At the federal level, you’re responsible for the employer’s share of Social Security and Medicare taxes (7.65% of wages paid) that should have been withheld. On top of that, the IRS adds penalties for failing to withhold income taxes and for not filing W-2s. The penalty rates depend on whether you at least filed 1099s for those workers. If you did, the rates are lower. If you didn’t file anything at all, they go up considerably. Interest accrues on everything from the date the taxes were originally due.

California is where things get really serious, especially for construction and contractor businesses. The state uses the ABC test under AB5, which is much stricter than the IRS common-law test. A worker is presumed to be an employee unless you can prove three things: the worker is free from your control, the work is outside the usual course of your business, and the worker has an independently established trade of that nature. That second condition is the one that trips up most trade businesses. If you run a plumbing company and hire a plumber as a 1099, it’s very difficult to argue that plumbing work falls outside your usual business operations.

The EDD can audit you and assess back payroll taxes, unemployment insurance, and state disability insurance plus penalties and interest going back years. They routinely share findings with other agencies, which can trigger additional action from the Franchise Tax Board and the workers’ comp board.

Workers’ compensation is another major exposure. If a misclassified worker gets injured on a job and you didn’t carry coverage for them, you face personal liability for medical bills and lost wages. Even if nobody gets hurt, your insurance carrier may audit your payroll records and assess additional premiums for workers who should have been covered.

The worker themselves can also file a claim. A misclassified employee in California can pursue back overtime, meal and rest break penalties, expense reimbursement, and other protections they were entitled to under state labor law. With California’s penalty structure, these claims add up fast.

If you suspect you have workers classified incorrectly, address it now rather than waiting for an audit. The IRS offers a Voluntary Classification Settlement Program that lets you reclassify workers going forward with significantly reduced penalties. California has provisions as well, though they tend to be less forgiving.

The best approach is to get your worker relationships reviewed and your payroll set up correctly from the start. A Long Beach bookkeeper who understands trade businesses can help you structure things properly so your books, tax filings, and payroll all reflect the right classifications before any agency comes knocking.