*The following article was updated in February 2022*
If you’re a California business owner and taxpayer, and if you’ve ever hired an independent contractor, then you should be familiar with an EDD audit. These 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 business owner can be liable for “unpaid” payroll taxes because the EDD has determined that they believe these workers are actually employees.
Many business owners, especially those in San Francisco, ask how the EDD is even familiar with the daily workings of California small businesses and know how to begin the audit process. Typically what happens to trigger an EDD audit is an independent contractor file for unemployment. Independent contractor is not eligible for unemployment benefits; so his claim triggers the EDD to look into the business practice.
What is EDD Audit?
An EDD audit is a payroll tax audit conducted by California’s Employment Development Department (EDD) to verify whether a business is correctly classifying its workers as employees or independent contractors. The audit ensures compliance with the California Unemployment Insurance Code (CUIC), and it reviews employer contributions to payroll taxes, such as unemployment insurance, disability insurance, and employment training tax. EDD audits are typically triggered by worker misclassification, discrepancies in tax filings, or complaints. Businesses found non-compliant may face penalties, interest on unpaid taxes, and back payments for misclassified workers.
Are EDD audits random?
The EDD typically does not randomly select businesses to audit because the process itself starts with a contractor filing for unemployment. That trigger is what initiates the audit process.
Businesses must follow the California ABC Test to classify an individual as a 1099 independent contractor rather than an employee. The Test came out of the 2018 California Supreme Court case, Dynamex Operations West, Inc. v. Superior Court of Los Angeles. The ABC Test states that all three of the following questions must have a “yes” answer in order to classify an individual as an independent contractor:
- 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.
If you want to determine whether there is a trigger for the EDD to audit your business, a good practice is to answer these 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.
EDD audits can be confusing, especially when they involve a former employee or independent contractor and you’re not sure what triggers the process. Don’t try to work with the EDD yourself. The best thing you can do to protect your business is to speak to a tax attorney with experience in EDD audits.
Allison Soares is a partner and tax attorney at Vanst Law. 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.
