Good morning Angela,
I'm Doug, and I'm very sorry to hear of your situation. My goal is to provide you with excellent service today.
Unfortunately, as the employee was not doing a job that could be classified as an independent contractor.
But the fact of the matter is that it is not illegal to pay an employee in cash. What you will have to do is insure that you withhold and pay to the state and feds the appropriate amount of withholdings. And presuming that you haven't had any need to send in your federal tax deposits and state deposits yet, then this employee really can't do much to get you in trouble. Be sure to add them to the workers compensation policy and pay their unemployment. Also, prepare a payroll "stub" for the employee showing the money you "withheld" for payroll taxes as the law requires.
The demand that you pay the 20K or the employee is going to try and report you for allegedly committing a crime is a felony In CA.
Under CA Penal Code, Extortion is a crime:
§518. Extortion is the obtaining of property from another, with his consent, or the obtaining of an official act of a public officer, induced by a wrongful use of force or fear, or under color of official right.
§519. Fear, such as will constitute extortion, may be induced by a threat, either: 1. To do an unlawful injury to the person or property of the individual threatened or of a third person; or, 2. To accuse the individual threatened, or any relative of his, or member of his family, of any crime; or, 3. To expose, or to impute to him or them any deformity, disgrace or crime; or, 4. To expose any secret affecting him or them.
§520. Every person who extorts any money or other property from another, under circumstances not amounting to robbery or carjacking, by means of force, or any threat, such as is mentioned in Section 519, shall be punished by imprisonment pursuant to subdivision (h) of Section 1170 for two, three or four years.
Offer him the W-4 to fill out---tell him that you have already withheld taxes based on his claiming one, and will refund the remainder (which would be just a few dollars) if he claims more.
As for getting the final pay to him, Count him as claiming only himself, pay him with a payroll check with a proper payroll stub on it and tell him that you are filing a felony extortion report with the police against him. That should shut him up.
Under CA law, he has committed another crime in CA by recording the conversations without the permission of all people in the discussion, in advance of the recording being made. He can be criminally prosecuted by the state for that as well. And the argument can be made that because the recording was illegal, it may not be used as evidence.
The reality is that the IRS and the state are not going to have a problem with this one insignificant lapse with this employee---so long as your business is not doing this on a regular basis. The 2 weeks this guy worked for you is easily handled and the fact that you are in between bookkeepers is a valid reason for being behind.
You may reply back to me again, using the Reply to Expert link, if you have additional questions.
I wish you the best in your future,