1099 or W-2? Avoiding EDD Reclassification Penalties

How to Classify Workers Correctly and Protect Your Business

In California, worker classification is one of the most dangerous compliance areas for small business owners — and the Employment Development Department (EDD) is actively auditing businesses that get it wrong.

If you’ve paid independent contractors (1099s) who should have been employees (W-2s), the EDD can reclassify them — and hit you with years of back taxes, penalties, and interest.

This article will help you:

• Understand how California classifies workers
• Avoid the most common reclassification traps
• Respond strategically if the EDD comes calling

If you’re already under audit, check out our guide on California tax enforcement and payroll audit defense.

What’s the Difference Between a 1099 and a W-2?

W-2 Employee:

• You withhold payroll taxes (PIT, SDI)
• You file DE 9 and DE 9C quarterly
• You pay Unemployment Insurance (UI), Employment Training Tax (ETT)
• You issue a W-2 at year-end

1099 Contractor:

• You do not withhold payroll taxes
• You report payments on a 1099-NEC
• The worker pays their own taxes
• You are not liable for unemployment or disability contributions

Sounds simple, right? Unfortunately, California law makes this a legal minefield.

The ABC Test (California Standard)

Since AB5, California applies the ABC test for classification:

A. The worker is free from control and direction
B. The work performed is outside your usual business
C. The worker is independently established in that trade

If you fail any one of these tests, the worker is presumed to be an employee.

This means:

• Your office assistant? Likely a W-2
• Your subcontractor on a client project? Possibly a W-2
• Your one-off bookkeeper or designer? Depends on facts and documentation

EDD Reclassification Penalties – What’s at Stake?

If the EDD audits and reclassifies your 1099 contractors, you may be on the hook for:

• Unpaid UI, SDI, ETT, and PIT
• 10–25% penalties
• 8–10% interest
• Trust fund recovery liability
• Joint referrals to the Franchise Tax Board and IRS

And yes — they may audit all 1099s paid over a 3-year lookback.

If you’ve had FTB collections issues in the past, that data may already be shared with the EDD.

Top Misclassification Mistakes to Avoid

No written agreement

Always have a signed contractor agreement outlining the scope, independence, and payment terms.

Paying through payroll

If your contractor is on your payroll system or receives regular checks, it looks like an employee relationship.

Controlling work hours or process

If you dictate when, where, and how the work is done — they’re likely an employee.

Relying on them long-term

If a contractor works for you 40 hours/week for a year with no other clients — that’s not independence.

Calling officers or owners “contractors”

You can’t 1099 yourself out of corporate payroll. This is a red flag, especially for S corps.

How to Avoid EDD Reclassification

✅ Use legitimate business entities (LLC/Corp) when hiring contractors
✅ Verify the contractor has multiple clients
✅ Avoid using contractors for core business functions
✅ File and remit all payroll taxes timely for W-2 workers
✅ Do not issue a 1099 to anyone treated as an employee

What If You Already Misclassified Workers?

We’ve helped businesses:

• Negotiate reduced assessments
• Retroactively correct worker filings
• Avoid criminal referral or tax fraud claims
• Resolve multi-agency audits from EDD, CDTFA, and FTB

If you're under audit now or have received an EDD inquiry, act fast. Waiting may limit your options — and increase your liability.

Need help responding to an audit? Start with our guide on what triggers an EDD payroll tax audit.

Why Work With Boulanger CPA

We help California business owners:

• Respond to worker misclassification audits
• Review contractor relationships
• Navigate AB5 and the ABC test
• Coordinate overlapping audits across state and federal agencies
• Protect their businesses from reclassification fallout

We’ve worked with:

• S corps
• Construction and real estate firms
• Medical practices
• Agencies and startups
• Professional services firms

Get Help Before the EDD Acts

If you're worried about how you've paid workers — or already received an audit notice — let’s fix it now.

Orange County-based. Serving all of California.
Virtual consultations available.

👉 Schedule your free audit strategy call

FAQ – Worker Classification & 1099 Audits in California

📣 About the Author

Marc Boulanger, CPA is the founder of Boulanger CPA and Consulting PC, a boutique tax resolution firm based in Orange County, California and trusted by high-income individuals and business owners across Southern California.

He is the author of Defend What’s Yours: A California Taxpayer’s Guide to Beating the IRS and FTB at Their Own Game, available now on Amazon. The book offers a step-by-step plan for resolving IRS and FTB tax debt without losing your business, your home, or your peace of mind.

With over a decade of experience resolving high-stakes IRS and State tax matters, Marc brings strategic insight to complex cases involving wage garnishments, bank levies, unfiled returns, and six-figure tax debts. He is known for helping clients reduce or eliminate tax liabilities through expertly negotiated settlements and compliance plans.

Marc is a Certified Public Accountant licensed in California and Oklahoma and holds the designation of Certified Tax Representation Consultant. He is a member of the American Society of Tax Problem Solvers (ASTPS) — the national organization founded by the educators and practitioners who have trained thousands of CPAs, EAs, and tax attorneys in IRS representation strategy.

Every case is handled with discretion, proven methodology, and direct CPA-led representation — not call center scripts.

📍 Learn more at www.orangecounty.cpa or call (657) 218-5700.