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Who is an Employee and Who is not an Employee: AN EDD WORLD VIEW

Whenever I go to an EDD office I make it a point to review the free EDD publications available to the public. The EDD publishes many free and invaluable "Information Sheets." These are on various topics including industry studies like the construction industry and the automotive repair industry. These studies serve a very practical function of allowing the practitioner to see where the EDD is coming from when it comes to an audit of your client in one of these specific industries.

Two of the most important information sheets are the ones that deal with common-law and statutory employees, Information Sheets DE231 and DE231SF. DE231 is entitled "Employment," and answers 3 key questions: Who is an employer? Who is an employee? Are there services of employees that are not covered? In other words, are there employees exempt from certain payroll taxes? This article will discuss these 3 categories of workers.

WHO IS AN EMPLOYER?

According to the EDD, a business becomes an employer when total wages paid to one or more employees are in excess of $100 in any calendar quarter. Wages can be either monetary or non-monetary compensation. The EDD does not audit startup businesses. Several years of operations go by before the EDD sends a notice of intention to audit. Therefore, this is an issue that we need to look at not by the passage of time but by the relationship between the worker and the employer. Obviously if the EDD determines that an independent contractor is in reality an employee, the hiring company is ipso facto an employer.

WHO IS AN EMPLOYEE?

An employee includes the following:

  • Any officer of a corporation.
  • Any worker who is an employee under the usual common-law rules.
  • Any worker whose services are specifically covered by law.

In the May and June 2010 issues of the California Tax Letter I discussed common-law rules and the major California cases that have interpreted those rules. I invite you to read those articles. Most of the audits that I see in my office involve small corporations. It is amazing to me how many owners of small corporations do not realize that they are employees by operation of law. It becomes my unpleasant duty to inform them that the 1099s that have been issued to them should have been W-2s and will be subject to EDD assessments for UI, DI, PIT and ETT, together with penalties and interest. There is no getting out of that part of an EDD assessment relating to owner-officers. Often the assessment against the owner-officer will be proportionately the largest dollar amount of the overall assessment. If you are an accountant or an attorney representing wholly-owned, incorporated partnerships, or family-owned corporations, you risk exposure to malpractice by not informing your clients in writing that they are statutory employees for both EDD and IRS purposes. Unfortunately, I do not see many tax practitioners doing this.

WHO IS NOT AN EMPLOYEE?

EDD publication DE231 states that independent contractors are not employees. An independent contractor is a person engaging in a separately established independent bona fide business. A bona fide business is subject to profit or loss. He or she is hired to perform a specific task and has the right to control the way the work is to be accomplished. An independent contractor has a substantial investment in a specific business and performs services to more than one business. The EDD defines an independent contractor by what it is not: "Generally speaking, they are anyone who is not an employee under the common-law rules unless they are statutory employees." This definition is not particularly helpful, but you must realize as a practitioner that this is the definition used by the EDD and we are stuck with it at the audit level. The right to control the worker is the most important single factor of the 23 factors listed in the EDD audit manual. It does not matter whether the right is exercised, it is the existence of the right to control that is used by the EDD auditor in his or her evaluation of the relationship between the parties. If there is any doubt in the mind of the EDD auditor it is usually resolved against the employer.

WHO IS AN EMPLOYEE NOT SUBJECT TO WITHHOLDINGS?

Services of certain acknowledged employees can be excluded from certain employment and withholding taxes, but you must be careful. Family members fall into this category and includes children under 18-years of age who work for their parents. Conversely, parents who work for their child may also be excluded. Spouses working for each other may also be excluded, and this exclusion should apply to same-sex marriages (see Section 297 of the California Family Code.)

There is a catch, however, to the intra-family exclusions. The intra-family exclusions only apply to businesses that are sole proprietorships or partnerships. The intra-family exclusion does not apply to a parent, child, or spouse working for a family corporation. The intra-family exclusion only applies to the UI, DI, and ETT. Wages paid to intra-family workers are subject to PIT withholdings and are reportable as PIT wages.

The next article in this series will discuss statutory employees and exempt employment.

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.