The IRS and the CA EDD (Employment Development Dept) are cracking down on employee vs. independent contractor status and on the issuance of 1099-NECs to non-corporate independent contractors.
Any non-corporate independent contractor who receives payments over $600 for the year should receive a 1099 (e.g., commissions, subcontractors). You would want to get a W9 (request for taxpayer identification number) from these recipients so they can be sent a 1099NEC at the end of the year. It is important to analyze all independent contractors to see if they should be reclassified as employees.
If you’ve been hearing more talk about California EDD audits lately, you’re not imagining it. While there hasn’t been a universal spike in random audits across all businesses, enforcement activity from the Employment Development Department (EDD) has clearly become more focused, more data-driven, and more aggressive in key areas—especially worker classification and payroll tax compliance.
At the same time, a proposed federal rule change from the U.S. Department of Labor (DOL) has many businesses asking an important question:
If the federal government makes it easier to classify workers as independent contractors, does that really matter in California?
For most California businesses, the answer is: not much.
The Short Answer: Yes, EDD Enforcement Is Increasing — But It’s Targeted
California is not broadly auditing every business at higher rates. Instead, EDD enforcement has shifted toward high-risk categories, meaning audits are more likely if certain red flags are present.
The biggest change is not volume alone—it’s precision. EDD is becoming increasingly sophisticated in identifying which employers are most likely to have payroll tax or worker classification issues before an audit even begins.
Why EDD Enforcement Has Tightened
1. Ongoing Pandemic-Era Fraud Recovery
California continues to recover from billions in improper unemployment insurance payments made during the COVID-19 pandemic. As a result, state agencies have increased enforcement efforts, expanded cross-agency data matching, and intensified payroll tax recovery initiatives.
This has indirectly increased scrutiny across payroll systems statewide.
2. Worker Classification Is Under a Microscope
The biggest driver of modern EDD audits remains the classification of workers as independent contractors versus employees.
California’s worker classification laws are among the strictest in the country due to AB5 and the state’s ABC test. Under this framework, workers are presumed to be employees unless the hiring entity can satisfy all three prongs of the test.
This has created increased audit exposure for businesses that rely heavily on:
- Independent contractors
- Freelancers
- Consultants
- Gig workers
- Remote service providers
Industries commonly affected include:
- Consulting and professional services
- Marketing and creative agencies
- Construction and trades
- Transportation and delivery services
- Small businesses using 1099 labor
If EDD determines workers should have been classified as employees, the result can include:
- Unemployment insurance liabilities
- Back payroll taxes
- Interest
- Penalties
The New Federal DOL Rule: Does It Change Anything in California?
On February 26, 2026, the U.S. Department of Labor proposed a new rule intended to replace the more restrictive 2024 federal independent contractor guidance.
The proposed rule would make it easier for businesses nationwide to classify workers as independent contractors under federal law by focusing primarily on two core “economic reality” factors:
- The employer’s degree of control over the work
- The worker’s opportunity for profit or loss
The proposal is intended to align more closely with prior judicial precedent and place greater emphasis on entrepreneurial independence.
The proposed rule would apply across:
- The Fair Labor Standards Act (FLSA)
- Family and Medical Leave Act (FMLA)
- Migrant and Seasonal Agricultural Worker Protection Act (MSPA)
Why the Federal Rule Likely Won’t Change Much for California Businesses
While the proposed federal rule may provide more flexibility nationally, California employers must still comply with both federal and state law.
Because California’s AB5 framework remains significantly stricter than the proposed federal standard, the ABC test continues to be the practical governing law for worker classification in California.
Why AB5 Still Dominates
California’s ABC test presumes workers are employees unless a business can prove all three requirements:
- A: The worker is free from the hiring entity’s control
- B: The work performed is outside the usual course of the company’s business
- C: The worker is customarily engaged in an independently established trade or business
The proposed 2026 federal rule is considerably more flexible and relies primarily on broader “economic reality” concepts rather than California’s rigid statutory framework.
As a result:
- A worker may qualify as an independent contractor federally
- But still be considered an employee under California law
For California businesses, this distinction is critical because EDD enforcement is driven primarily by California standards—not federal flexibility.
Independent Contractor vs. Employee: Why It Matters
Under federal law:
- Employees are economically dependent on the employer and entitled to protections such as minimum wage, overtime, and unemployment benefits.
- Independent contractors operate their own business and are generally not covered by those protections.
There are also significant tax implications:
- Employees split Social Security and Medicare taxes with employers
- Independent contractors pay the full 15.3% self-employment tax themselves
Because payroll taxes directly impact state revenue, California has strong incentives to closely scrutinize worker classification arrangements.
Data Matching Is Becoming More Advanced
EDD now utilizes increasingly automated systems to compare:
- IRS filings
- Payroll tax reports
- Unemployment claims
- Wage records
- Business registration information
This means inconsistencies are more likely to trigger audits automatically—even without an employee complaint.
Common Triggers for an EDD Audit
While audits can still occur randomly, many are now initiated due to identifiable risk factors such as:
- Heavy reliance on 1099 contractors
- High unemployment claims
- Sudden payroll changes
- Underreported wages
- Inconsistent tax filings
- S-corporations with questionable reasonable compensation
- Businesses operating in historically high-risk industries
What Businesses Should Take Away
The key takeaway is not that every California employer should expect an audit tomorrow. Rather, businesses should understand that:
- EDD enforcement is becoming more targeted
- California remains significantly stricter than federal law
- AB5 continues to control most worker classification decisions in the state
Even if federal rules become more contractor-friendly, California businesses cannot assume those relaxed standards apply at the state level.
For many employers, the biggest compliance mistake is believing that a worker classified properly under federal law is automatically compliant in California. In many cases, that is simply not true.
How Employers Can Reduce Risk
Businesses can proactively reduce audit exposure by:
- Reviewing contractor relationships regularly
- Documenting independent contractor arrangements carefully
- Maintaining consistent payroll and tax reporting
- Evaluating AB5 applicability before issuing 1099s
- Reviewing S-corp reasonable compensation practices
- Consulting advisors before restructuring worker classifications
How Employers Can Reduce Risk
Businesses can proactively reduce audit exposure by:
- Reviewing contractor relationships regularly
- Documenting independent contractor arrangements carefully
- Maintaining consistent payroll and tax reporting
- Evaluating AB5 applicability before issuing 1099s
- Reviewing S-corp reasonable compensation practices
- Consulting advisors before restructuring worker classifications
Final Thoughts
EDD audit activity in California is not necessarily exploding across the board, but it is becoming smarter, more targeted, and more focused on worker classification and payroll tax compliance.
At the same time, proposed federal changes may create confusion for businesses operating in California. While the federal government may move toward a more flexible contractor standard, California’s AB5 framework remains firmly in place and continues to set the higher compliance bar.
For California employers, understanding the difference between federal flexibility and California’s stricter standards may be more important now than ever.
Serving contractors and real estate businesses across California and the western United States
As a local Enrolled Agent (EA) firm based in Van Nuys, CA, our team specializes in helping:
- Contractors
- Electricians
- Plumbers
- Developers
- Property management companies
- Real estate brokerages
and other closely held businesses (typically $1M–$15M in revenue) navigate complex tax rules. Many of our clients are owner-operated businesses generating over millions in annual revenue.
We work with clients throughout California, Nevada, Arizona, Utah, Washington, Oregon, and Idaho, and we understand the tax challenges that construction and real estate businesses face every day.
For personalized guidance, please schedule a consultation appointment with a Partner at Bernstein Financial Services to help you determine your optimal planning strategies.
The information provided in this blog post is for general informational purposes only and is not intended as legal advice. Every business and financial situation is unique, and the strategies discussed may not be applicable to your specific circumstances.