Managing employee payroll taxes can get quite complicated, with a number of areas being particularly opaque. One of those is the question of employee classification; is a person properly classified as a worker or an independent contractor?
Misclassifying workers as independent contractors carries with it some significant consequences, including penalties and even potential fraud prosecution, so it is a topic worth exploring in some detail.
The California payroll tax structure for an employer in this state is based on four distinct taxes, commonly referred to as the CA SUI, ETT, SDI, and PIT payroll taxes. There are different rates for each of these taxes and the calculation methods are different as well.
The California Employment Development Department can legally withhold money owed to you by the state for repayment of debt. In other words, either through error or willful action, you owe a monetary debt to the State of California.
The EDD is within its legal rights to withhold money from a variety of programs and tax refunds if you do not pay up. It works with the California Franchise Tax Board, the State Lottery, and the State Controller to collect the outstanding debt.
It is that most un-wonderful time of year: tax time. April 15 may be a bit far away, but as a small business owner, you need to get your documentation for 2016 together as soon as possible. Your tax professional will thank you.
By the way, one of the changes for next year includes moving a filing deadline from April 15 to March 15 if your business structure is a pass-through. More on that later. First, here is a rundown of the documents you need to gather for your accountant.
What does the employment classification of workers have to do with payroll tax audits?
Everything.
When the Employment Development Department of the State of California decides to audit, the classification of your workers is the auditor’s sole concern. Additionally, the IRS often adopts the results of the EDD audit to use in assessing federal penalties.
For this reason, it is critical to classify your workers properly and supply only the information the auditor asks for, nothing more.
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In a previous post, we talked about the difference between independent contractors and employees. One of the biggest differences, and one that often drives intentional worker misclassification, is that employers must withhold and pay payroll taxes for employees whereas they do not for independent contractors.
You have hired someone to do work for you. Is that person an employee or an independent contractor?
The answer is important because misclassifying an employee as an independent contractor, whether intentionally or through ignorance, can land you in court and in debt for payroll taxes.
There are several tests from a variety of regulatory agencies that are used to try to determine employment status and occasionally changes are made to the standards. Even if you classified certain of your workers correctly before, you might need to revisit the question to ensure you remain in compliance.
Small businesses, of which there are thousands in California, spend the highest percentage of time of any business entity preparing and submitting taxes. Federal, state, and local tax requirements are extremely complex and change every year.
Multiple agencies administer different taxes, and each has its own set of rules and methods of payment. It is no wonder that small business owners often have common tax issues and outcomes of inadvertent noncompliance.
EDD payroll tax problems in California typically come down to two things: misclassifying workers as independent contractors, and falling behind on payroll tax deposits.
The California Employment Development Department administers four separate payroll taxes: Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and Personal Income Tax (PIT) withholding. If you’re behind on any of them — or if EDD questions how you’ve classified your workers — the exposure can reach back three or four years and include both the back taxes and penalties on top.
The whole question of whether someone is your employee hinges on a three-part test under California law — and the default answer is that they are.
California’s ABC test, codified at Labor Code § 2775 through AB 5, starts from the presumption that any worker providing services is an employee. To treat someone as an independent contractor, you have to satisfy all three parts: (A) the worker is free from control over how the work is performed, (B) the work falls outside the usual course of your business, and (C) the worker is customarily engaged in an independently established trade or occupation.
Part B is where most businesses get tripped up. If you run a construction company and you hire someone to do framing, that work is not “outside the usual course” of your business, regardless of how the arrangement is labeled. If EDD reclassifies your contractors as employees, it assesses back UI, SDI, ETT, and PIT withholding for every one of them — often three to four years back, with interest and penalties added.
California payroll tax deposits are due on a schedule tied to your federal deposit frequency — missing them triggers a 15% penalty from EDD, and personal liability follows.
The late deposit penalty is 15% of the amount due. That adds up quickly on payroll that runs into the hundreds of thousands of dollars.
Here’s the part that catches business owners off guard: California Unemployment Insurance Code § 1735 allows EDD to assess personal liability against any person with control over payroll who willfully fails to remit. Officers, owners, check signers, and anyone with authority over which bills get paid can be assessed individually, even after the company shuts down.
An employer in trouble with EDD is often in trouble with the IRS at the same time.
The IRS equivalent is the Trust Fund Recovery Penalty (TFRP) under IRC § 6672. It assesses 100% of the employee’s share of FICA and withheld income tax against any responsible person who willfully failed to remit. The willfulness standard does not require intent to evade — courts have found willfulness when a business owner paid other creditors while knowing payroll taxes were overdue. EDD and IRS investigations run on parallel tracks. An audit from one agency does not prevent the other from opening its own.
EDD audits typically cover the three most recent tax years and focus on worker classification, payroll records, and the gap between what you reported and what the records show.
Auditors request payroll records, contractor agreements, 1099s, and bank statements. They compare your reported wage base against total compensation paid and flag discrepancies. Cooperation matters, but statements made during an audit can expand its scope. If the audit looks likely to produce a large misclassification assessment, having counsel present before the auditor interviews anyone is worth considering.
Resolution options include installment agreements, Offers in Compromise, voluntary disclosure, and challenging the audit findings on appeal.
If you have not yet been contacted by EDD, voluntary disclosure is the strongest option. EDD’s Voluntary Disclosure Program allows employers to come forward, report unreported wages, and pay back taxes with significantly reduced penalties. Early self-correction consistently produces better outcomes.
If EDD has already assessed a liability, an Installment Payment Agreement is typically the first step. For businesses or individuals who cannot pay in full, EDD also has an Offer in Compromise program — separate from the IRS’s — with similar eligibility standards: doubt as to collectibility or hardship that makes full collection inequitable.
If the assessment itself is wrong, there is a formal appeals process through the California Unemployment Insurance Appeals Board (CUIAB). Appeals on misclassification can succeed, but the ABC test sets a high bar and the burden is on the employer to prove all three prongs.
Yes. Under California Unemployment Insurance Code § 1735, EDD can assess individuals — officers, owners, and others with control over payroll — for unpaid UI, SDI, and PIT withholding if the business fails to remit. The personal assessment is not limited to what the business still owes; it attaches once the liability is established and the company does not pay.
California’s ABC test under Labor Code § 2775 sets the standard for worker classification. All three prongs must be satisfied to treat someone as an independent contractor: they must be free from your control, their work must fall outside your core business, and they must operate an independently established business. Most staffing arrangements fail Part B, which is why EDD audits so frequently end in reclassification.
EDD will issue a Notice of Assessment after the audit closes. You have 30 days to file a written protest, and if the protest is denied, you can appeal to the California Unemployment Insurance Appeals Board (CUIAB). The CUIAB is an independent administrative tribunal; hearings are conducted by administrative law judges. You can also appeal further to the superior court.
The 15% late deposit penalty is typically assessed at the time of the audit finding and is generally not waived just because you enter an installment agreement. Some penalty abatement is available for first-time failures with a reasonable cause, but it requires a specific written request and EDD evaluates it on a case-by-case basis.
If you’re working through an EDD payroll tax problem — whether it’s an audit letter, a reclassification assessment, or falling behind on deposits — our overview of California payroll tax obligations covers the full landscape, and our tax debt resolution page walks through your options for resolving back payroll tax debt. Book a free 15-minute call to talk through where things stand.
Whether you’re dealing with an EDD audit, trust fund recovery penalties, or unfiled 941s, payroll tax issues compound quickly. A brief review can clarify what you’re facing and what resolution options apply.
Discuss My Payroll Tax Issue → Or call: (619) 378-3138
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If you have employees, you are liable for federal payroll taxes. Some taxes are withheld from your employee’s wages, some you must pay yourself.
The Internal Revenue Service, or IRS, administers payroll taxes as part of its responsibilities. Remaining in compliance means understanding how and when payroll taxes are calculated, filed, and paid.