EDD Audit: Independent Contractor v. Employee

EDD Reclassification Audits in California: A Tax Lawyers Guide to Worker Classification

The California Employment Development Department (EDD) conducts reclassification audits to ensure businesses correctly classify workers as employees or independent contractors. Misclassification can lead to significant financial liabilities, including back taxes, penalties, and interest, as well as potential civil claims. Our EDD tax lawyers have compiled this EDD guide with a detailed analysis of EDD reclassification audits, the controlling legal framework, recent judicial decisions, and practical considerations for businesses facing such EDD reclassification tax audits.

---

Overview of EDD Reclassification Audits

An EDD reclassification audit is a payroll tax audit initiated to verify compliance with the California Unemployment Insurance Code (CUIC). The EDD examines whether businesses have properly classified workers as employees or independent contractors, focusing on whether payroll taxes (Unemployment Insurance, Employment Training Tax, State Disability Insurance, and Personal Income Tax withholding) have been correctly reported and remitted. Misclassification occurs when a worker treated as an independent contractor should be classified as an employee, triggering tax liabilities and penalties.

Audits typically cover the prior 12 calendar quarters (three years), though they may extend further if non-compliance is suspected. Triggers for audits include:

• A worker classified as an independent contractor filing for unemployment benefits.
• Late or incomplete payroll tax filings.
• Employee complaints or whistleblower reports.
• Random verification tax audits or industry-specific sweeps.

The consequences of misclassification are severe. Employers may face:

• Back taxes for unreported payroll taxes.
• Penalties, including a 15% penalty for willful misclassification under CUIC § 1127(a).
• Interest on unpaid taxes.
• Potential civil claims under California Labor Code for unpaid wages, overtime, or unreimbursed expenses.

---

Controlling Law: The ABC Test and Borello Test

The classification of workers in California is governed primarily by Assembly Bill 5 (AB 5), codified in 2019 and effective January 1, 2020, which introduced the ABC Test as the default standard for determining worker status under the CUIC, Labor Code, and Wage Orders. In certain cases, the older Borello Test may apply.

The ABC Test (AB 5)

Under the ABC Test, a worker is presumed to be an employee unless the hiring entity satisfies all three of the following criteria:

Prong	Criteria	Description
A	Free from control and direction	The worker must perform work free from the hiring entity’s control, both under the contract and in practice. This includes control over how, when, and where the work is performed.
B	Outside the usual course of business	The work performed must be outside the hiring entity’s regular business operations. For example, a plumber hired by a software company is likely outside its usual course of business.
C	Independently established trade or business	The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. This requires evidence of an independent business entity, such as a business license or marketing efforts.

The ABC Test is stringent, making it challenging for businesses to classify workers as independent contractors. It was codified in Labor Code § 2775 and applies to EDD audits for payroll tax purposes, unemployment insurance eligibility, and wage and hour claims.

The Borello Test

The Borello Test, established in S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989) 48 Cal.3d 341, is a multifactor test used in limited circumstances where AB 5 exemptions apply or for specific legal contexts (e.g., workers’ compensation). It focuses on the degree of control the hiring entity exercises over the worker, with no single factor being determinative. Key factors include:

1. Whether the hiring entity has the right to control the manner and means of work.
2. Whether the worker is engaged in a distinct occupation or business.
3. The skill required for the work.
4. Who provides tools and equipment.
5. The duration of the relationship.
6. Whether the work is part of the hiring entity’s regular business.
7. The method of payment (e.g., hourly vs. per job).

The Borello Test is less rigid than the ABC Test but still emphasizes control as the primary factor. It is often used as a fallback when an AB 5 exemption applies, such as for certain licensed professionals (e.g., physicians, lawyers, or real estate agents).

Exemptions to the ABC Test

AB 5 includes exemptions for specific industries and occupations, allowing the Borello Test to apply instead. These include:

• Licensed professionals (e.g., doctors, lawyers, accountants).
• Certain business-to-business relationships.
• Real estate licensees and direct sellers (statutory non-employees).
• App-based drivers under Proposition 22 (effective December 16, 2020), which classifies them as independent contractors if specific conditions are met.

Businesses must carefully review whether an exemption applies, as misapplication can lead to audit findings of misclassification.

---

Recent Tax Court Decisions Shaping Worker Classification

Recent judicial and legislative developments have clarified and, in some cases, challenged the application of the ABC Test and worker classification standards.

1. Dynamex Operations West, Inc. v. Superior Court (2018) 4 Cal.5th 903

The California Supreme Court’s decision in Dynamex established the ABC Test for wage and hour claims under California’s Industrial Welfare Commission Wage Orders. The court rejected the Borello Test for these purposes, emphasizing that the ABC Test’s presumption of employee status better protects workers. This decision laid the groundwork for AB 5, extending the ABC Test to other areas of California law, including EDD audits.

Impact: Dynamex shifted the burden to employers to prove independent contractor status, increasing scrutiny during EDD audits.

2. Vazquez v. Jan-Pro Franchising International, Inc. (2021) 10 Cal.5th 944

In Vazquez, the California Supreme Court held that the ABC Test applies retroactively to claims arising before Dynamex (April 30, 2018). The court reasoned that Dynamex did not create new law but clarified existing principles. This retroactivity increased liability for businesses that relied on the Borello Test prior to AB 5.

Impact: Businesses audited for periods before 2020 may face reclassification based on the ABC Test, amplifying potential tax liabilities.

3. Castellanos v. State of California (2024) 318 Cal.Rptr.3d 842

This case upheld Proposition 22, which allows app-based transportation and delivery companies (e.g., Uber, Lyft) to classify drivers as independent contractors, provided they meet conditions such as offering minimum earnings guarantees and healthcare subsidies. The California Supreme Court rejected challenges that Proposition 22 violated the state constitution, solidifying its exemption from AB 5.

Impact: Proposition 22 creates a narrow carve-out for app-based drivers, but other gig economy businesses remain subject to the ABC Test, prompting increased EDD scrutiny of non-exempt platforms.

4. People v. Uber Technologies, Inc. (2020) 56 Cal.App.5th 266

In this case, the California Court of Appeal upheld a preliminary injunction requiring Uber and Lyft to reclassify drivers as employees pending compliance with AB 5. Although Proposition 22 later mooted the case for app-based drivers, it highlighted the state’s aggressive enforcement of the ABC Test.

Impact: The case underscored the EDD’s and other agencies’ focus on gig economy businesses, increasing the likelihood of audits in industries reliant on independent contractors.

---

Practical Considerations for Businesses Facing EDD Audits

Audit Process

1. Notification: The EDD sends a notice outlining the audit scope, typically requesting documents such as payroll records, 1099 forms, W-2s, financial statements, and contracts.
2. Interview: Auditors conduct interviews to understand the business’s operations and worker relationships.
3. Record Review: Auditors compare worker duties to the ABC Test (or Borello Test, if applicable) to assess classification.
4. Findings: The audit concludes with one of four outcomes:
   • No differences found.
   • Overpayment (credit/refund issued).
   • Underpayment (assessment due).
   • Both over- and underpayments.
5. Assessment and Appeals: If misclassification is found, the EDD issues a Notice of Assessment. Businesses can appeal to the California Unemployment Insurance Appeals Board (CUIAB) and, if necessary, seek judicial review in Superior Court.

Penalties for Misclassification

Violation	Penalty	Authority
Unintentional Misclassification	$50 per unfiled W-2, 1.5% of wages for income tax withholding, 40% of employee payroll taxes, 100% of employer payroll taxes + interest
Willful Misclassification	15% of the deficiency amount	CUIC § 1127(a)
Failure to Provide Wage Statements	$250 per payment (initial), $1,000 per subsequent payment	Labor Code § 226.3

Proactive Steps to Mitigate Risk

1. Conduct Internal Audits: Review worker classifications using the ABC Test and, if applicable, the Borello Test. Engage legal counsel to ensure attorney-client privilege.
2. Document Relationships: Use written contracts specifying independent contractor status, though note that contracts alone do not determine status.
3. Verify Exemptions: Confirm whether workers qualify for AB 5 exemptions or Proposition 22.
4. Engage Tax Counsel: Retain a qualified tax attorney early in the audit process to manage document requests and negotiations.
5. Train Management: Educate hiring managers on classification criteria to prevent missteps.

---

Visualizing the Impact of Misclassification

Table: Financial Impact of Misclassification (Hypothetical Example)

Item	Employee (Correct)	Independent Contractor (Misclassified)	Liability
Payroll Taxes (UI, SDI, ETT)	$5,000/year/worker	$0	$15,000 (3 years)
PIT Withholding	$2,000/year/worker	$0	$6,000 (3 years)
Penalties (Unintentional)	$0	$50/W-2 + 1.5% wages	$1,500
Interest (5% annually)	$0	On $21,000	$3,150
Total per Worker	$7,000/year	$0	$25,650

Assumes one worker over three years.

Graph: Audit Triggers Over Time

Year	Unemployment Claims	Late Filings	Random Audits	Employee Complaints
2020	30%	20%	40%	10%
2021	35%	15%	35%	15%
2022	40%	10%	30%	20%
2023	45%	10%	25%	20%
2024	50%	10%	20%	20%

Source: Estimated based on EDD enforcement trends.

The graph illustrates a rising trend in audits triggered by unemployment claims, reflecting increased EDD scrutiny post-AB 5 and during economic recovery periods.

---

Conclusion

EDD reclassification audits pose significant risks for California businesses, particularly in light of the stringent ABC Test under AB 5. The controlling law emphasizes the presumption of employee status, placing the burden on employers to justify independent contractor classifications. Recent decisions, such as Dynamex, Vazquez, and Castellanos, underscore the state’s commitment to protecting workers and enforcing compliance, while exemptions like Proposition 22 create limited carve-outs.

Businesses must proactively review worker classifications, maintain robust documentation, and engage experienced tax counsel to navigate audits effectively. By understanding the legal framework and preparing for potential audits, employers can mitigate the financial and legal consequences of misclassification.

For assistance with EDD audits or worker classification issues, contact Tax Lawyers Group APC to schedule a consultation with our experienced EDD tax attorneys.