In our last article, we examined the questions that are asked in an independent contractor audit. In this article, we would like to examine the purpose behind those questions in a little more depth.
The auditor’s first goal in an independent contractor audit is establishing a system and a pattern of routine for the business’s operations. For example, if we have a retail store and the retail store has two locations, in each location, we have anywhere between five and seven employees at a time. The Employment Development Department auditor will use that information to develop a pattern within the business on who the key members of the business are. Essentially, who are the key members of the business and what services do those individuals perform.
The auditor here is establishing a pattern of who the business's workers are that function as employees. The reason the auditor doing that obviously is to compare the employees to any independent contractors that the business may have. The Employment Development Department wants to look at the key functions that each employee performs. The EDD auditor is going to take those functions and then compare and contrast those functions to those performed by independent contractors. They are going to see if there are similarities between the two and, if so, you could be in for big trouble.
For example, you might have a situation where you have a business with both salespeople who are W2 salaried employees and who were issued 1099s. If the functions of the 1099 worker and the employee are the same, the Employment Development Department is going to seek to reclassify the 1099 worker as an employee (and hold the employer liable for all the past due employment taxes) absent sufficient justification from the employer they should be treated as a contractor. The initial scope of those questions is to establish background on the business, create a framework for who the employees are in the business and what they do.
Additionally, the Employment Development Department is going to look at form of entities as well. During the independent contractor audit, the auditor is going to look to see if there are maybe multiple payroll tax accounts associated with the business. For example, you often have time where you have a sole-prop business that will incorporate during some time in the audit period in question, so the EDD auditor will go back and look at both accounts, to try and trace the accounts to establish some sort of the normalcy. They will look for consistent treatment between the employees and the independent contractors over the life of the business’s operations.
In some situations, during an independent contractor audit, you may encounter a situation where you have a business that may be associated with some bad behavior in the past. The new owner, prior the audit, decides to scrap the entity and create a new entity. The Employment Development Department is going to be trying to look for similarities there too. The auditor will be looking for who is calling the shots at the business. Who is really directing control? Who is managing operations? Who is signing checks? Who is really the responsible party? This is important not only from an officer compensation standpoint, but from a business continuity standpoint. Evidence that there was deliberate action to defeat the collection of payroll tax will be treated potentially as fraud.
The Employment Development Department also is going to want to know who the officers are in the company and how they are getting paid. However, the EDD auditor is seeking to also establish who has some level of control over the business. That way, if there is a payroll tax assessment later against the business and the business decides to shut down, the Employment Development Department will have information on who the responsible parties are. The EDD can use that information to pursue an assessment against those responsible parties.
Finally, the EDD is also going to examine reasonable compensation issues. The EDD auditor is looking at the salaries of each officer and the relationship/ratio of K-1 distribution income associated with each officer. The reason for this is that the EDD auditor is making sure that officer compensation paid through W-2 salary is not set arbitrarily low and/or that there is a fair balance between salary and profit distributions based on 1) their position, 2) their job duties and responsibilities, and 3) the fair value of their service contributions to the business.