them as either an employee or an independent contractor. 

An independent contractor is a worker that has the free will to decide when, where, for how long, and in what conditions they work. These flexible luxuries come at a cost. Employers are not required to pay independent workers the same way they would their employees. Specifically, they are not required to provide healthcare, sick leave, vacation time, or pension plans to independent contractors. 

Employees, on the other hand, work directly under the direction of their employer. Their employer reserves the right to instruct them on how they expect them to complete tasks and when they need to be present to complete their work. Hiring an employee requires sourcing a candidate and often includes a commitment to working indefinitely unless conditions change. This commitment level varies from independent contractors who get hired for short-term projects or jobs that often include a specific end date. 

EDD comes into play because they are responsible for collecting payroll taxes and administering unemployment benefits across the state of California. Part of their duties also includes auditing businesses’ payroll taxes. One of the things that they look for when determining which businesses to audit is whether companies are correctly classifying their workers. One significant red flag that tells them that a business has incorrectly classified its workers is when an independent contractor files for unemployment. 

Independent contractors are not eligible to receive unemployment benefits since they technically employ themselves and only work for others under short-term contracts. If a contractor were to file for unemployment, it likely means that they should never have been classified as an independent contractor and instead were wrongly classified and should be registered and paid as an employee. 

How should I prepare for a 1099 classification audit?

If your business receives notice from EDD that they plan to audit for your worker’s wrongful classification, there are immediate steps that you should take to prepare for the audit.

First, if you employ independent contractors, begin gathering any data that proves that they are indeed independent contractors. Some things that can help verify their status include the following:

• A signed contract stating their status as a contractor 
• Private advertising
• A business license 
• An independent business website

It may be challenging for businesses to review the details of each individual worker’s status because, in some cases, they’re dealing with hundreds, if not thousands, of workers. The best way to review their appropriate status is to assess each of the categories identified by IRS for distinguishing contractors from employees. These categories include behavioral control, financial control, and relationship. 

Based on the breakdown of these categories, businesses can more easily identify the status by which to correctly classify their workers. 

Let’s review an example. Worker A, let’s call him Andrew, works on your construction site installing windows. You hired him through an ad he posted in the paper for his services, and you offered him a fixed rate for his services to complete this job. Andrew should be classified as a 1099 independent contractor. 

Worker B, Brenda, is your project manager. She has worked for you for two years now and works a standard 40 hours per week to managing all of your construction projects. You pay her an hourly rate of $50/hour, and she receives paychecks every other week. Additionally, she receives healthcare coverage that is deducted from her paychecks in addition to Social Security and unemployment insurance. Brenda is a W-2 employee. 

While not all examples may be as simple as this, it may be worth your while to take a deep dive into the status of your employees. In the event of any existing 1099 contractors, you should gather significant evidence to prove that they are correctly classified. This may include the contract you signed when hiring the worker, the original ad they posted, their website, a professional license, or even their independent business card. These items can serve as proof for an auditor that the worker is correctly classified.