Navigating the California Employee vs Independent Contractor Maze

Subtitle: Playing 10 Questions with California’s Employment Development Department about How to Onboard Former Freelancers


Since the California Legislature passed Assembly Bill 5 (AB5) in September of 2019, the rules regard who is and who is not an employee in this state have gotten ever more stringent – and confusing.

Why confusing? Because there was a very loud roar from several industries whose workers’ statuses were so severely compromised by this Bill.

I remember being at the 2019 CSEA State Tax Agency Liaison Meeting (STALM) in Sacramento after the bill was signed and one of the big concerns was truckers. Many of them work for the same company all year round (one “employer”) but own their own rigs and have always filed their tax returns using a Schedule C. Suddenly, if they had to be employees, there goes their federal deduction for the depreciation on the very expensive rig (costs approach $100,000 for some), the interest or lease fees, the fuel costs and all the other, legitimate out-of-pocket expenses they have in order to do their “jobs.”

They were not the only industry with legitimate issues. Nearly a year after AB5 was passed, Governor Newsome signed AB2257 on September 4, 2020. This gave us  an entire list of industries and employees that are now exempt from the rules of AB5.

But we weren’t done yet. The entire industry of gig transportation workers (the original target for AB5) did more than just protest. They floated a 2020 ballot proposition to exempt gig workers from AB5. Proposition 22 passed in the November election. So now, the main workers for whom AB5 was written are exempt from AB5 by law. Granted, Prop 22 came with some conditions requiring Lyft, Uber, etc. to provide employee-style benefits and certain work-hour restrictions.

Still confused?

That brings to mind the exit line from the parody television series, Soap. “”These questions—and many others—will be answered in the next episode of…Soap.”

Well, I have some bad news for you. I will not be clearing up the entire situation. But…I did have some important questions that really needed to be clarified by our California Employment Development Department (EDD). They were kind enough to bring an entire team of their key staff to this year’s CSEA STALM virtual meeting.  Some of my questions were covered during the meeting. Others were answered afterwards by one the EDD’s team of Taxpayer Advocates.

OK, let’s play 10 Questions with the dedicated team at California’s Employment Development Department:


Q1.  All businesses that pay workers must use the ABC test that will probably define their long-term freelancers as employees. Does California have any law or amnesty provision similar to the IRS’ Voluntary Classification Settlement Program (VCSP)? (Note: In very simple terms, the IRS program works with companies that had consistently been issuing a Form 1099 to all affected freelancers. They can pay 10% of one year’s payroll taxes and avoid being audited for all the earlier open years.)

  1. California does not have a program like this. It would require the state legislature to pass laws to make this possible. Perhaps CSEA should lobby our legislature for an amnesty program for AB5.


Q2. Since there is no VCSP-like program, what are the consequences (or protections) for those employers who sign up with the EDD for the first time to comply with the new laws?

  1. A. There are no specific protections. But newly registered employers are not apt to face automatic audits for all the earlier years when they are not in compliance. In other words, the EDD will not get a specific alert that this new employer has been in business for 20 years and has just now registered as an employer. When filling in the DE1 registration form, the employer should simply enter the current year in box D as the first payroll date.

Q3. But wait! The statute of limitations to assess payroll taxes is open for all years in which the employer had employees but didn’t file payroll tax returns. Doesn’t that still leave the employers vulnerable for all the years when they did not treat their workers as employees?

  1. A. Yes, it does. But EDD doesn’t have the time or staff to simply audit everyone. So they will only audit a business if there is a valid reason. Some valid reasons include:
  • Workers filing unemployment or disability claims without ever having been on payroll
  • Someone submits an Audit Lead Referral (same form as worker classification request – Form DE230)
  • Public informants in general
  • On Site inspections
  • Forms 1099 NEC or MISC
  • Random industry surveys

There are multi-agency strike force teams that go out and do inspections  of certain kinds of businesses. For instance, restaurants are notorious for not reporting employees and/or paying in cash.

If EDD does perform an audit and the business has not put the proper workers on payroll, then that may result in the audit going back for several years.

Q4. In the event of an EDD audit, how many years is EDD most likely going to examine?

  1. A. Typically EDD starts with the assumption of 3 years. If payroll tax returns have not been filed, and this was due to negligence or intentional disregard, they may go back further than that.

On the other hand, if a company has been filing payroll tax returns all along but excluded some of their workers (by issuing 1099s to them), the EDD may only look back for 3 years – unless there is evidence of fraud or intent to evade taxes.

Q5. Naturally, if the audit determines that they should have been paying their workers as employees, there are likely to be penalties. What can employers expect?

  1. There are a variety of different options open to the EDD. But, in some cases, penalties are mandatory. For instance, if the employer never registered with EDD and didn’t file payroll tax returns, there is a mandatory penalty of 15% of the assessed taxes (Unemployment Code Section 1126). If an employer was registered, but misclassified some of their employees, the 15% penalty is not mandatory and is applied if the examiner determines that the failure was due to negligence or intentional disregard.

The worst penalties tend to be generated for willful non-compliance involving 
fraud and intent to evade. Those could amount to 50%. If they failed to provide information returns in the past, then there is the potential for another 50% penalty. In other words, penalties can end up being 100% of the taxes owed. 

A common example is the restaurant industry, mentioned above. They may be hiding workers and demonstrate a clear intent to evade taxes. These are the kinds of cases where fraud penalties can be applied.

For a list of all the penalty codes – here’s a chart –

Q6. Speaking of audits of newly registered employers, are there extra records or precautions they must take to avoid problems going forward (beyond normal recordkeeping and defining employee functions)?

  1. A. These employers should make sure they have the 1099 records for the past years.
    They should be prepared to provide them in the event of an audit. If these employers are audited, encourage them to cooperate with the examiners. Penalties start to build when they try to hide the truths.  

Q7. This discussion about hiding employees, paying them under the table and so on, brought up a common problem in our state. Illegal aliens as employees. Setting aside all the other legal problems with this kind of hire, let’s look at what employers can do if they do want to put illegal aliens on their payroll. The EDD has a way to handle this, right? What can an employer do to ensure the withholding is credited to the correct worker?

  1. According to the EDD’s Tax Processing and Accounting Division regarding the proper completion of the Quarterly Contribution Return and Report of Wages(Continuation) (DE 9C) – when an employee does not have an SSN or ITIN. Employers enter the employee’s name and put all zero’s in the SSN field on the DE 9C.  Do this for each quarter, showing the name the same way, and the EDD will have a record of the data on each employee, by name.
    If the employee later provides either the SSN or ITIN at a future date, the employer should submit a Form DE 9ADJ correcting the previously reported information.

Q8. That brings up the question of illegal aliens applying for EDD benefits. Is that even possible?

  1. Yes, it is. If the employer has been filing payroll tax returns that include these workers, they are eligible for disability benefits if they become ill or unable to work. However, they are not eligible to collect unemployment benefits.


Q9. What should employers do when a worker (often a friend or family member) begs to be treated as an independent contractor instead of as an employee? Is the employer still liable for penalties when they were not the ones to initiate this employment status.

  1. Absolutely! Advise your clients to protect themselves first – to not succumb to these requests. The employer will be totally exposed for the payroll taxes, penalties and workers compensation – and any potential lawsuits when the employee reports the employer for not being in compliance with the law.

Q10. There is so much to know. Where can employers get all the information they need to know about how to start doing payroll for the first time – or how to do a better job?

  1. EDD agrees that employers need to be educated. They offer employment status tax seminars online. They are taught regularly – and people can ask questions. This page gives employers choices of several topics.


Frankly, I was pleasantly surprised about the information regarding illegal aliens. Perhaps the IRS has a similar program? Who knows? The question has been posed to them. When they come back with an answer, I will update this report.

In the meantime, if you are and employer, and are still confused – work with an experienced Enrolled Agent or CPA to make sure you get it right.





Unemployment Code Section 1126

EDD AB 5 – Employment Status

CA Labor and Workforce Development Agency

 EDD –  DE 40 tax audit guidelines