EDD Audits: How a California Employment Tax Audit Actually Works

The Trigger

Knowing why the EDD is looking, because it shapes the whole audit.

• An unemployment or disability claim. A worker the business paid as a contractor files a claim, lists the business as an employer, and the EDD opens an inquiry. This is the most common trigger by far.
• A referral. The IRS, the CDTFA, the Labor Commissioner, and the Contractors State License Board share information with the EDD.
• Information matching. A business that issues many 1099s and few W-2s, or that reports no payroll in an industry that always has one, draws attention.
• Random selection and industry programs. Construction, trucking, restaurants, salons, and staffing are audited more often.

The audit begins with an inquiry letter or a pre-audit questionnaire and a request for an entrance interview. With a power of attorney on file, we handle the interview and the questionnaire, because the auditor’s first impression of how the business uses its workers is set there.

Classification

Applying the tests that decide who was an employee.

The ABC test

For most purposes since 2020, a worker is an employee unless the business proves all three of the following:

• A. The worker is free from the business’s control in performing the work.
• B. The work is outside the usual course of the business.
• C. The worker is customarily engaged in an independent business of the same kind.

Part B is where most businesses lose. A delivery company’s drivers, a salon’s stylists, and a construction company’s laborers are doing the business’s own work.

The exemptions

The law exempts many occupations and relationships from the ABC test, including licensed professionals, certain business-to-business arrangements, and referral agencies, each with its own list of conditions. An exempt relationship is judged under the older, more flexible test that weighs control and a dozen other factors. Knowing which test applies to each worker is the first thing we establish.

Other issues

Beyond classification, auditors look for wages paid in cash or outside the payroll system, officers of a corporation who took distributions but no salary, and bonuses, allowances, and reimbursements that should have been reported as wages.

Records and Fieldwork

Managing what the auditor examines over the three-year period.

The audit period

The standard audit covers the twelve most recent completed calendar quarters. It can be extended where no returns were filed or where the auditor finds fraud.

What is requested

• Payroll records and the quarterly returns filed
• Every 1099 issued, and the general ledger accounts for contract labor, outside services, and commissions
• Bank statements and cancelled checks, which the auditor uses to find payments to individuals that appear nowhere else
• Contracts with workers, invoices they submitted, and evidence that they ran their own businesses: licenses, insurance, other clients, advertising
• Federal and state income tax returns for the same years

Our part

We organize the records by worker rather than by document, so that each payment is matched to the evidence of that worker’s independence. We also assess each worker’s classification honestly before the auditor does, so that the business knows where its position is strong and where it is not.

The Assessment

Reviewing the auditor’s findings and the notice that follows.

The findings

The auditor presents proposed findings at an exit conference, worker by worker, with the wages reclassified and the tax, penalties, and interest computed. This is the point to correct errors, because the notice that follows carries a deadline.

The notice

The EDD then issues a Notice of Assessment. It includes unemployment and disability contributions, employment training tax, and state income tax that should have been withheld, plus penalties and interest. A penalty for failing to file returns is added where none were filed, and a larger penalty applies where the auditor finds that the misclassification was deliberate.

Petition and Beyond

Contesting the assessment, settling, and protecting the owner.

The petition and the hearing

The petition goes to the California Unemployment Insurance Appeals Board, an agency separate from the EDD. Before a hearing is held, the EDD’s settlement office can negotiate, and many petitioned cases resolve there. If not, an administrative law judge hears the case, with testimony from the business and the workers, and issues a written decision that either side can appeal to the Board itself.

Credits and offsets

Part of an assessment is state income tax the business should have withheld from workers who, in many cases, paid that tax themselves on their own returns. The EDD allows a credit where that can be shown, and we gather the workers’ filing information to claim it.

Payment and the owner

A final assessment can be paid on an installment plan. If a corporation or LLC does not pay, the EDD can assess the responsible officers personally for the unpaid contributions and withholding, with a standard similar to the federal trust fund penalty described in our payroll tax guide.

Going forward

An audit usually ends with a decision to put the reclassified workers on payroll. We help the business do that cleanly, and where the business believes its contractors are genuinely independent, we document the relationship so that the next audit reaches a different result.

What It Costs

EDD audit representation is billed by the hour, because the work depends on how many workers are involved and how far the audit goes. A petition and hearing are quoted separately once the assessment is known. We give an estimate at the first meeting after reviewing the inquiry letter and a list of the workers paid.