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What Happens if the EDD Reclassifies my Independent Contractors as Employees?

In a previous blog post we discussed the factors to consider in determining whether your workers are employees or independent contractors. So what if your business is audited by the EDD and the auditor determines that your “independent contractors” should actually be classified as “employees”? The result of such a determination by the EDD is that the compensation received by those workers in the tax periods under audit will be considered “wages”, subject to state employment taxes (also known as state payroll taxes). State employment taxes are Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and Personal Income Tax (PIT) withholding.

What compensation is considered wages?

According to the EDD, wages are all compensation for an employee’s personal services, whether paid by check or cash, or by the reasonable cash value of noncash payments, such as meals and lodging. The method of payment, whether by private agreement, consent, or mandate, does not change the taxability of wages paid to employees. Payments are considered wages even if the employee is a casual worker, a day or contract laborer, a part-time or temporary worker, or is paid by the job, day, hour, piece rate, salary, or any other method or measurement. Supplemental payments, including bonuses, overtime pay, sales awards, commissions, and vacation pay, are also considered wages.

Personal Income Tax Wages

Personal Income Tax (PIT) wages are cash and noncash payments subject to state income tax (different and separate from state employment tax). Wages that must be reported on an individual’s California income tax return are PIT wages. Most payments for employees’ services are reportable as PIT wages. For additional information, refer to Information Sheet: Personal Income Tax Wages Reported on the Quarterly Contribution Return and Report of Wages (Continuation) (DE 9C), DE 231PIT.

What types of compensation are not considered wages?

The EDD has specified certain types of payments that are not subject to state employment taxes or reportable as PIT wages.

• Payments to a child under the age 18 years who is employed by his or her father or mother (or by a partnership consisting only of father and mother), or service performed by an individual who is employed by his or her son, daughter, spouse, or registered domestic partner. See Information Sheet: Family Employment, DE 231FAM.

• Payments to a child under the age 18 years who is employed by his or her father or mother (or by a partnership consisting only of father and mother), or service performed by an individual who is employed by his or her son, daughter, spouse, or registered domestic partner. See Information Sheet: Family Employment, DE 231FAM.

• Repayment of required or necessary business expenses incurred by the employee while performing services for the employer (e.g., travel expenses).

• Sickness or accident disability payments made more than six calendar months following the last month in which the employee worked (subject to PIT withholding and reportable as PIT wages).

• Severance payments if the purpose is to supplement Unemployment Insurance benefits (reportable as PIT wages).

• Vacation or holiday pay earned but not paid prior to the termination of employment (reportable as PIT wages).

• Health insurance premiums or health care expenses paid by the employer on behalf of the employee or the employee’s dependents who have not reached 27 years of age by the end of the taxable year. Refer to Section 938.4 of the CUIC.

• Sickness or accident disability payments under a workers’ compensation law.

• Moving expenses, if it is reasonable to believe the expenses are an allowable deduction to the employee under Sections 217 and 132 of the IRC.

• Employee achievement awards, if it is reasonable to believe the amount is excludable from gross income under Section 74(c) of the IRC.

• Scholarship payments or fellowship grants, if it is reasonable to believe the amount is excludable from gross income under Section 117 of the IRC.

• Dependent care assistance programs, if it is reasonable to believe the amount is excludable from gross income under Section 129 of the IRC.

• Payments from a qualified plan to an employee for retirement (subject to PIT withholding for California residents unless the recipient elects exemption from withholding).

• Employer contributions to a trust under Section 401(a) of the IRC or to an annuity plan under Section 403(b) of the IRC. Employer contributions to certain qualified retirement or deferred compensation plans, such as those defined in Sections 401(k), 408(k), 408(p), and 403(b) of the IRC, are also not subject to employment taxes, unless the contributions result from a salary reduction agreement. Refer to the DE 231TP for the status of employee contributions to retirement plans. DE 231A Rev. 17 (7-16) (INTERNET) Page 2 of 3

• Employee payroll deductions made under a cafeteria plan that follows the provisions of Section 125 of the IRC made for the following purposes:

– Medical insurance

– Dental insurance

– Vision insurance

– Life insurance

– Dependent care assistance

– Reimbursement of medical or hospital expenses

• Fees paid to a director of a corporation for performing services in the capacity of a director as defined in Section 622(b) of the CUIC. These services are subject to PIT withholding and reportable as PIT wages if the director is a common law employee. Refer to Information Sheet: Employment, DE 231. Payments to directors for services not defined in Section 622(b) of the CUIC may be considered wages for all employment tax purposes. • Back pay awarded to an employee because the employer failed to comply with the Worker Adjustment and Retraining Notification (WARN) Act (subject to PIT withholding and reportable as PIT wages).

So what happens next if my workers are determined to be employees?

The auditor will issue a Notice of Assessment to you. This notice will explain the details of what state employment taxes you owe as a result of the determination that your workers are employees. If you are unable to pay this assessment outright, you have the option of getting on a payment plan. You may also appeal the determination if you feel it was made in error.

Contact a Tax Attorney

If you have been audited by the EDD or are currently facing an EDD audit, contact a tax attorney at Disparte Tax Law for a free consultation. We can help guide you through the process and advocate on your behalf.

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