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. Many entrepreneurs only realize the risks after learning about EDD payroll tax audit triggers, which can flag their business for investigation.
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
- IRS trust fund recovery penalty exposure
- 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. Some clients have also faced California FTB audit triggers that led to overlapping investigations.
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. Many owners also discover related issues like bank levies. If that’s you, it’s important to know how to get an EDD bank levy released quickly before it cripples cash flow.
Need help responding to an audit? Start with our guide on what triggers an EDD payroll tax audit and what to do if you’re behind on payroll taxes in California.
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 and explore more in Defend What’s Yours.
Frequently Asked Questions
What is the difference between a 1099 contractor and a W-2 employee?
A 1099 contractor is self-employed and responsible for their own taxes, while a W-2 employee works under your direction and requires payroll tax withholding.
Why does EDD care about worker classification?
The EDD enforces payroll tax compliance. Misclassifying workers as contractors can lead to unpaid payroll taxes, penalties, and interest.
What are common triggers for EDD reclassification audits?
Worker complaints, 1099 reporting mismatches, or industries with frequent misclassification (construction, trucking, gig economy) often trigger audits.
What penalties can result from misclassification?
Penalties include unpaid payroll taxes, failure-to-withhold penalties, interest, and possible fraud assessments if misclassification is willful.
How does California’s ABC Test affect classification?
The ABC Test presumes workers are employees unless the employer proves independence in control, work performed outside the usual course of business, and independent trade engagement.
Can reclassification impact federal taxes too?
Yes. The IRS also enforces worker classification rules, and findings from the EDD may be shared with the IRS.
Should I hire a CPA for worker classification issues?
Yes. A CPA can review your workforce, ensure proper compliance, and defend against EDD reclassification penalties.
📣 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.
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