IRS audits are often the “hot button” topic when it comes to taxes and audits. However, if you’re a California business owner and taxpayer, you should also be familiar with the EDD audit, especially if you’ve ever hired an independent contractor. The California Employment Development Department (EDD) state payroll audits occur when a business has classified a worker as an independent contractor instead of an employee. This means the San Francisco business owner can be liable for “unpaid” payroll taxes because the EDD has determined that they believe these workers are actually employees. EDD audits can be confusing, especially when you’re not sure what triggers the process. Let’s look at the most common triggers for EDD audits.
Worker Misclassification
The most common trigger for an EDD audit is when an independent contractor applies for unemployment insurance. Independent contractors — also known as freelance or gig workers — are not employees. They are Form 1099 contracted workers. Therefore, they are not eligible for unemployment insurance. That filing is what will trigger the EDD to look further into the business and start an audit process.
Late or Missing Payroll Tax Filings/Payments
Oftentimes, failure to pay payroll taxes, or pay them on time, can raise a red flag and draw attention to your business. This can cause the EDD to dig deeper into your business and look at your employment records and independent contractor agreements, which can then cause an EDD audit to occur.
Workers’ Compensation Audits
Investigations by insurance regulators may also trigger EDD audits. Independent contractors are not entitled to workers’ compensation since they are not company employees. Therefore, if the department of insurance investigates a workers’ compensation claim, and it’s determined the claimant is a contractor, then the EDD may conduct an audit of the company.
Cash Payments
Frequent cash payroll is viewed suspiciously and is often the trigger of an audit. If in that audit process, it’s discovered that there are independent contractors being classified as employees, the EDD may send the business a notice of audit.
To make sure your company does not receive an EDD audit, businesses must follow the California ABC Test to classify an individual as a 1099 independent contractor rather than an employee. If you want to determine whether there is a trigger for the EDD to audit your business, a good practice is to answer the following three questions. If you cannot answer “yes” to all three of these questions – and you’ve classified the individual as an independent contractor and not an employee – chances are you may face an EDD audit in the foreseeable future.
- The worker is free from the control and direction of the hirer in relation to the performance of the work, both under the contract and in fact;
- The worker performs work that is outside of the usual course of the hirer’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed by the hirer.
EDD audits can be confusing, especially when they involve a former employee or independent contractor and you’re not sure what triggers the process. The best thing you can do to protect your business is to speak to a San Francisco tax attorney with experience in EDD audits. Let them make sure your business is not doing anything to trigger an EDD audit.
Allison Soares is a partner and tax attorney at Vanst Law LLP. It doesn’t matter the issue: audits, collections, appeals, international disclosures, grumpy people— Allison enjoys fixing problems. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits from San Francisco to San Diego.
