Employment Tax Audits
For small business owners, audits are not limited to income taxes. An additional audit risk concerns employment taxes. In California, employment tax audits are generally administered by the Employment Development Department (EDD); though, audits may also be initiated by other state agencies such as the Division of Labor Enforcement (DLSE), Franchise Tax Board (FTB), Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB). A common employment tax audit scenario concerns whether a worker is properly classified as an employee or an independent contractor. Another common audit issue concerns whether an employee is paid a reasonable wage as may be required by the tax code.
An employment audit adjustment by one state agency may seem to be a minor inconvenience, but it can quickly snowball into larger problems with other state agencies and a resulting massive tax bill from the IRS. Uncertainties exist because the various government agencies may interpret the laws and regulations differently. Given the many agencies which have jurisdiction, it is critical to hire counsel to help navigate these uncertain matters.
Employees vs. Independent Contractors
An employer’s internal costs of maintaining an employee vis-à-vis an independent contractor is greater because employers must contribute toward a Social Security match and pay other benefits that aren’t paid to independent contractors. Thus, employers may cut costs by treating some workers as Form 1099 independent contractors rather than W-2 Form employees. A trap for the unwary employer is the treatment of W-2 employees as 1099 independent contractors, and a subsequent audit and determination that the worker was improperly classified. This results in liabilities for tax, penalties, and interest.
In determining whether a worker is an employee or an independent contractor, the IRS considers the degree of control and independence of the worker based on three categories: behavioral, financial, and the type of relationship. Each category has several factors to be analyzed.
Behavioral control includes the types of instructions given, the degree of the instructions given, whether an evaluation system is used, and whether training is given. If instructions specifically provide for when, where, and how to work, a worker is more likely to be classified as an employee. Additionally, if the instructions given are very detailed, it is an indicator that the business has a high level of control over the worker, increasing the likelihood that the worker is an employee. The use of an evaluation and training are also indicators of an employer-employee relationship.
The opposite is also true, if loose instructions are given to complete a job with little control, no formal evaluation, and no training program, it is likely that the worker is an independent contractor.
An analysis of financial control includes the amount of the worker’s investment, whether expenses are reimbursed, whether there is an opportunity for the worker to make a profit or a loss, whether the worker can seek out other business opportunities, and the method of payment. If the worker has a significant investment in necessities for a business such as equipment, and if business expenses are not reimbursed, it is more likely that the worker is an independent contractor. Likewise, if the worker has a possibility of incurring a loss due to the investment made or expenses incurred, it is more likely that the worker is an independent contractor. If the worker is free to seek out business opportunities on the open market, it also increases the likelihood that the worker is an independent contractor. If the worker is paid a flat fee for a job, rather than an hourly wage or salary, it is more likely that the worker is not an employee.
Type of Relationship
The type of relationship refers to how the worker and business view their relationship to each other. Some of these considered factors are written contracts, whether benefits are given, permanency of the relationship, and whether services provided are a key activity of the business. Although written contracts are considered, merely stating how a worker is classified is insufficient to determine a worker’s status; rather, the details of the contract are most important. Moreover, benefits such as health insurance, retirement plans, and vacation and sick days are all indicators of an employer-employee relationship. If the relationship is expected to be ongoing, rather than for a specific project or period, it is likely to be viewed as an employment situation. If the services provided are a key aspect of the business, it may also be an indicator that the worker is an employee.
California Employment Audits
Although California employment audits differ from federal employment audits, the most significant factor considered is whether the business has control over how the work is done, and the manner and means in which it is performed. Additional factors include:
- Whether the worker is engaged in business distinct from the business
- Whether the work is a part of the regular business of either party
- Which party provides tools, equipment and work location
- The amount of the worker’s investment in equipment or materials
- Whether services rendered require a special skill
- The kind of occupation with consideration to industry practices
- The worker’s opportunity for profit or loss
- The length of time that services are to be performed
- The expected length of the working relationship
- The method of payment, whether by job or by time
- Whether the parties believe that an employer-employee relationship has been created, although this is not a decisive factor
Even in the absence of control over work, California may determine that an employment relationship exists based on the amount of control the business has on the operation as a whole, the importance of the worker’s duties to the business, and the nature of the work. It is also important to note that labeling a worker as an independent contractor in a contract and issuing the worker a 1099 are not determining factors.
What to Do if Your Business is Selected for an Employment Tax Audit
Because different government agencies may interpret the various factors without uniformity, employers who are notified of an employment tax audit should seek qualified counsel to guide them through this process.
Let Our Experienced Tax Attorney Guide You Through the Audit Process
If your small business has been selected for an audit and you are concerned with how to handle the process, we encourage you to contact NewPoint Law Group, LLP. To schedule a free consultation, call 800-358-0305 or contact us online today.