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How to Protect Your Private Practice From a California Payroll Tax Audit

Did you know you can be held personally liable for payroll taxes if the California Employment Development Department (EDD) reclassifies your independent contractors?

Yes, you read that correctly.

Most taxpayers and business owners—including those that own your own private law practice—are unaware of this fact. But because of a recent case ruling—Dynamex Operations West, Inc. v. Superior Court of Los Angeles—the EDD is getting stricter with conducting these investigations, which are essentially worker re-classification audits.

These California state payroll tax audits (commonly referred to as an EDD audit) occur when a business has classified a worker as an independent contractor instead of an employee. Essentially the EDD can personally assess the business owner/attorney for “unpaid” payroll taxes because the EDD has determined that they believe these workers are actually employees. They do this because California generally encourages workers to be classified as employees to protect them. They want the worker to be covered by worker’s compensation and have the right to collect unemployment if they were to lose their job (even as an independent contractor).

I know what you’re thinking. This is very confusing and frustrating to many business owners and taxpayers.

But if you’ve ever hired an independent contractor, you could be facing this tax audit. And if you don’t know how to protect yourself and your practice, you could be facing a huge financial burden. Here’s what you need to know and how to safeguard your practice.

How do I know I’m facing a California state payroll tax audit?

The EDD conducts different audits to ensure that employers are functioning correctly according to state laws and the tax code. Most EDD audits start when a worker files for unemployment and the business receives a three-page letter that may seem very vague and inconspicuous.

What happens if I don’t respond to the letter?

If an EDD audit notice sits in a pile and no one responds to it, the EDD has been known to make a determination based upon the type of industry, the historical payroll of the company or the number of 1099s issued. The EDD will then send out a proposed assessment. If the company does not respond to that notice, contest it, or provide additional documentation by the deadline, then the balance due will eventually be sent to the collections department.

I’ve seen some very sophisticated business owners and private practitioners react to the EDD notice. They try to go back to the assessment side and have an agent adjust the audit results. However, they don’t realize that the left hand doesn’t talk to the right hand at the EDD. The agent on the assessment side may be working with you, while the collection side is still trying to collect the balance due.

What’s the first step to take after receiving a notice I’m being audited?

Once you’ve contacted a tax attorney, start getting your records and other relevant documents in order. Having these documents organized will be a big help in your defense. The more documentation you are able to present in your defense, the easier it will be to get you through the audit process successfully.

What kind of records might be requested from me?

The most common records the EDD requests during an audit are general employment questionnaire, payroll records, federal income tax return, bank statements, wage information for particular time frames, and employee registers. After these documents are requested, the actual audit begins and the EDD may request other additional documents.

What are the penalties associated with EDD audits?

Depending on the reason for your EDD audit, you could be liable to face a wide range of fines that can cause you a considerable amount of financial strain. These sorts of fines include a percentage of unpaid taxes, set dollar amounts for each case of unreported employees or independent contractors, and much more.

What happens if I don’t agree with the proposed assessment from the EDD?

If you don’t agree with the proposed assessment the EDD gives you after their audit is complete, you can appeal the assessment.

How do I ensure the independent contractor I hired is not considered an employee by the EDD?

This is the most difficult question to answer and it depends on your industry, the type of work you do, and how you treat the person working for you. The EDD will look for things such as whether you asked the contractor to work certain days and times, if you have signed contractors if you required them to attend company meetings or trainings, or if you did not want them working for other companies.

Receiving a California payroll tax audit is a confusing and scary matter, especially for small business owners and private practitioners who have a lot at stake. But knowing what to expect and handling the request will help you immensely as you navigate the murky waters of the EDD audit.

Allison Soares

Allison Soares is a partner and tax attorney at Vanst Law. Before starting her own practice, Soares was a partner at a tax law firm where she honed her skills handling a wide variety of tax and employment-related cases. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits.

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About the Author: Allison Soares is a partner and tax attorney at Vanst Law. Before starting her own practice, Soares was a partner at a tax law firm where she honed her skills handling a wide variety of tax and employment-related cases. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits.

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