I talk to so many business owners whose worst fear is being audited by the Internal Revenue Services. While the IRS is an agency that many people do not want to interact with, there is another audit risk that many companies face, especially those in California. That is the California Employment Development Department (EDD). An EDD audit can be very stressful and costly. However, if you protect yourself and your business by assuring that classification of employees is done correctly during payroll taxes, your audit risk is generally decreased. Here is all you need to know about EDD audits.
Over the last several years, California has become stricter with conducting audits and investigations, which are essentially worker re-classification audits. EDD audits are focused on reclassifying independent contractors (sometimes called “gig workers” or freelancers) to employees. An EDD audit will include a review of business records for the past three years, specifically records with special interest on documentation about your employees and independent contractors.
One event that triggers an EDD audit is when a former worker files for unemployment. The application for unemployment, even when filed by an independent contractor, is an indication that the contractor was formerly an employee because unemployment is only open to employees. Another reason an EDD audit may occur is due to the late payment of payroll taxes, cash salary payment, reports by an unhappy worker, or late payment of wages.
The first indication of an EDD audit is when you receive an Inquiry Regarding Records notice from the EDD. This means your business has been selected for an audit. The contents of the notifications include a list of the necessary files needed for the audit and the Preaudit Questionnaire. The necessary documents may include bank and financial statements from the business for a specific time and period. It may also include copies of checks, check registers, ledgers, journals, pay records, 1099s, W-2s, and EDD’s Quarterly Contribution Return and Report of Wages (Forms DE-9 and DE-9C). The questions are written to root out the payroll practices of business owners, and serve as bait for the EDD audit in knowing how to approach the main audit carried out later.
Once the auditor is assigned, they will request an in-person meeting. I strongly recommend working with a tax attorney with experience in EDD audits. Your attorney can help gather all of the documentation from the business and can handle the interview and audit without you attending the meeting. After the audit, the results are discussed through a phone call or in person. In the interview, disputes are resolved and more information that was not part of the initial audit is identified and reviewed if necessary. You also have the option of requesting a pre-assessment conference with the auditor’s supervisor if you’re not satisfied with the auditor’s terms of the agreement.
At the conclusion of an audit, you may receive results that are not favorable to you and you may receive a bill from the EDD. The tax bill may show an incorrect payment of taxes due to low payment made in comparison with the amount charged to the business by the EDD. In rare cases, the results may reflect no change seen in the audit in comparison with the last audit.
The penalties obtained as a result of the underpayment of payroll taxes by a business is added to the interest rate and also the original payment of the taxes. These penalties and interest are charged by the EDD. A 10% increase in penalty will also be added if the deadline for the original payment has passed, typically around 30 days. It is best to avoid these penalties and interests by avoiding underpayment. However, a taxpayer has the option of appealing an EDD assessment if not satisfied by the assessment, or if an error during the determination process is noticed by the taxpayer.
If you are a California business facing an EDD audit, or the potential of an audit, I highly recommend you speak with an experienced California tax attorney who has worked in the EDD audit space. You cannot afford to be reactive to the EDD. Be proactive and protect yourself as the surge of EDD audits continues for California businesses.
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.
