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Independent Contractor Audits: Six Required Steps Before Lawsuit for Refund

The IRS is conducting 6,000 random audits ( the next three years to determine if businesses have misclassified certain employees as independent contractors. The audits are intended to help close the US. Government Accountability Office’s estimated $15 billion tax gap due to misclassification of employees. In California, the Employment Development Department (“EDD”)investigates misclassification of employees and, if misclassification is found, can issue an assessment against the offending business to recover tax-related withholding the employer should have paid but didn’t (including unemployment and state disability insurance payments, employment training taxes, and personal income tax) and penalties.  Now, a California Court of Appeal has emphatically warned employers about the administrative steps they must follow if they intend to challenge the EDD assessment in court and seek a refund of the tax related payments.
The steps a business must take to seek a refund after an EDD assessment are well-defined by statute. Miss a step, or get them out of order, and the business may be stuck without a remedy after paying the assessed taxes and potential penalties.   This recent decision is a stark reminder, coming at a time when more and more businesses may face audits on their classification of workers.

Merchandising Concept Group, Inc. used independent contractors to make retail product displays (Merchandising Concept Group, Inc. v. California Unemployment Insurance Appeals Board (2010) 141 Cal.App.4th 1274). The EED audited the company, found the contractors were misclassified, and issued an assessment of $110,000, plus penalties. Merchandising Concept challenged the assessment by filing a petition for reassessment with an administrative law judge. The assessment was affirmed, but the penalty was reversed because the company had reasonably relied on its legal counsel when it failed to file adequate tax returns.  The company (and the EDD) appealed this decision to the EDD Appeals Board, and lost.  The Appeals Board noted that its decision was “final,” but this didn’t mean the administrative procedure was finished. The EDD Board included with its decision instructions for the company to seek judicial review, after exhausting the administrative process and paying the assessed taxes.
The company paid the assessed taxes, immediately filed a claim for refund with the EDD and at the same time filed a petition for writ of mandate with the superior court seeking a reversal of the “employee” classification and an order of refund.   This is where the company made its mistake.  The EDD process hadn’t yet been concluded — the company had just filed a claim for refund with the EDD, but did not await the denial and complete the administrative review process, before filing with the court for a refund.  This was fatal.

The superior court dismissed the company’s case, and the company appealed.  The Court of Appeal also rejected the company’s arguments, explaining that Merchandising Concept had failed to exhaust its administrative remedies because it did not wait for a decision from the EDD Appeals Board on the claim for refund.  The Court of Appeal set out the six steps that must be taken before a bringing a lawsuit to recover the taxes paid:  1) the business files a claim for refund or credit; 2) the director of the EDD denies the claim; 3) the business files a petition for review with an administrative law judge;  4) the administrative law judge issues a decision; 5) the business or the director of the EDD files an appeal with the EDD Appeals Board regarding the petition for review of the denial; and 6) the Appeals Board issues its order or decision and serves notice of the decision. (See, California Unemployment Insurance Code (UIC) §§ 1178, 1180,1221-1224, and 1241).

Merchandising Concept only completed the first step before filing its petition for writ of mandate with the court.  The writ proceeding was neither proper nor practical.  Even if successful, it could only have resulted in a determination that the assessment was incorrect, but wouldn’t have gotten the company its refund.
Businesses must follow the six administrative steps and get the EDD’s final decision on a petition for review of the denial of a claim for refund — which comes after the EDD’s decision on the petition for reassessment — before going to court to pursue a refund action against the director of the EDD (UIC §1241(a)).   In effect, a business challenging an assessment is faced with exhausting these steps for both the denial of the petition for reassessment, AND for the denial of the claim for refund.  This is especially important since national and local government agencies are looking for ways to increase revenue, and audits are looming on the horizon.  The EDD has an information bulletin that explains the process.

Erin L. McDermit, Employment Group