Why Worker Misclassification Can Tank a Business Sale
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 spends eighteen months getting a company ready to sell. Revenue is up. Margins are clean. The buyer’s letter of intent comes in at a number the owner is happy with. Then due diligence starts, and the buyer’s team asks for a list of every independent contractor paid in the last four years, along with the contracts, invoices, and a description of what each person actually does.
That request used to be a formality. It isn’t anymore.
Buyers, and more importantly the private equity groups and lenders behind them, have started treating worker classification as a standard line item in due diligence. Somewhere along the way, deal teams learned what tax attorneys have known for years: a misclassified workforce is an unbooked liability, and unbooked liabilities have a way of showing up right before closing.
Why This Matters at the Deal Table
When a company classifies workers as independent contractors instead of employees, it avoids payroll taxes, unemployment insurance contributions, workers’ compensation premiums, and a long list of employee benefit obligations. If California determines those workers were actually employees, the company owes back payroll taxes, penalties, and interest going back years. EDD audits routinely reach back three years, and that window can now extend as far as eight years in certain cases.
In a business sale, that exposure doesn’t stay with the seller by default. It depends heavily on deal structure.
In an asset sale, the buyer can often insulate itself from prior payroll tax liability by not assuming the entity itself. In a stock or membership interest sale, the buyer typically steps into the seller’s entity, and with it, the entity’s history. A buyer’s attorney who understands this will price that risk into the deal, hold funds back in escrow, or walk away from the transaction structure altogether.
We’ve seen deals where a classification issue didn’t kill the sale, but it cut the purchase price by six figures. We’ve seen others where the buyer required a full EDD audit resolution before closing, adding months to a timeline the seller had already promised to investors or family.
How California Determines Worker Status
California uses the ABC test, codified through AB 5, to determine whether a worker is an employee or an independent contractor. Under this test, a worker is presumed to be an employee unless the hiring business can prove all three of the following:
The worker is free from the control and direction of the hiring business in connection with the performance of the work, both under contract and in fact.
The worker performs work that is outside the usual course of the hiring business’s business.
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
That second prong is where most companies get into trouble. A construction company that classifies its framers as independent contractors is going to struggle to argue that framing is outside the usual course of a construction business, which is one reason EDD scrutinizes the construction industry so heavily. A marketing agency that classifies its graphic designers as contractors faces the same problem if design work is the core service the agency sells. For a closer look at how the classification decision itself gets made, see our breakdown of W-2 versus independent contractor status in California.
Some industries fall under exceptions to the ABC test and instead use the older Borello multi-factor test, which looks more broadly at control, skill required, and the nature of the working relationship. Whether a company qualifies for one of those exceptions is its own legal question, and getting it wrong compounds the exposure rather than resolving it.
What Shows Up in Due Diligence
Sophisticated buyers, and the accounting firms doing quality of earnings reports on their behalf, know what to ask for. They request 1099s and W-2s side by side. They ask how long each contractor relationship has lasted, since a “contractor” who has worked full time for the same company for six years looks a lot like an employee on paper. They ask whether contractors use their own equipment, set their own hours, and work for other clients. They ask whether the company has ever received an EDD notice, audit letter, or unemployment claim from someone it classified as a contractor. Our step-by-step guide to the EDD audit process covers much of the same ground a buyer’s diligence team will walk through.
By the time a business goes to market, the paper trail already exists. It just hasn’t been reviewed by someone looking for problems yet.
A common mistake business owners make is assuming that because they’ve paid contractors this way for years without an audit, the arrangement is safe. Absence of enforcement is not the same as compliance. EDD audits are often triggered by a single unemployment claim filed by one former contractor, and a business sale process itself can trigger scrutiny, since buyers occasionally reach out to agencies or reference checks in ways sellers don’t anticipate. In the more serious cases, misclassification that looks intentional can move beyond a civil audit entirely. We’ve written about how hiring practices around independent contractors can trigger a criminal investigation when the facts point to willful conduct.
Successor liability is the other piece owners underestimate. Even in deal structures designed to limit it, California has mechanisms to pursue successor entities for unpaid payroll tax obligations under certain conditions. A buyer’s attorney who has seen this before will build protective language into the purchase agreement specifically because of it.
What Sellers Should Do Before Going to Market
The businesses that move through due diligence cleanly are the ones that looked at their own worker classification before a buyer did.
That starts with an honest inventory. List every worker paid as a 1099 in the last four years. For each one, look at how the relationship actually functions, not how the contract describes it. Ask whether the work is core to the business, how long the relationship has run, and how much control the company exercises over schedule and method.
Where the analysis raises questions, there are options short of converting everyone to W-2 status overnight. Some companies restructure specific roles. Some conduct a voluntary classification review with counsel to quantify exposure before a buyer does it for them. Some negotiate the timing of a conversion so it doesn’t disrupt the business or the deal narrative. What doesn’t work is discovering the problem for the first time when a buyer’s diligence team sends the request list, or waiting until an audit notice has already arrived to start asking questions.
Sellers preparing for a transaction eighteen to twenty-four months out have the most flexibility. Sellers already in exclusivity with thirty days to close have very little, and that’s usually when the phone call to a tax attorney happens.
A Buyer’s Diligence Team Will Find What’s There
Business owners spend years building value into a company, and worker classification is rarely the thing they think about when they think about that value. It should be. A clean cap table and strong EBITDA multiple mean less if the buyer’s counsel flags six figures of unbooked payroll tax exposure during the fourth week of exclusivity. The businesses that handle this well are the ones that treat classification as a deal readiness issue long before a letter of intent is on the table.
FAQ
Does an asset sale protect a seller from worker misclassification liability?
An asset sale can limit a buyer’s exposure to a seller’s prior payroll tax history, but it doesn’t automatically eliminate the seller’s own liability to EDD. The seller’s entity can still face an audit and assessment after closing, separate from what the buyer assumes.
Can a business be audited by EDD just because it’s being sold?
A sale itself doesn’t trigger an audit, but the due diligence process around a sale often surfaces classification questions that lead a buyer, lender, or their advisors to ask for documentation the company hasn’t had to produce before, and that scrutiny sometimes leads to a referral or a claim.
How far back can EDD look at worker classification during an audit?
Standard EDD audits typically cover three years. If the agency determines misclassification was intentional, that period can extend further, and in some cases now reaches eight years.
What is the difference between the ABC test and the Borello test?
The ABC test, used for most industries under AB 5, presumes a worker is an employee unless the hiring business proves all three prongs of the test. The Borello test applies to certain exempted occupations and industries and instead weighs multiple factors, primarily the degree of control the hiring business has over the work.
