Worker Classification Due Diligence: What Buyers Look for Before Acquiring a Business
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.
When the acquisition process starts, 1099s are probably not at the top of the due diligence checklist. However, at some point in the process, a buyer’s due diligence team will want to dig into the company’s 1099s. While the seller has answered these questions many times before – certainly to their CPA at tax time- they’ve likely not had to justify worker classification for someone deciding whether to acquire the company.
Worker classification is one issue that can slow down a business sale, especially here in California where CA EDD is especially vigilant about 1099 classification. Misclassifying a worker – or, in many cases, a whole class of workers – can be the result not of trying to cut corners or “cheat” but of a failure to revisit a working relationship that made sense when it was started but has evolved over time.
Why Does Worker Classification Matter in a Business Acquisition?
Buyers have to weigh risk. Sellers may look at their workers and think, the acquiring company will change so many things; this isn’t a priority. But a buyer isn’t just acquiring a company’s revenue and assets. In California, they can also be acquiring its unresolved worker classification exposure.
EDD’s “successor-liability” rules mean a buyer can become responsible for a seller’s unpaid payroll tax liability, and a worker classification issue is one of the most common sources of that liability. If workers who were treated as independent contractors should have been classified as employees, the exposure includes unpaid payroll taxes, penalties, and interest that can stretch back several years.
That’s why worker classification shows up early in most due diligence checklists, often before financial statements are fully reviewed. A buyer’s attorney knows that this is one of the few categories of risk that follows the business rather than staying with the seller.
What Do Buyers Actually Look for in Worker Classification Due Diligence?
Buyers start with the list of everyone paid as a 1099 contractor and ask how long each relationship has lasted. A contractor relationship that’s run for years, especially one that looks the same today as it did when it started, draws more attention than a short-term project engagement.
Questions come up such as:
- Does the company control the worker’s schedule?
- Does the worker use company equipment, wear a company uniform, or work exclusively for this business?
- Is the work part of the company’s core service offering, or something incidental to it?
These questions map directly to how California’s ABC test and the Borello test evaluate a working relationship, and buyers know it.
We often see the same pattern come up in service-based businesses, construction, and healthcare, industries where long-term contractor relationships are common and where the line between contractor and employee has historically been treated loosely.
What Is the ABC Test and Why Does It Matter in a Sale?
California’s ABC test, established under AB 5, presumes a worker is an employee unless the hiring business can show all three of the following:
- The worker is free from the company’s control and direction,
- The work performed falls outside the company’s usual course of business,
- The worker is customarily engaged in an independently established trade or occupation doing similar work.
All three conditions have to be met. A business that satisfies two out of three still has a classification problem.
A contractor may genuinely operate independently in terms of schedule and equipment, but if the work they do is central to what the company actually sells, that second condition becomes difficult to meet.
How Does the Borello Test Factor Into Due Diligence?
Certain industries and relationships remain subject to the Borello test rather than the ABC test, based on statutory exemptions carved out after AB 5 passed. Borello weighs a broader set of factors, primarily the degree of control the business has over how the work gets done, but also considers things like whether the worker has a distinct business, provides their own tools, and bears the opportunity for profit or loss.
Buyers and their counsel need to know which test applies before they can evaluate the risk accurately, which means classification due diligence often starts with a threshold question: does this business or this specific relationship qualify for a Borello exemption, or does the ABC test apply?
Getting that wrong in either direction, assuming an exemption that doesn’t apply or missing one that does, changes the entire risk picture for the deal.
What Documentation Do Buyers Request During Worker Classification Review?
Beyond interviews and observation, buyers typically request a specific set of records. Signed independent contractor agreements for each worker, particularly ones that have been updated recently rather than left unchanged for years. 1099 filings compared against payroll records to confirm consistency. Evidence of how work is assigned and supervised, including whether workers can decline assignments or set their own schedule. And documentation of whether contractors carry their own business licenses, insurance, or work for other clients.
The absence of this documentation is often more concerning to a buyer than an imperfect answer. A business that has never formally documented its contractor relationships looks riskier than one that documented an arrangement that turns out to need adjustment.
How Does a Worker Classification Issue Affect Deal Price or Terms?
When a buyer’s due diligence team identifies a classification risk, it rarely kills a deal outright. More often, it changes the terms.
A buyer may request an escrow holdback tied specifically to potential EDD liability, sized to cover the estimated exposure if the classification were challenged. Some deals get restructured so certain contractor relationships are converted to employees before closing, which resolves the exposure but adds cost and complexity to the transition. In other cases, the purchase price gets renegotiated to reflect the risk the buyer is now assuming along with the business.
The businesses that handle this best are usually the ones that identified the issue themselves, months before a buyer’s due diligence team found it, and had already started addressing it.
What Should Sellers Do to Prepare for Worker Classification Due Diligence?
A classification review doesn’t need to wait for a buyer to request one. Sellers who run their own internal review before going to market tend to have more control over how any issues get resolved.
That starts with listing every worker currently classified as a 1099 contractor and asking, honestly, how each relationship would hold up under the ABC test or the applicable Borello factors. Contracts should be current, not holdovers from years earlier that no longer reflect how the relationship actually works. Any contractor who looks more like an employee in practice, regardless of how they’re classified on paper, is worth addressing before a due diligence team raises it as a finding.
This is also where working with a firm that regularly handles EDD audits matters. The same factors EDD examines during an audit are the factors a buyer’s counsel examines during due diligence, which means audit-readiness and deal-readiness are, in practice, the same project.
Where This Leaves Business Owners Preparing to Sell
Worker classification tends to feel like a settled question until someone outside the business asks about it for the first time. A relationship that’s worked fine for years, that both the business and the worker are satisfied with, can still carry exposure that only becomes visible once a buyer’s counsel starts asking the specific questions the ABC test and Borello test require.
Reviewing that exposure before it’s a due diligence finding gives a seller room to fix what needs fixing, document what’s already sound, and walk into a sale knowing what a buyer is going to find before they find it.
This is one piece of a larger picture that comes up in nearly every California business sale. For the full breakdown of successor liability, tax clearance certificates, and what IRS, EDD, and CDTFA look for during a sale, see our complete guide to selling your business without triggering an audit.
Frequently Asked Questions
Can a buyer be held responsible for a seller’s worker misclassification? Yes. Under EDD’s successor liability rules, a buyer of business assets in California can become responsible for the seller’s unpaid payroll tax liability, including liability stemming from worker misclassification, up to the purchase price of the business.
What is the difference between the ABC test and the Borello test? The ABC test presumes a worker is an employee unless the business can show all three specific conditions are met. The Borello test applies to certain statutorily exempted relationships and weighs a broader set of factors, primarily the degree of control the business has over how the work is performed.
How far back can EDD look at worker classification during an audit or due diligence review? EDD audits typically cover three years, but that period can extend to eight years or more if fraud or willful misclassification is suspected.
Should a seller reclassify contractors before going to market? It depends on the relationship. Some situations are best resolved through reclassification before closing, others through documentation that supports the existing classification, and some require a deeper review to determine which applies. This is worth evaluating case by case rather than applying one fix across every worker.
What happens if worker misclassification is found during due diligence? It doesn’t usually end a deal, but it often changes the terms, through an escrow holdback tied to the estimated liability, a purchase price adjustment, or a requirement that certain relationships be resolved before closing.
