IRS and EDD 1099 Worker Misclassification Cases

The contemporary labor environment, especially in California, has blurred the lines between employees and independent contractors. While the distinction may appear primarily administrative, it carries critical legal and tax implications. Employers who treat workers as 1099 contractors improperly risk exposure to back payroll taxes, interest, and harsh penalties at both the federal and California state levels. Even a single unemployment claim or labor complaint by a let-go independent contractor or sub contractor can trigger an Employment Development Division (EDD) or IRS inquiry—potentially expanding into a criminal tax investigation if misclassifications and other payroll tax understatements appear willful.

California, in particular, has intensified scrutiny via the ABC test (Dynamex, AB 5, AB 2257), making it harder to classify certain workers as contractors. Meanwhile, the IRS continues to apply a 20-factor test (or “common law” rules) at the federal level. Mastering these dual sets of standards—and the statutory exceptions (e.g., Proposition 22, Borello professions)—is essential to avoiding crippling fines, trust fund recovery penalties, and the possibility of felony tax charges for repeated or intentional noncompliance.

When you receive a California state or federal notice of an employment tax audit from the IRS or a state taxing authority, the notice will usually outline the audit’s scope and schedule. At that point, you should immediately gather all pertinent records and consider retaining an employment tax law firm to represent you throughout the proceedings. At the Tax Law Offices of David W. Klasing, our dual-licensed California Tax Attorneys and CPAs understand the gravity of federal and California worker classification and employment tax audits. We assist in preparing for the audit by meticulously reviewing your employment records to identify any errors or noncompliance that may become the focal point of the state or federal examination. Contact us online HERE or call 888.310.3543 for a reduced rate initial consultation.

Why Are 1099 Contractor Audits Increasing?

In California, the EDD administers payroll taxes and unemployment benefits. A major red flag occurs when a purported “independent contractor” applies for unemployment benefits—implying the individual was actually an employee. This discrepancy often triggers a misclassification audit, where the EDD seeks unpaid employment taxes (e.g., unemployment, disability) and imposes fines for each misclassified worker.

On the federal side, the IRS monitors 1099 usage for possible underreporting of income and the absence of required payroll tax withholdings. Businesses with a large number of “contractors” may draw particular scrutiny—especially if these workers fulfill core, ongoing roles that typically belong to employees.

When you receive a California state or federal notice of an employment tax audit from the IRS or a state taxing authority, the notice will typically detail the audit’s scope and schedule. At that point, you should promptly gather all relevant records and consider retaining an employment tax law firm to represent you throughout the process. At the Tax Law Offices of David W. Klasing, our dual-licensed California Tax Attorneys and CPAs understand the seriousness of worker classification and employment tax audits. We assist in audit preparation by carefully reviewing your employment records to identify any errors or noncompliance that may be targeted during the examination.

Key Legal Frameworks: Federal vs. California

Federal and California state agencies—including the IRS and the California Employment Development Department (EDD)—have dramatically increased their oversight of businesses that utilize 1099 independent contractors.

An EDD audit is commonly triggered when a worker who is classified as a “contractor” files for unemployment, while an IRS audit may result from red flags on your personal or entity tax returns or matching anomalies in your payroll reporting. Both agencies can impose substantial back taxes civil and criminal tax penalties, and even recommend life-altering criminal prosecution if they deem that you have willfully misclassified employees.

Federal Law: The 20-Factor Test

For federal tax purposes, the IRS evaluates worker classification using three core standards—behavioral control, financial control, and the relationship of the parties—all analyzed under what is commonly known as the “20-factor test.” This test requires employers to consider a variety of factors to determine whether a worker should be classified as an employee or an independent contractor.

Key Factors Assessed by the 20-Factor Test:

Behavioral Control:

• Who controls the order or sequence of work?
• Does the employer set detailed working hours or provide explicit instructions?
• How much training or supervision does the worker receive?
• Is the worker required to work on the employer’s premises or submit regular reports?

Financial Control:

• How is compensation provided (hourly, by project, or otherwise)?
• Does the worker have the opportunity to realize a profit or suffer a loss?
• Are business or travel expenses covered by the employer?

Relationship of the Parties:

• How continuous is the relationship between the worker and the employer?
• Does the worker have their own facilities or provide services to multiple entities?
• Is the worker integrated into the core business functions?

When an employer exerts significant control—such as by setting the order and sequence of work, providing tools and training, and closely integrating the worker’s role into the company’s primary operations—the IRS is more likely to classify that worker as an employee. This classification requires the employer to withhold payroll taxes, contribute to Social Security and Medicare, and comply with other employment tax obligations.

Conversely, if a worker operates independently, manages their own schedule, supplies their own tools, and provides services to multiple clients, they are more likely to be classified as independent contractors. Misclassification not only increases the risk of costly back taxes and interest but can also lead to severe civil tax penalties—and, in cases of willful misclassification, even life-altering criminal tax charges. Employers must carefully document both contractual agreements and day-to-day practices to ensure they align with these federal guidelines, thereby avoiding the risk of audits and enforcement actions that can be financially and legally devastating.

California Law: The ABC Test

Under Dynamex (2018) and AB 5 (refined by AB 2257), California presumes all workers are employees unless the company proves all three of the ABC prongs:

1. A: The worker is free from the hirer’s control when performing the work.
2. B: The worker’s tasks lie outside the company’s usual course of business.
3. C: The worker habitually engages in an independently established trade/occupation of the exact nature.

If the worker fails any prong, they must be classified as employees, triggering wage/hour protections, mandatory withholdings, and potential liability for prior misclassification. Note that certain professionals (doctors, lawyers, real estate agents, barbers, etc.) revert to the older Borello standard, analyzing multiple control factors. Borello still generally presumes the worker is an employee unless proven otherwise.

Proposition 22 for App-Based Workers

California’s Proposition 22 (passed in November 2020) exempts certain app-based rideshare and delivery workers from the ABC test, classifying them as independent contractors if specific conditions are met (flexible scheduling, no forced acceptance of tasks, etc.). This measure primarily affects companies like Uber, Lyft, and DoorDash but does not override classification rules outside of app-based transport/delivery contexts.

If you aren’t sure how to file with the IRS or state of California or believe you may have fallen out of compliance with California or federal law, the knowledgeable dual licensed Employment Tax Attorneys & CPAs at the Tax Law Offices of David W. Klasing are here to help. Call our offices at (888) 310-3543 to set up an appointment online to talk about your situation.

Misclassification Risks: Civil, Criminal, and Trust Fund Tax Penalties

Employers who misclassify workers as 1099 contractors instead of employees face a broad spectrum of penalties under both federal and California law. Whether the misclassification is deemed negligent or willful, the consequences can include significant back payroll taxes, interest, and civil fines. For example, if the IRS or state taxing authority determines that a worker was indeed an employee, your business may be assessed:

• Back Payroll Taxes: Covering FICA, FUTA, Medicare, and state unemployment/disability taxes.
• Interest and Civil Penalties: Interest accrues from the original due dates; under California Labor Code §226.8, willful misclassification can trigger civil fines ranging from $5,000 to $25,000 per worker per violation.
• Information Return Penalties: Failing to file accurate returns (e.g., W-2s, 1099s) may result in additional fines under IRC §6721.
• Deposit Penalties: Late deposits of withheld taxes can lead to increased penalties under IRC §6656(b).

In addition, responsible persons within a business may be held personally liable for unpaid trust fund taxes, as the IRS can pursue personal assets—often without the shield of bankruptcy (United States v. Sotelo, 436 U.S. 268).

Beyond these civil penalties, intentional misclassification can expose your business to criminal tax liability. Under statutes such as 26 U.S.C. §7202, §7206, and §7201, willfully misclassifying workers to avoid payroll tax withholding can result in:

• Felony Charges: Criminal prosecution may lead to imprisonment of up to five years.
• Substantial Fines: Fines may reach $100,000 for individuals or $500,000 for corporations.
• Restitution Orders: Courts may require repayment of back taxes, penalties, and accrued interest.
• Additional Penalties for Fraudulent Withholding: Employers who knowingly provide false wage or tax statements can face extra fines per statement, with the potential for imprisonment.

Employees, too, may be subject to penalties for filing fraudulent withholding allowance certificates or providing incorrect tax identification numbers (TINs) under IRC §§6682(b) and 7205(a). Misclassification not only results in significant civil liability but also risks personal exposure under the Trust Fund Recovery Penalty (TFRP) and potential criminal tax prosecution if willful conduct is established.

Worker Classification Audits and Common Pitfalls

A single ex-worker applying for state unemployment or complaining about wages often alerts the California EDD, which can expand the inquiry to the entire workforce. On the federal side, routine DIF or tip matching might reveal payroll anomalies, prompting an IRS employment tax audit. Red flags include:

• Core Business Functions: Workers performing integral tasks that typically belong to employees.
• Cash Payments: Paying in cash or “under the table,” especially if workers claim jobless benefits.
• Mixed W-2 and 1099: A worker partially reported as W-2 but also received a 1099.
• No 1099 or W-2: Failing to issue any form, leaving the worker with no impetus to file taxes.

If you sense a willful pattern—like historically mislabeling employees or diverting withheld amounts to other expenses—you could face a high-risk “eggshell” audit scenario. In such audits, every word or record you supply can prompt a “last affirmative act of tax fraud,” exposing you to felony tax charges. Non-attorney CPAs can be forced to testify against you if subpoenaed, emphasizing the importance of seeking attorney-client privilege through an experienced dual-licensed tax lawyer-CPA. At the tax law offices of David W. Klasing, our skilled and reputable criminal tax defense attorneys have the Attorney-Client Privilege and Work Product Privileges that will prevent the very professional that you hire from potentially being forced to become a witness against you, especially where they prepared the returns that need to be amended in a subsequent criminal tax audit, investigation or prosecution.

Remember: IRS and California state agencies (like the EDD, the Franchise Tax Board, or the Labor Commissioner) frequently share data. A conclusive state-level determination that your “contractors” are employees may invite an IRS trust fund or criminal tax referral—and vice versa—further compounding liabilities and raising the specter of parallel criminal tax charges.

Pro Tip:  If you commonly utilize undocumented workers in your business this is exponentially more dangerous in the current federal political environment.

Steps to Address or Avoid Misclassification

Proper Documentation and Controls

Maintain well-drafted, realistic independent contractor agreements that genuinely reflect the worker’s self-directed status. Keep records demonstrating the worker’s ability to accept or reject projects, their ownership of tools, and their independence from day-to-day managerial oversight—particularly in states applying the ABC standard. However, remember that an agreement’s label alone is insufficient if actual work conditions reveal employee-level control.

Preemptive Classifications or Voluntary Programs

• Form SS-8: Employers can ask the IRS for a formal classification ruling (though this can be risky if unfavorable).
• Voluntary Classification Settlement Program (VCSP): Qualifying businesses can reclassify future workers as employees with reduced tax liabilities for past periods. Consultation with an attorney before filing is crucial, as it opens lines of disclosure with the IRS.

Amended Returns or Disclosures

If you realize you’ve consistently misclassified workers, timely amended returns or a structured voluntary disclosure (where possible) can mitigate penalties and avert a worst-case scenario. However, once an audit or investigation commences, the door may close on lenient settlement options.

Note:  As long as a taxpayer who has willfully committed tax crimes self-reports the tax fraud (including a pattern of non-filed returns) through a domestic or offshore voluntary disclosure before the IRS has started an audit or criminal tax investigation/prosecution, the taxpayer can ordinarily be successfully brought back into tax compliance and receive a nearly guaranteed pass on criminal tax prosecution and simultaneously often receive a break on the civil penalties that would otherwise apply.

How to Prepare for an IRS or EDD 1099 Independent Contractor / Worker Classification Audit

Gather Evidence that proving that they are “Truly Independent.”

If you rely on 1099 contractors, immediately collect documentation that establishes each individual’s independent status. Begin with the “nuts and bolts”:

1. Business Indicators
   • Are they willing to show business cards or a license?
   • Do they have a website or advertise publicly (Google, flyers, social media)?
   • Can they provide proof of maintaining their own insurance?
2. Signed Contracts (if Dated Properly)
   • If you have an older, valid independent contractor agreement, that’s excellent.
   • Warning: Do not create brand-new agreements mid-audit and submit them to the auditor—it looks suspicious and can backfire, leading a routine civil tax audit to escalate to the clandestine IRS-Criminal Investigation Division.
3. Invoices & Payment Records
   • Ensure there is a paper trail for all 1099 payments, ideally correlating to discrete projects or tasks rather than a stable “wage.”
4. Social Media Checks
   • If a contractor’s LinkedIn says “Employee” of your business, that is a red flag. Ask them to correct it if it is factually inaccurate.

Group Workers by Function

If you have numerous individuals, consider grouping them by their roles rather than simply labeling them as W-2 vs. 1099. For instance, create categories such as “Sales,” “Administrative,” or “Professional Services.” Within each group, identify who is an employee and who is a contractor—then confirm there is a legitimate basis for that split.

High-Risk Areas: Workers directly tied to your core revenue streams (e.g., main production staff in a manufacturing firm) are more likely to be flagged as employees, primarily if they work exclusively or predominantly for you.

Google & Social Media Screening

EDD Auditors Do i—So Should You

• The auditor has likely Googled your business already. They will also look up your contractors to see if they’re self-identifying as employees or disclosing external clients.
• If you find an anomaly—like a contractor publicly calling themselves an employee—ask them to correct it before the audit. Consistency is key.

Employee vs. Business Identity

• A worker listing themselves on Facebook as “XYZ Company’s Staff” or “inhouse professional” can cast doubt on your classification.
• Politely ensure that profiles accurately reflect the reality of them being an independent business operator.

Other Key Documents

Professional Licenses

Doctors, attorneys, cosmetologists, or any licensed professional present a stronger case for independence if they hold themselves out as a self-run practice.

Insurance Certificates

Liability or commercial insurance in the contractor’s name is excellent proof they are not relying on your coverage.

Marketing Collateral

Any promotional flyers, business cards, or websites they have created is tangible evidence of a separate enterprise.

The Risk of Last-Minute Contractor Agreements

Some businesses try to whip up brand-new “independent contractor agreements” during an audit. This can look as though you are trying to fabricate evidence. If you have no existing contract, it may be better to explain the arrangement directly rather than furnishing freshly minted documents.

Why it is Counterproductive

• The auditor may assume the worker was never truly independent, especially if the agreement’s execution date is during or right before the audit.
• Any sense of deception can escalate the issue, potentially inviting fraud penalties or even IRS-CID’s criminal tax referral.

How the Tax Law Offices of David W. Klasing Can Protect You

If a consistent pattern is observed—such as repeatedly misclassifying employees or reallocating withheld taxes to other expenses—you may be facing a high-risk “eggshell” audit. In these audits, every document and statement you provide could trigger what might be considered the “last affirmative act of tax fraud,” potentially exposing you to felony employment tax charges for actions that are outside of the ordinary 5 or 6 year statute of limitations. Since non-attorney CPAs can be compelled to testify if subpoenaed, it is essential to secure attorney-client privilege by working with an experienced dual-licensed tax lawyer-CPA. At the Tax Law Offices of David W. Klasing, our reputable criminal tax defense attorneys enjoy both Attorney-Client and Work Product Privileges, ensuring that even the professionals you hire are protected from being forced to testify against you—especially if they prepared the returns that later need amendment in a criminal tax audit, investigation, or prosecution.

Preemptive Classifications or Voluntary Programs

1. Form SS-8: You may request a formal classification ruling from the IRS—though this can be risky if unfavorable.
2. Voluntary Classification Settlement Program (VCSP): Qualifying businesses can reclassify workers as employees for future periods while paying reduced taxes for prior years. Attorney consultation is critical before filing, as it opens lines of disclosure with the IRS.

Amended Returns or Disclosures

If you realize you have consistently misclassified workers, timely amended returns or the Voluntary Classification Settlement Program (VCSP) may significantly reduce penalties and avert the worst outcomes. Once an audit or criminal employment tax investigation begins, however, lenient settlement options narrow considerably or disappear altogether.

Contact the Tax Law Offices of David W. Klasing Today If You Are Worried About IRS 1099 Worker Misclassification Cases

At the Tax Law Offices of David W. Klasing, our boutique law firm of dual-licensed Criminal Tax Defense Attorneys & CPAs brings decades of experience to bear in managing both California and federal worker classification audits, employment tax controversies, and high-risk “eggshell” scenarios. We provide comprehensive worker classification analysis by measuring your business model against the ABC test, Borello exceptions, Proposition 22 criteria, and the IRS’s 20-factor guidelines—ensuring you clearly understand risk areas and discover potential compliance solutions. Our robust employment tax and worker classification audit representation includes responding to IRS or EDD notices, clarifying records, and structuring every phase to prevent disastrous disclosures or the expansion of employment tax audits across multiple years or entities. We also facilitate entry into voluntary programs like the Voluntary Classification Settlement Program (VCSP) where applicable, balancing penalty reduction with the risk of sensitive information disclosure, and we aggressively defend your constitutional rights if criminal tax charges—such as those arising under 26 U.S.C. §§7202, 7206, or 7201—are pursued.

Employers must take proactive steps to avoid misclassification allegations by verifying worker status with the government and maintaining detailed, consistent documentation. If errors occur, whether intentional or unintentional, our legal team works diligently to protect your company from back taxes, interest, and crippling civil or criminal tax penalties. We assess your exposure, help resolve misclassifications through amended returns or voluntary disclosures, and, if necessary, negotiate penalties to mitigate liability. With our integrated legal and accounting expertise, we safeguard your company’s and personal assets from the severe repercussions of 1099 misclassification. Call us at (800) 681-1295 or contact us online to schedule a reduced-rate initial consultation and learn how we can help secure your future while keeping your business compliant.