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The Risk of Treating Employees as Independent Contractors – EDD and IRS Headaches

By Robert S. Schriebman

This is a very vast topic, and one can probably write a book about what happens when an employer treats employees as independent contractors. As a matter of fact, I did write a book about it! It is entitled CALIFORNIA TAXATION PRACTICE AND PROCEDURES and was published by Commerce Clearing House in 2005. Therefore, this current discussion will be an overview.

Misclassifying employees as independent contractors in order to save payroll taxes and be more competitive can land you in hot water with both the IRS and EDD.

At the IRS level things are changing rapidly. In September 2011, the IRS signed an agreement with the US Department of Labor (US DOL) to work together in punishing those who misclassify workers. If the IRS discovers employee misclassification, it will notify the US DOL. Conversely, the US DOL will notify the IRS when it discovers employee misclassification. Each federal agency will hand over the violator to the other agency. Misclassified employees may also be entitled to damages for violation of their civil rights under Title VII of the Civil Rights Act of 1964. These misclassified workers may also have rights to employee benefits as well as retirement plan contributions much in the same way that a returning US service member will retain his or her employment rights when they return to their jobs after serving their country.

If you do business as a corporation or LLC and you have misclassified your employees as independent contractors you may be in for a four-part whipsaw. Let us look at this through the eyes of both the EDD and the IRS. These could be very large headaches indeed.

EDD HEADACHES

Before we even begin to look at all the tax problems generated by the misclassification of workers, let us first turn our intention to the California Department of Labor (DOL). There are teams of EDD and DOL personnel who travel together in one vehicle. If they spot a potential employment violation they will get out of the car and “take names.” The employer will first be brought before the DOL for a series of hearings that will result in stiff fines for misclassifying workers, paying workers under the table, and not giving them the appropriate paperwork such as a regular wage and hour report. A fine will be assessed for each violation – each payroll tax period. Those fines are stiff and add up fast. These hearings will be attended by both DOL and EDD representatives. Therefore, anything you say at these hearings will be heard by two agencies.

After the DOL is finished with the employer, the matter is turned over to the EDD for an employment tax audit. The audit can go back as far as eight years depending upon the employer’s failure to file quarterly payroll tax returns.

After the EDD audit there will be an assessment issued at the corporate level. If this assessment is not contested or paid, the EDD will “pierce the corporate veil” and hold corporate officers personally liable for every cent owed by the corporation or LLC pursuant to CUIC § 1735.

IRS HEADACHES

The EDD and the IRS have agreements that provide the sharing of information between the state and federal governments. The IRS does not look at every EDD case, but they do not tell me what triggers their curiosity and involvement. When a client asks me what the odds are of IRS involvement I reply, “If the IRS gets involved in your EDD matter, the odds are 100% against you!”

The IRS will use all of the investigative reports and working papers prepared by the EDD in its examination efforts and will use the EDD’s findings in deciding whether workers are employees. In other words, the IRS will not remake the wheel. The IRS tax and penalty rates are many more times higher than the EDD rates, so you can expect a relatively large IRS bill.

The IRS will initially issue a corporate level or LLC level assessment against the entity. If the assessment is not paid the IRS will also pierce the corporate veil and hold responsible officers personally liable under the  Trust Fund Recovery Penalty set forth in IRC § 6672.

In addition to the IRS whipsaw, the employer may have to face the US DOL as well as civil rights violations as discussed above.

IN CONCLUSION

Both the EDD and IRS have never been tougher on employment tax misclassification violations. It is just not worth the exposure to save a few dollars in payroll taxes. You will wind up repaying those taxes, plus penalties and interest. The attorney’s fees involved in representation can get very expensive.

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Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure”, both published by Commerce Clearing House.