In California, a “1099 independent contractor audit” usually means an Employment Development Department worker-status audit focused on whether people you paid as contractors should have been treated as employees for payroll tax purposes. EDD enforces unemployment insurance, state disability insurance, employment training tax, and personal income tax withholding. Since AB 5 and AB 2257 reorganized the rules into Labor Code sections 2775 to 2787, most audits start with a presumption of employee status under the ABC test, unless a statutory exemption applies, in which case the Borello multi-factor test applies. Proper preparation can make all the difference between a contained, civil examination and a costly assessment that ripples to other California & Federal tax & regulatory agencies and tax years.
Know What Triggers EDD Audits and What the First Letter Means
EDD tax audits are commonly triggered when a worker you paid on a Form 1099 files for unemployment or disability benefits, and an EDD benefits office flags a “status” issue. Other triggers include information mismatches, non-filing of required reports, tips from compliance outreach, and referrals from the IRS, FTB, or CDTFA. The initial contact identifies the period under review, the auditor, and a records due date. Expect a request for bank statements, general ledger, check registers, 1099s, W-2s, payroll reports, contracts, statements of work, invoices, proof of business insurance, business licenses, evidence of who performed the services, and lists of all workers with total payments. Before you respond, file an EDD power of attorney on Form DE 48 so your representative can communicate directly with the auditor and set ground rules for how information will be provided and whether an entrance interview is necessary.
Two compliance items EDD often checks immediately: whether you filed California’s Report of Independent Contractor(s) on Form DE 542 within 20 days of paying or entering into a contract of $600 or more, and whether you issued the required Forms 1099-NEC and the federal transmittal. Systemic lapses here can signal broader exposure and are easy for auditors to verify.
Understand the Tests the Auditor Will Apply and Assemble Proof Before You Speak
The ABC test presumes a worker is an employee unless the hiring entity proves all three prongs. A: the worker is free from the control and direction of the hiring entity, both under the contract and in fact. B: The work performed is outside the usual course of the hiring entity’s business. C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. Do not assume the ABC test applies to every relationship. AB 2257 reorganized numerous exemptions where the Borello test continues to govern, including certain professional services, referral agency relationships, business-to-business relationships, and specific creative or specialized roles. If an exemption fits, you must prove the exemption’s conditions and then show the Borello factors support contractor status based on how the work is actually performed.
Build a worker-by-worker matrix before producing anything. For each worker, include services performed, dates, total paid by quarter, where the work was performed, how the person was found and engaged, whether they served other clients during the engagement, who supplied tools and workspace, whether there was supervision, and how quality and deadlines were managed. Gather documentary proof of independence, such as the worker’s business license, website or ads, EIN, insurance certificates, invoices on the worker’s letterhead, written contracts that match reality, and evidence that they provided services to other customers during the same period. If you plan to rely on an exemption, assemble the specific items the statute requires. For example, many exemptions require a written contract, a separate place of business, the ability to set rates, and the ability to accept or reject jobs. Auditors will test what happened in practice, not just what the contract says.
Produce the Correct Records in the Right Way and Control the Audit Process
EDD publishes an Employment Tax Audit Process and uses its internal Tax Audit Guidelines manual to structure examinations. Most audits begin with a “test year,” typically one year within the three-year audit period. If the test year shows reclassification issues, the auditor may expand the scope to the remaining quarters or to additional worker groups. You can improve outcomes by producing organized, paginated records that tie to your books and bank statements and by providing a clear reconciliation from disbursements to the specific workers under review. Avoid casual interviews where off-the-cuff answers on control, supervision, or the usual course of business can decide the ABC test. Have your representative serve as the point of contact, answer in writing where possible, and address any misunderstandings promptly.
Expect the auditor to test whether your 1099 population includes people doing the same core function as your employees. They will compare contracts to actual practice, ask whether contractors used company email, attended staff meetings, followed company schedules, or wore uniforms, and whether you restricted their ability to work for others. They may contact workers directly. Make sure your contact information for workers is complete and up to date so you can anticipate those calls. If your records are incomplete, auditors can use indirect methods such as bank deposit analysis or sampling. Proactively reconcile bank activity with worker payments and identify owner draws, vendor payments, and accurate contractor payments to ensure the auditor does not over-include items.
Quantify Realistic Exposure and Plan for UI, SDI, ETT, and PIT
If workers are reclassified, the EDD assesses four components. Unemployment Insurance (UI) and Employment Training Tax (ETT) are employer-funded contributions. State Disability Insurance (SDI) is an employee tax that should have been withheld and remitted; when it is not, EDD will treat it as due from the employer. Personal Income Tax (PIT) is California personal income tax that should have been withheld. EDD commonly estimates PIT using flat rates where you did not withhold. After an assessment, you can often reduce the PIT portion by providing worker-level information to compute what should have been withheld using each worker’s IRS Form W-4 or California Employee’s Withholding Certificate, Form DE 4, or by using a reasonable method where forms do not exist. In some cases, certifications that workers reported the income on their own returns can reduce the PIT principal. These adjustments seldom eliminate penalties tied to failure to withhold, but they can materially reduce the PIT balance.
Penalties and interest can be significant. Depending on facts, EDD can apply 15 percent additions for late contributions or late reports, per-return or per-wage-item penalties for e-file failures, 50 percent fraud or intent-to-evade penalties on contributions where warranted, and separate information-return penalties. Interest runs by statute. You should model exposure quarter by quarter before the exit conference. That modeling informs whether to contest worker status for all workers or concede it for specific groups in exchange for narrowing the period and penalties.
Protect Appeal Rights and Coordinate With Other Agencies So One Problem Does Not Become Two
If the auditor proposes reclassification and tax, you will receive a Proposed Notice of Assessment and be offered an exit conference. Use the conference to address classification, taxable wage calculations, and the computation of PIT. If the issues are not resolved, EDD will issue a Notice of Assessment. You generally have 30 days to file a Petition for Reassessment with the California Unemployment Insurance Appeals Board. Filing a timely petition preserves your rights and allows you to request EDD’s Settlement Program, which is available after a petition is on file. Settlements are negotiated based on the hazards of litigation and can resolve worker status, wage base, and penalties. If you miss the 30-day window, the assessment becomes final, and you lose access to the settlement track.
Coordinate exposure outside EDD. A reclassification can raise questions at the Franchise Tax Board and the California Department of Tax and Fee Administration. EDD may pursue personal liability of responsible persons for unpaid wage withholding under Unemployment Insurance Code section 1735, and CDTFA has analogous responsible person provisions for sales and use tax under Revenue and Taxation Code section 6829. FTB may still ask how the EDD reclassification aligns with personal income tax reporting, but it does not administer wage withholding. CDTFA may test sales records, resale and exemption certificates, and use tax accruals if your business is in a sales and use tax regime. Keeping the numbers and the narrative consistent across agencies is a core way to avoid duplicate examinations and inconsistent positions.
Contact the Tax Law Offices of David W. Klasing if You Received an EDD Independent Contractor Audit Notice
Independent contractor audits are classic high-risk eggshell matters. A seemingly simple answer about control or the usual course of business can determine whether the ABC test applies. At the Tax Law Offices of David W. Klasing, every matter is attorney-led, and our CPAs are employees of the firm who work as part of the legal team. From day one, we file your EDD power of attorney, take over communications with the auditor, and build the examiner grade record that actually wins. We construct a worker matrix, test your facts against Labor Code sections 2775 to 2787 and any applicable exemption, and, where an exemption applies, build a Borello analysis that matches how the work was actually performed. We reconcile bank activity to worker payments, separate vendors and owners from actual contractors, and present organized support that anticipates how EDD will test the file.
We also model exposure across UI, SDI, ETT, and PIT before the exit conference and quantify legitimate ways to reduce the PIT portion post-assessment by providing the computations and attestations EDD accepts. Where the auditor has used an unfair test year or a sampling method that overstates liability, we challenge the scope, sampling design, and projections so that one anomalous data point does not contaminate the entire period. If a Notice of Assessment issues, we file a timely Petition for Reassessment, preserve your rights, and pursue EDD’s Settlement Program where the hazards warrant. If appropriate, we coordinate with FTB and CDTFA so your EDD resolution does not create a federal or state problem elsewhere, and we harden your go-forward model so you do not relive the audit.
At the Tax Law Offices of David W. Klasing, you get a single team that manages both the numbers and the narrative. Our dual-licensed employment tax attorneys & CPAs prepare you for any interviews, keep your responses precise and on point, and help you avoid unguarded conversations that could become admissions. If collections start, we stabilize the file and secure a workable installment agreement while we resolve the dispute. To speak confidentially with our dual licensed California Tax Attorneys and CPAs, call 800-681-1295 or book a reduced-rate initial consultation online HERE today.
