IRS vs. California EDD on Reclassification of Independent Contractor

California businesses whose outside contractors are examined for misclassification wish they had a Jedi mind power over auditors to say: “These are not the workers you are looking for.”

Because the IRS and the California Employment Development Department (EDD) have somewhat different approaches when examining worker classification for independent contractors, it is important to understand where the similarities between the two examinations end. In a nutshell, federal law is more generous in limiting IRS reclassification of independent contractors and in options to reduce potential liability than offered by the EDD, but requires diligence in either event to assert rights. On the appeals side, businesses may overlook the necessity to affirmatively pursue cases. With EDD appeals businesses may not realize that ALJ proceedings are not before a court and require at the ALJ level full pursuit of rights as the CUIAB second appeal does allow new document production as permitted before the Tax Court.

Commonality of IRS and EDD

Businesses hire an outside contractor rather than an employee for many reasons. Special expertise is one reason. Another related reason is limited resources make more cost effective to contract for an outside service as needed, rather than to have permanent staffing. On the other hand, both the IRS and the EDD are concerned whether businesses are trying to avoid the costs of employment, including avoiding employer payroll tax liability1. Compounding this is the fact that a worker’s classification is not always clear.

In determining a worker classification, while the tests are slightly different – the IRS has a 20-factor test, and the EDD’s analysis is based on a 10-factor test, they both share in common the fundamental question whether a business has the right to control the detail over method and manner of the worker’s services – thus making the worker an employee. This is not always self-apparent and therefore taxpayers and IRS/EDD auditors do not always agree with each other.

For example, example, assume an outside software engineer is hired to develop a software module that will regulate air intake for a carburetor. That module is critical to the overall function of a soon-to-be completed software program to operate the vehicle electronic system. To assure that the module fits into the program, the auto maker may require a particular program language be used, that it be compatible with other software components and that the module works correctly. However, for purposes of worker classification views may differ as to whether the auto maker’s exacting requirements control the method and manner of the worker’s performance – indicia that the worker is a controlled employee, or in the alternate, that the business, in setting parameters, is only seeking a working result, and is not supervising the worker. While in Detroit, an auto maker’s specifying highly exacting parts requirements from suppliers will not turn suppliers into employees, within nearly the same context, the IRS and EDD may disagree as to services.

Section 530 Safe Harbor

Given these uncertainties, for nearly 40-years, Section 530 of the Revenue Act of 1978 (Section 530) mandates that the IRS may not retroactively reclassify independent contractors as employees or impose federal employment taxes, penalties and interest if the hiring business:

  • Consistently treated the workers (and similarly situated workers) as independent contractors;
  • Complied with the Form 1099 reporting requirements with respect to the compensation paid the workers for the tax years at issue;2 and
  • Had a reasonable basis for treating the workers as independent contractors.

Accordingly, for federal employment tax purposes only, the IRS will not reclassify a worker as an independent contractor where the original classification had a reasonable basis. Such a basis may include reliance upon a previous audit examination, a custom of practice in the industry, the advice of a diligent accountant/attorney or another reasonable basis shown to the IRS.

Interestingly, a custom of practice does not require that all workers in the industry be treated the same. For example, certain sports coaches may be considered independent contractors, and not employees, wherein the community is split on their classification. Under the Small Business Job Protection Act, it is substantial if 25% of the community can be shown to be treating workers as independent contractors. In determining the reasonable basis, the fact that workers are employees for state unemployment tax or wage and hour law requirements will not make section 530 inapplicable.

By contrast, the EDD provides no such Section 530 safe harbor. This means that even where legal advice was rendered or the practice has been to treat workers as independent contractors, the EDD may still reclassify workers as employees. In addition, the IRS and EDD may share information, wherein the outcome by the EDD may differ from that of the IRS.

Reduced Assessments

Even where a worker is classified as an employee, there are provisions where the IRS grants reduced liability. Under Internal Revenue Code Section 3509, the employer liability for a misclassification error is partly reduced. While there is no direct abatement of the employer portion, as to the employee withheld portion, under Section 3509, the liability is reduced to 20% of the 7.65 percent employee withheld social security liability. The effective rate is then only 1.53%. In addition, the employer liability for failure to withhold is reduced to 1.5% of wages. However, the employer portion of taxes is not reduced. Because these reductions are significant, Section 3509 relief is often the preferred choice and is permitted provided that the employer is no to found to have intentionally disregarded the requirement to deduct and withhold tax.

While federal law also provides for the opportunity by workers to assist the deemed employer by completing consents to disclose that they have already paid their income taxes – thereby there is no withholding liability,

By contrast, the EDD provides no statutory reductions. There is no reduction to the employer liability for failure to withhold where an individual was reclassified as an independent contractor. However, the EDD allows businesses to claim a credit or to eliminate liability for failure to withhold wages where reclassified workers voluntarily submit a Form DE938P, permitting the EDD auditor to review and confirm that all wages were reported by the worker on his or her return and personal income taxes were paid. This closes out payroll withholding liability for state income taxes. Liability is then limited to the remaining state payroll taxes imposed, namely taxes otherwise withheld or charged for state unemployment insurance, state disability insurance and the employee training tax.

In addition, the EDD is not alone in issuing penalties. Under Section 226.3, the California Labor Commissioner may issue a $250/payment penalty, initially, and $1,000/payment penalty thereafter for failure on each payment to a worker for failure to provide a proper wage statement. In addition, with respect to worker misclassification, under Labor Code Section 226.8, the Labor Commissioner may further impose a penalty under Labor Code Section 226.8 for each will instance between $5,000 and $55,000 per instance in a civil penalty, which increases to $10,000 to $25,000 per instance if the agency believes the company in question followed a pattern of behavior over time. Furthermore, with California having adopted the Secure Choice Retirement Plan, to be implemented starting in 2019, and in 2022 for employers with 5 or more employees, a reclassification may result in either/both $250 and $500 fines per reclassified worker for not participating in the state’s Secure Choice IRA contribution program.

Compliance Settlement Program

In addition, the IRS provides two additional provisions for relief, the Compliance Settlement Program and the Voluntary Compliance Settlement Program. Each of these programs was updated in December 2017, to provide for greater relief.

The Voluntary Compliance Settlement Program is available to taxpayers to obtain relief without an audit examination, wherein, in addition to Section 3509 relief, liability will be limited to one tax year – and where there is possibly a custom of practice in the industry, to reduce liability to 10% of what otherwise might be assessed, provided that the workers are prospectively treated as employees. Taxpayers must meet certain eligibility requirements and apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. Eligibility obviously includes not being under an employment tax audit – for itself or any affiliate (as defined under section 1504(a) and is not contesting in court the classification of the class or classes of workers from a previous audit by the IRS or Department of Labor.

The application should be filed at least 60 days prior to the date the taxpayer wants to begin treating its workers as employees. The IRS will make every effort to process Form 8952 with sufficient time to allow for the voluntary reclassification on the requested date.

The regular Compliance Settlement Program is available to taxpayers to obtain relief during an audit examination. The business must have filed timely 1099s and may fall under one of several options. First, if the taxpayer is entitled by custom to classify workers as independent contractors, the program is optional because the IRS cannot assess a tax. If it is uncertain – and it often that where custom of practice is asserted and shown in part, then the offer will be made to pay just 25% of one year’s payroll tax found due after applying Section 3509 and entering into a closing agreement. Second, if custom of practice is denied, then the offer will be made to pay just 1 year’s payroll tax found due after applying Section 3509 and entering into a closing agreement.

If as auditors may not be completely aware of this program – and the process of entering into a closing agreement is complicated, it should be brought to the immediate attention of the auditor (and his or her supervisor) if an assessment is proposed, including the terms of December 2017 revised Internal Revenue Memorandum Section 4.23.6 Classification Settlement Program (CSP). While the program is not for all taxpayers (such as those who are out of business), it should not be assumed that the auditor understands the full scope of these procedures.

By contrast, the EDD provides no such relief. If found to be an employee during the audit period, then adjustments will be proposed for all audit years under examination.

Appeals Process

It is not unusual for the IRS and EDD auditors to reach a different conclusion than from the business. Where the IRS is involved, the next avenue is to file a protest with the IRS’s protest unit, and endeavor to have the appeals unit reach a different conclusion. The IRS’s protest unit may reach a different conclusion from the auditor, giving greater weight to a reasonable basis under Section 530 or other facts ignored by the auditor. Alternatively, if the appeals unit is unfavorable, since 1997, the Tax Court has had jurisdiction to determine whether or not a worker is properly classified, as an alternative to payment of taxes and seeking a refund through the U.S. District Court or U.S. Court of Federal Claims.

Again, by contrast, the process with respect to the EDD upon receiving a final Notice of Assessment is to file within 30 days from the date of the Notice a petition with the CUIAB. Upon filing a petition, there is then, and only then, the opportunity to request a prehearing settlement. Otherwise the matter will be heard before an ALJ at the Office of Tax Petitions. It is critical at this stage to get all critical evidence before the ALJ. Differing judges take different approaches and may complicate right for a second appeal before the CUIAB. If matters do not work in favor during administrative appeals, then the remedy of overturning the decision requires payment of tax and seeking a suit for refund in California superior court.


Given the differences between the two agencies, it is important to carefully consider worker classification and the differences between the IRS and EDD. Opportunities may be lost not only during the audit examination process, but also in missing circumstances where it is necessary to push during the appeals process to get a proper determination. Getting a knowledgeable representative involved as early as possible is important to protect worker classification.


1 In order to identify businesses of concern, the EDD provides on-line a Form DE-230, wherein workers may anonymously report a business may have misclassified a worker. These are often relied upon by the EDD to identify businesses and to claim misclassification with no consequence to the worker making incorrect statements. The execution oddly identifies that EDD is not bound by any statement and not that there are consequences wrong statements.

2 The 1099’s filed need not be timely filed. Medical Emergency Care Associates v. Com’r, 120 T.C. 436 (2003).


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