What is an EDD Audit?

An EDD audit is a payroll tax audit to ensure that a company correctly classified workers as employees, wages made to employees are accurately reported, and protects workers’ rights to receive benefits. Our EDD tax attorneys represents companies and businesses in EDD Audits.

Douglas Wade, Attorney

By Douglas Wade, Attorney

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Table of Contents

1. What is an EDD Audit?

2. Can Companies Ignore an EDD Audit?

3. What are the duties and responsibilities of the EDD?

4. Why does EDD audit occur?

5. Why does EDD audit my company?

6. What is Employee Misclassification?

7. What is the Difference Between an Independent Contractor and an Employee?

8. How Does Employee Classification Play Into the Audit?

9. What documents do I need to provide to EDD for audit?

10. What questions will an EDD audit ask an employer?

11. How Far Back Will the EDD Audit Reach?

12. How Long Do EED Audits Last For?

13. What Happens After an EDD Audit?

14. Can an employer appeal EDD Audit decision?

15. Does EDD works with the IRS?

16. How can an EDD Audit Attorney help?

What is an EDD Audit?

EDD audits focus on the correct classification of employees within their organizations. These audits also ensure that the company complies with California’s Unemployment Insurance Code (CUIC). An EDD audit occurs when the government wants to ensure business owners report payments made to employees properly and protect workers’ rights to benefits. Many have heard EDD audits referred to as “payroll tax audits.” These audits help the government ensure that companies are:

Reporting payments to workers correctly
Ensuring employees’ rights to benefits

EDD audits have one concrete goal: to discover if the company pays its payroll taxes properly under the laws of the state of California. For example, if an employee applies for unemployment insurance and then states that they should be considered a worker instead of a contractor, an EDD audit may follow.

If you get an EDD audit, you could face penalties and interest on taxes you owe. The first step you should take is to contact an EDD audit attorney. In this article, we will briefly explain how and why EDD audits companies and go over the information that every California business owner should know about EDD audits.

Quiz: Is a manicurist working in a nail salon an employee or manicurist?

Answer: Employee. Our EDD audit attorneys represented countless nail salons in EDD audits because the salon mistakenly classified their workers as independent contractors.

manicurist independent contractor

Can Companies Ignore an EDD Audit?

Ignoring an EDD audit is a bad idea for several reasons. First, penalties will soon follow, and the EDD will not forget about the audit request or the documents they send. Ignoring an audit in California results in penalties such as fines and more. Taxpayers who care about their companies should never ignore an audit. The company should contact a skilled business attorney if it is concerned about the impending audit.

What are the duties and responsibilities of the EDD?

The EDD is responsible for Unemployment Insurance, Disability Insurance, Paid Family Leave Benefits, and Employer Tax Collection. The EDD will investigate and audit an employer when it has reasons to believe an employer is misclassifying a worker as an independent contractor and cheating on payroll taxes. Therefore, an agency like the EDD is needed to keep track of the money companies pay to the state and ensure that the state’s businesses are paying their fair share.

Why does EDD audit occur?

Generally, EDD audits begin when a worker formerly categorized as a contractor applies for unemployment insurance (UI) benefits. So why does this action create a “red flag” for the EDD?

Only employees of companies are permitted to apply for UI benefits. Therefore, the worker applying for UI benefits is ostensibly stating that they were considered employees, not contract workers. Therefore, independent contractors in California cannot legally apply for or receive UI benefits.

When companies file their tax returns late, do not pay payroll taxes on time, pay workers in cash only, or lay off workers for the wrong reasons, they can initiate an EDD audit. For example, an audit can commence if a worker is unhappy about their employment conditions and reports their company or boss to the EDD or the IRS. Companies that do not pay their workers on time can also generate an EDD audit.

Why does EDD audit my company?

The audit occurs when the government wants to ensure business owners report payments made to employees properly and protect workers’ rights to benefits. The purpose of an EDD audit is to find inconsistencies and determine if the employer has fully paid the owed payroll taxes under California law. If a worker applies for unemployment insurance and makes the case of being an employee rather than an independent contractor, EDD audits may occur.

EDD auditors have one main goal: identifying how a company classifies its employees. Once the EDD determines this, they can determine what the business owes in payroll taxes. If the company pays the correct taxes, the EDD will typically not penalize the company. However, suppose the EDD receives information suggesting that the business owner misclassified their workers. In that case, the company is probably not paying sufficient payroll taxes and therefore violating the law. The EDD is perpetually on high alert for such situations, and they must audit companies that flout the state’s laws.

What is Employee Misclassification?

Misclassification of workers occurs when an employer improperly classifies their employees as independent contractors so that they do not have to pay minimum wage, payroll taxes, or comply with meal breaks and rest break laws.

Many companies misclassify their workers accidentally. However, even unintentional misclassification of employees can lead to a long, arduous EDD audit.

Some company owners do not fully understand the difference between employees and independent contractors. However, all California company owners must know that there are key differences between hiring workers and hiring independent contractors. The EDD and the IRS do not excuse businesses claiming they did not pay their taxes “accidentally.”

What is the Difference Between an Independent Contractor and an Employee?

An employee is on a company’s payroll and receives wages and benefits. A worker is an independent contractor when there is flexibility and autonomy but does not receive benefits such as minimum wage, overtime, rest break, or meal breaks.

Companies must withhold payroll taxes for employees. Businesses must also pay employer payroll taxes for an employee who is a part of their company.

On the other hand, independent contractors are responsible for their own taxes. Experts describe comparing employees and contract workers as a concept called “direction and control.”

Company workers deemed employees:

Possess a minimum of control over how they complete their work and tasks, when they complete their tasks and work, or where they work

Are supervised by the owner of the company or controlled by the business owner in some manner

Are seen to be under the business owner’s “right to control.”

Independent contract workers, on the other hand, work much more freely. Contract workers:

Possess control over where, when, and how their work is completed
Are not under the control of their employers, or the company’s direction

For example, a gardener may work for numerous clients during the week. The gardener has his truck, shovels, and rakes, and the gardener works when they want to and not where they are told to work.

The IRS and the EDD examine many different details when comparing employees to contractors and then make their decision case by case. Unfortunately, in today’s business world, many companies misclassify their workers. Some do this by accident, and some businesses attempt to avoid paying their fair share of taxes and manipulate the system for their gain.

However, when a business misclassifies its workers, they can be subject to audits, and as a result, they can lose a lot of money and possibly even their entire company.

How Does Employee Classification Play Into the Audit?

Misclassification audits happen when EDD suspects you of incorrectly classifying your employees or contract . EDD auditors are especially concerned with worker classification. Misclassifying workers creates multiple problems, and misclassification is exactly what the EDD is looking for when they begin an audit. When a company wrongly categorizes its workers, they increase the chances that they are paying the wrong amount of payroll taxes.

Auditors face a difficult audit task: deciding whether a company’s workers are employees or contract workers. Auditors should review all necessary information and attempt to make a fair decision regarding the company’s policies and workers. However, some auditors seek the decision that works best for the EDD and is not favorable for the business. The EDD auditors do not do any favors for businesses and are known to take a hard line regarding worker classification. When businesses classify their workers incorrectly in an attempt to pay a lesser amount of taxes, the EDD usually finds out at some point and audits them.

Additionally, while the EDD works in tandem with the IRS, the two agencies do not always make the same decisions. This concept means that even if the IRS classifies workers as independent contractors, the EDD might classify them as full-time employees.

What documents do I need to provide to EDD for audit?

Many business owners wonder what types of documents the EDD asks to business owners to produce. The EDD’s request for documents depends on each situation and differs from company to company. However, the EDD is typically interested in specific forms and records that pertain to payroll taxes, company finances, employee payments, and similar issues.

The EDD-requested list may include the following:

Time-specific bank and financial statements
Canceled checks
Records of pay
Check registers
Ledgers
EDD’s Quarterly Contribution Return and Report of Wages
Journals
Financial records
1099s
W-2s

What questions will an EDD audit ask an employer?

An EDD auditor will verify the business ownership and entity type for your income tax return. The list of questions that the EDD sends to businesses before the audit aids the auditor in planning for the action of the audit. The list also has a second purpose: to provoke the company owner and taxpayer to make statements about the business’ payroll methods.

EDD auditors are known to be aggressive, and usually, there is a reason, or a series of reasons, that they decide to audit a business. We do not recommend that the company owner, or anyone else, act antagonistically towards EDD auditors. However, when taxpayers become aggressive, the auditor may decide to further the audit or make things more difficult for the company.

On the other hand, company heads do not need to be overly helpful to EDD auditors. When businesses tell auditors everything and give them everything they ask for, they may be doing themselves a disservice.

Essentially, it can be dangerous to give auditors too much company information. At the same time, it can be dangerous to withhold too much information. Our experience leads us to recommend that taxpayers take a middle road, neither providing too much information nor too little. It does not pay to be aggressive with auditors or mistreat them, but one must not be overly accepting and sympathetic.

How Far Back Will the EDD Audit Reach?

Generally, the EDD employment tax audits cover a three-year statutory period, comprising the 12 most recently completed calendar quarters. However, for some companies, this three-year period goes far longer, depending on special circumstances and the evidence the auditor has. In some cases, auditors begin with a three-year audit, but then they extend the audit based on the material they review and the information they find.

Companies should expect that the audit will take approximately 3-6 months and that the auditor will focus on a three-year financial history.

How Long Do EED Audits Last For?

The payroll tax audit process takes six months when completed effectively, but it is wrong to think that your audit will be over in exactly six months. Audit times vary based on the company’s sense of cooperation, the company’s offenses or clean record, and the time it takes to locate necessary information. We have seen companies face audits lasting over a year when they fail to adhere to the EDD’s requests and rules. The general rule is to complete every request honestly and promptly and hopes for the best.

What Happens After an EDD Audit?

After the audit, the audit committee, executive director, and senior financial staff are responsible for reviewing the draft audit report, asking questions about the auditors’ findings, and evaluating any recommendations before they are presented to the board in the final report.

Here are the most likely scenarios that follow an EDD audit:

The auditor decides that the company has paid too much in taxes, and the EDD issues the company a refund

The EDD determines that the company has not paid enough in taxes, and the auditor charges the business with the difference it must pay.

The auditor decided that there were no differences between what the company paid in taxes and what they should pay. This audit is called a “no-change audit.”

If the auditor decides that the business did not pay enough, the EDD will request that the company pay the difference and add interest and penalties to the sum, subject to the situation. The company must pay within 30 days, or penalties will continue until the taxpayer pays what they owe.

However, when the EDD determines that a company has underpaid its taxes, the EDD tells the IRS. Usually, the IRS takes the EDD’s data into account when they assess. The involvement of the IRS means that the company may have to pay double fines, penalties, and interest.

Can an employer appeal EDD Audit decision?

If you are an employer who disagrees with a EDD Notice of Determination (or Ruling) (DE 1080CT), or Notice of Modification (DE 1080M) you have the right to appeal the EDD’s decision within 30 days of the mailing date on the notice.

Does EDD works with the IRS?

The EDD works with the IRS, and California FTB to collect any money you owe from an Unemployment Insurance (UI) or State Disability Insurance (SDI) benefit overpayment. The EDD communicates with the IRS, and the IRS often uses EDD data and results to help with its company assessments. Therefore, an EDD audit may be a serious issue for a company but can also lead to greater problems.

For example, if the EDD finds, through an audit, that a business is misclassifying workers and not paying the correct taxes, it may fine and penalize them. The IRS can then examine the EDD’s audit results, including the penalties, and assess whether the business is acting by the law.

Because the EDD works with the IRS, businesses should be especially wary of EDD audits. In addition, taxpayers must ensure that they are correctly paying and categorizing workers and keeping track of all financial documents.

The EDD also works with these agencies:

The California State Controller
The State of California Franchise Tax Board
The California State Lottery

How can an EDD Audit Attorney help?

Overall, the EDD auditing process in California is something no business wants to undergo, but it is a common reality in the business world. An audit can drastically affect a business’s liability, whether the company is small or large, new or old.

When an EDD audit appears on the horizon, the most intelligent thing a company owner can do is contact an experienced tax attorney. At Nakase Wade, our skilled attorneys have helped many California businesses make it through this complex and challenging time. The more prepared and organized a business is, the easier it is to make it through the audit process, and the better chance the outcome will be positive.

Our goal in advising our clients is to help to lessen their anxiety. We will clearly and calmly explain the reasons for California’s EDD audits and tell you what to expect. We will also help your company collect all the necessary documents for a successful audit, so you can move smoothly through the process and continue running a successful business.

When taxpayers deal with EDD auditors without the help of an attorney, they often struggle to understand the terms, concepts, and different phases of the audit while continuing to do business successfully. Our skilled, experienced attorneys will help your company through the audit, so you can continue to succeed.

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