Author
John Milikowsky, Esq. | Founder | John Milikowsky represents U.S. and foreign businesses and individuals in sophisticated business transactions involving U.S. tax matters. Relentlessly defending each client in federal and state audits and criminal investigations to protect their civil rights and provide financial security.

A business owner pays a worker $80,000 over the course of a year as a 1099 contractor. EDD shows up for an audit. The auditor asks for the contractor’s business license. There isn’t one. That single missing document can unravel the entire independent contractor relationship, and turn that $80,000 into a payroll tax liability the business never saw coming.

This happens more often than most business owners expect. The problem isn’t that employers are trying to cheat the system. It’s that they genuinely don’t know what documentation is required to support an independent contractor classification under California law.

Here’s a practical checklist of what to verify before you cut that first 1099 check.

Does the Worker Look Like an Independent Business?

The core question EDD is asking in any audit isn’t whether you called someone a contractor, it’s whether that person actually operates as an independent business. AB 5, which took effect in 2020 and fundamentally changed how California classifies workers, reinforced this standard. The law doesn’t just ask whether a worker has a contract. It looks at whether that worker has the structure and independence of a real business.

That means the checklist starts with the basics:

EIN or Business Entity An independent contractor should have a federal Employer Identification Number (EIN), a DBA (fictitious business name), or a formal business entity (an LLC, S-corp, or similar). These aren’t dealbreakers on their own, but they’re indicators of legitimate independent business status. A person who has none of these is operating as an individual, which looks a lot like an employee.

Business License This one trips up a surprising number of businesses. In California, most cities require a business license for anyone operating commercially within city limits. If a contractor works across multiple cities, they may need licenses in each jurisdiction. The good news is this information is generally public record, you can look it up by name or business name in most California cities.

As John Milikowsky explains: “I can’t tell you how many contractors or companies we work with who hire contractors who don’t have a business license. And they’re like, ‘Nope, sorry. Yeah, they look great, but they don’t have that. So we can’t qualify them as an independent contractor.’”

EDD auditors know where to look. If your contractor doesn’t have a business license, that’s a red flag the auditor will note immediately.

Insurance In industries like construction, insurance isn’t optional. An independent contractor should carry their own coverage. The key detail: the contractor pays for it. If the company is paying the insurance premiums on a worker’s behalf, that’s another signal that the relationship looks more like employment than independent contracting.

Do They Have Other Clients?

One of the clearest indicators of genuine independent contractor status is whether the worker has multiple clients. A contractor who works exclusively for your business, week after week, year after year, isn’t functioning like an independent business. They’re functioning like an employee without the paperwork.

EDD looks at this closely. A worker who derives 100% of their income from one company raises questions about who actually controls the work and whether the classification is legitimate. This doesn’t mean a contractor can never be your primary vendor. But if they have no other clients at all, be prepared to explain why the relationship still qualifies under the ABC test or Borello standard.

How Is the Money Flowing?

The structure of how payments move between the business and the worker matters more than most people realize.

In industries like nail salons and beauty services, EDD has a specific preference for how independent contractor relationships should be structured. The booth owner leases space to the stylist or nail technician. The contractor runs their own transactions, collecting payment directly from clients using their own point-of-sale system. They then pay the booth owner rent, sometimes plus a percentage of revenue.

John Milikowsky describes the distinction plainly: “If you collect all the money from the client and then give them their cut, that’s why you’re giving them a 1099, because you paid them. But if it’s the reverse, they’re paying you. You could be giving them a 1099 for rent payments. That’s a whole different dynamic.”

When the business collects all revenue and distributes to the worker, that pattern looks like employer-employee. When the worker collects their own revenue and pays the business, it supports independent contractor status.

This structure doesn’t translate to every industry. A freelance camera operator on a film set isn’t going to invoice the producer independently and then pay the production company. But in industries where it does work, particularly trades and personal services, getting the payment flow right is essential documentation for an EDD audit.

What Happens When the Classification Gets Challenged?

This is where the financial reality hits. A misclassified worker doesn’t just mean back payroll taxes. It means interest, penalties, and potentially years of recalculated wages and employer contributions. Business owners often find out the true cost when it’s already too late to restructure.

One of the most common calls Milikowsky Tax Law receives goes something like this: the business owner says they can’t afford to put their contractors on payroll. There’s not enough margin. The immediate assumption is that there’s no solution.

That’s not always true. There are ways to restructure how services are priced and delivered so that the business remains profitable while bringing worker relationships into compliance. The analysis starts with understanding both the business model and what EDD actually requires.

The Short List: What to Verify Before Paying a Contractor

Before issuing a 1099 to any worker, run through these questions:

  • Does the worker have an EIN, DBA, or formal business entity?
  • Do they hold a current business license in the city or cities where they work?
  • Do they carry their own insurance (particularly in construction and licensed trades)?
  • Do they have other clients, or are they working exclusively for your business?
  • Is the payment structure genuinely bilateral, meaning the contractor collects their own revenue and pays you, or does your company collect everything and distribute to them?
  • Is there a written agreement in place that documents the nature of the relationship?

None of these items alone determines classification. EDD looks at the totality of the relationship. But missing multiple items on this list is where audits turn into assessments.

Frequently Asked Questions

Does an independent contractor have to have an LLC or S-corp in California? No. A formal entity isn’t required, but having some form of business identity (an EIN, a DBA, or a registered entity) supports independent contractor status. A contractor who operates as a sole individual with no business identity has a harder time demonstrating they’re an independent business.

What happens if a contractor doesn’t have a business license in California? Under AB 5’s framework, operating without a business license in the relevant jurisdiction is a factor EDD and courts can use to support reclassification as an employee. It’s one of the clearest and easiest items for an auditor to check.

Can a worker be a 1099 contractor if they only work for one company? It’s possible, but it creates risk. Single-client arrangements weaken the argument that someone is genuinely operating an independent business. If a worker’s entire livelihood comes from your company, EDD may look closely at whether they should be classified as an employee.

What is the ABC test in California? AB 5 adopted the ABC test for most industries. To classify a worker as an independent contractor, a business must show: (A) the worker is free from the control and direction of the company; (B) the worker performs work outside the usual course of the company’s business; and (C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature.

What should I do if I receive an EDD audit notice? Don’t respond without understanding your exposure first. The documentation you submit (or fail to submit) shapes how the audit proceeds. An attorney experienced in EDD audits can help you assess the risk before you respond.

Milikowsky Tax Law defends businesses in the face of complex government tax controversies. We’ve been working with business owners defending them against IRS, EDD, FTB, and CDTFA audits since 2009. Reach out or visit us at caltaxadviser.com to see how Milikowsky Tax Law keeps businesses in business.

 

The post What to Check Before You Pay a Worker as an Independent Contractor appeared first on Milikowsky Tax Law.