In the past, California employers found it to be a convenient and cheaper alternative to expand their businesses by employing independent contractors. The rules were, however, drastically altered after Assembly Bill 5 (AB 5). The California Employment Development Department (EDD) takes a hostile attitude toward businesses that misclassify their employees as independent contractors.
The repercussions of this can be incredibly damaging if the EDD decides your freelancers are legally W-2 employees. Hire an expert who can provide sales tax audit help and some other assistance.
What Is AB 5?
AB 5 is a California law that changed the definition of an independent contractor, the “ABC Test”.
The test is that the worker is presumed to be an employee unless the hiring business can prove all three of the following:
a) Freedom From Control
The worker should work alone and not be under the direct control of the way the work is done.
b) Work Outside the Core Business
It is the duty of the contractor to undertake the work outside of the normal business activities of the company.
c) Independent Trade or Business
The worker would have to be self-employed and have their own business in that line of work.
Failure on any aspect of the ABC Test can lead to reclassification.
How does the State Win and Retain the Battle Against the EDD?
Payroll taxes are a significant source of revenue for California. The state loses when businesses treat workers as 1099 contractors, rather than W-2 employees:
a. Payroll taxes
b. Unemployment insurance contributions
c. Disability insurance payments
d. Workers’ compensation coverage
Consequently, the EDD has dramatically ratcheted up audits of the following:
1. Gig economy businesses
2. Creative agencies
3. Construction companies
4. Trucking operations
5. Healthcare staffing firms
6. Freelance-heavy startups
The agency will often begin an audit based on a worker complaint, unemployment claims filed by any worker, or discrepancies in payroll information. Look for a professional (like an IRS tax attorney in San Diego) who can guide you in tax matters.
What Will an EDD Audit Cost?
During an EDD misclassification audit, you will likely receive requests for:
1. Contractor agreements
2. Payroll records
3. Payment histories
4. Business invoices
5. Communication records
6. Work schedules
7. Tax filings
Financial Consequences of Reclassification
If EDD reclassifies workers as employees, businesses can expect:
a. Back payroll taxes
b. Unpaid unemployment insurance
c. State disability liabilities
d. Interest charges
e. Failure-to-withhold penalties
f. Wage claim exposure
g. Workers’ compensation issues
In extreme cases, obligations are created over several years and impact on dozens of workers at the same time.
Common Misclassification Mistakes
There are several ways that many businesses unknowingly breach AB 5 by doing:
a. Employing full-skimmer as freelancers.
b. The decision to hire contractors for the core company services. The use of contractors for the company's core services.
c. Compensating contractors in a similar way to employees.
Many employers believe that the remote work or flexibility of a job means that the person is automatically classified as an independent contractor, but California law is more stringent than that.
Here are Some Tips to Help Minimize Audit Risk
1. Regularly check on Contractor Relationships.
2. Be aware that old classifications may not always be in compliance with changing California laws.
3. Sign and adhere to Detailed Written Agreements.
Identify and Isolate Contractors From Employees
Do not hire the contractors as personnel by making use of:
1. Company email structures
2. Mandatory schedules
3. Performance reviews
4. Employee-style supervision
Track Independent Business Activity Document
The following are examples of contractor evidence that is considered strong:
a. Business licenses
b. Separate websites
c. Multiple clients
d. Independent advertising
e. Professional insurance
Don't wait to get legal or tax advice. Get legal or tax advice early.
AB 5 compliance is very complex. Audits can be avoided, and very big liabilities can be avoided if the work is done professionally before the audit.
The best approach is to act in a proactive manner and comply with the regulations. The ABC Test, taking care to ensure that contractors are independent, and reviewing business practices periodically, can help businesses steer clear of potentially serious legal liability and huge payroll tax assessments.
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