The letter is usually short and unremarkable. The Employment Development Department would like to examine your records for a period covering the last three years, and an auditor has been assigned. There is a date, a list of documents, and a phone number.
It does not read like a serious event. It frequently is one.
Why you were selected
Most classification audits start in one of three ways, and none of them require anyone to have complained about you.
A worker filed for unemployment. Someone you paid on a 1099 applied for benefits, the EDD found no wage record, and the file was flagged. This is by far the most common trigger.
A workers' compensation or wage claim. Any claim from someone you treated as a contractor raises the same question.
Cross-agency data. The EDD shares information with the IRS, the Franchise Tax Board and the CDTFA. A pattern of 1099 payments that looks like payroll can surface without any human complaint at all.
You should assume the audit concerns a specific worker, even though the examination covers everyone.
What the auditor is actually testing
Since AB5 was codified into California law, the default test for employment status is the ABC test. It is deliberately hard to satisfy. A worker is presumed to be an employee unless the hiring business proves all three of the following:
A — The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract and in fact.
B — The worker performs work that is outside the usual course of the hiring entity's business.
C — The worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.
Prong B is where most businesses fail, and it catches people who genuinely believed they were compliant. If you run a landscaping company and you pay a landscaper on a 1099, that worker is performing work inside the usual course of your business. It does not matter that they set their own hours, use their own truck, or signed a contract saying they are an independent contractor. Prong B is not satisfied, so the worker is an employee.
There are statutory exemptions — certain licensed professionals, some business-to-business relationships, referral agency arrangements and others — and where one applies, the older, more flexible Borello multi-factor test governs instead. Whether you fit an exemption is a genuinely technical question, and it is usually the most productive place to spend effort in an audit.
What they will ask for
Expect a request covering roughly three years:
- Federal and California payroll tax returns, and the general ledger
- All Forms 1099 issued, with the underlying invoices
- Bank statements and cancelled cheques
- Contracts and agreements with the workers in question
- Certificates of insurance, business licences and any evidence of the workers' independent businesses
- Your own corporate records and ownership information
The auditor may also want to interview workers directly.
How an assessment is built
If workers are reclassified, the assessment covers the employer-side taxes that should have been paid: Unemployment Insurance, Employment Training Tax, State Disability Insurance and Personal Income Tax withholding — plus penalties and interest running from the original due dates.
Two features of this make it bite harder than people expect.
Sampling and extrapolation. Auditors commonly examine a sample period and project the findings across the full audit period. A small error in the sample becomes a large number in the assessment. Challenging the sample methodology is often more valuable than arguing any individual worker's status.
Personal liability exposure. Certain assessments can be pursued against responsible individuals, not just the entity. The corporate shell does not automatically absorb it.
And the EDD is not the only agency. A reclassification finding can flow onward to the IRS, to workers' compensation liability, and to wage-and-hour exposure under the Labor Code — where the multipliers are considerably worse.
What to do in the first week
Do not start the conversation alone. The auditor is professional and generally reasonable, but they are gathering evidence. Informal remarks about how you manage your workers become findings.
Appoint a representative. Filing a power of attorney moves the correspondence and the interviews to your representative. This is routine and expected; it does not make you look guilty.
Do not alter records. Ever. Reconstructing a missing document is one thing. Backdating a contract is a different category of problem entirely.
Gather the evidence of independence. For each worker, look for: their own business licence, their own EIN, a certificate of insurance, evidence they served other clients, their own equipment and premises, invoices they generated rather than ones you generated for them, and any marketing they do. This is the material that supports prongs A and C — and, where an exemption applies, the Borello analysis.
Find out whether an exemption applies. This is the single highest-value question in most audits, and it is easy to answer wrongly without reading the statute closely.
Fix it going forward. How you are treating workers today matters to how the audit is resolved. Continuing an arrangement the auditor has flagged does not help you.
Prevention costs a fraction of this
The businesses that come through these audits cleanly are the ones that reviewed classification before anyone asked them to. That review is not expensive and it is not long: for each role, work through the three prongs honestly, check whether a statutory exemption applies, and where a worker is properly an employee, put them on payroll before the EDD does it for you retroactively with penalties attached.
If you are currently paying anyone on a 1099 for work that sits inside your core business, that is worth looking at this month rather than next year.
We review classification as part of every payroll engagement, and we represent employers through EDD examinations. If a letter has arrived, send it to us — the first read is free, and the first week is the week that matters.