What happens if you get an EDD audit?

An EDD audit is a process of verification that you have correctly withheld and reported personal income tax for wages paid to your employees. If you get an EDD audit, you may be liable for a wide range of fines, interest, and penalties on taxes that you owe.

By: Brad Nakase, Attorney

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An EDD audit occurs when the government wants to make sure business owners are reporting payments made to employees properly and protecting workers’ rights to benefits. EDD audit is done in order to determine whether or not a company has paid the correct amount of taxes according to California tax law. Failing to timely meet your filing or payment obligations can trigger an EDD audit. After the auditor has completed the review a final determination will be issued, along with any proposed fines and penalties. 

In this article, our EDD audit attorney discusses California EDD audit as follows:

What Is an EDD Audit?

If an individual manages a company in California, then it is probable that he or she knows about the Employment Development Department (EDD). The EDD is a taxing agency that is in charge of collecting, accounting, and enforcing the state’s main employment taxes.

When the EDD orders an audit, it should be known that the auditor will assume from the beginning that the employer is not compliant. Thus, his or her goal will be to discover violations and collect fines, tax penalties, interest, as well as back taxes from the employer.

In general, the EDD is considered to be a lot more aggressive than the Internal Revenue Service when it performs audits. Thus, an entrepreneur should be anything but complacent when facing an audit of their employment practices. That is to say, an employer should consistently reevaluate how he or she classifies workers and make sure that he or she is recording and paying the right amount of payroll taxes.

There are 31 employment tax district offices in California, and it is in these locations that field operations, such as audits, are performed. The EDD is the third biggest taxing agency. Recently, it has been working more and more with the Internal Revenue Service. Due to its wide-ranging authority to investigate, as well as the potential duration of an audit, most employers who undergo investigation find it beneficial to find an EDD attorney to manage the process and make sure of a positive outcome.

What is the purpose of an EDD audit?

The purpose of an EDD audit is to investigate inconsistencies and determine if the employer has fully paid the owed payroll taxes under California law. The purpose of an EDD audit purpose ensures that employers correctly report all workers, wages, and contributions for Employment Training Tax, State Disability Tax, Unemployment Insurance, and California personal income tax withholding. The payroll tax audit verifies compliance with the CUIC, ensures workers are correctly classified, and employee payments are properly reported.

What Payroll Taxes Does the EDD Investigates?

The Employment Development Department (EDD) is California’s payroll tax collection department. The EDD investigates and collect taxes on unemployment insurance, disability insurance and personal withholding tax. As one of the biggest departments in the state, the Employment Development Department (EDD) is in charge of administering the regulations for payroll tax for individuals and businesses in California.

Payroll tax income goes toward many of the public services that allow California to operate in an orderly and efficient way. Some of the areas that are directly benefited include roads, public parks, schools, and health services. It is clear, therefore, why the EDD audit is so aggressive when it comes to making sure that individuals and businesses in California pay their fair share. The EDD audit and administering and collecting of payroll taxes involve:

  • Unemployment Insurance (UI). This is a tax paid by employers that is meant to take care of expenses associated with the benefits program for the unemployed in California.

  • State Disability Insurance (SDI). This is a tax paid by California employees that takes care expenses associated with providing benefits for workers who suffer illness or injury.

  • Employment Training Tax (ETT). This is a tax paid by California employers that supports a training program for employees in particular fields.

  • Personal Income Tax (PIT). This is a tax paid by employees on income that is earned.

What Sets Off an EDD Benefit Audit?

The benefit audit process is a joint effort by employers and the Employment Development Department (EDD) to protect the Unemployment Insurance (UI) Fund’s integrity and detect potential fraud. An EDD audit occurs when the California government wants to ensure business owners report payments made to employees properly and protect workers’ rights to benefits. To perform a valid audit, matching earnings from work performed to the benefits weeks listed is necessary.

Failing to meet your filing or payment obligations timely can trigger an EDD audit. The EDD and California consider payroll tax revenue to be a serious matter. This is because the budget would collapse without the proper funding, and the results of this would negatively impact many areas of life. The EDD therefore makes it their mission to collect payroll taxes, in addition to performing payroll tax audits of specific businesses that enforces the collection of payroll taxes. Via these procedures, the state auditor looks at the following areas:

  • Random Audits. Some of the audits the EDD performs are decided according to a random pick of companies. The chance that this happens to a business is fairly low, but one may always be included in a randomized audit.

  • Contractor Unemployment Filing (Obstructed Claims). An independent contractor may not receive benefits for unemployment from their contractor. This means that if the contractor files for these benefits sometime later, it will by default trigger a warning, which alerts the EDD to potential misclassification and will probably cause an audit.

  • Worker’s Compensation Insurance/CA Department of Insurance. If the California Department of Insurance conducts an audit of a business’ worker’s compensation or otherwise investigates it, then the EDD may do so as well, performing their own audit to reclassify employees or payments.

  • EDD Task Force. On occasion, the EDD sends its inspectors to several companies to interview workers regarding their employer’s practices and the conditions of their current work. The EDD does so to check whether there are any irregularities that it may warrant an audit.

What Happens During an EDD Audit?

The EDD tax auditor requires your business financial documents for assessment. A business owner may expect an EDD auditor will verify the business ownership and entity type for your income tax return. An EDD audit also investigates the proper classification of workers in a company and verifies business owners’ compliance with the California Unemployment Insurance Code (CUIC). The length of the EDD audit will vary between several months to several years.

When the EDD initiates a tax audit, the first step is getting an audit letter which lists the specific required information demanded of the company owner. Some typical requests for documents might include the following:

  • Payroll registers
  • General employment questionnaire
  • Wage information for certain time frames
  • General ledger registers
  • Employee registers

When the EDD audit letter is sent, responses are usually desired within 10 days of the letter being issued.

The following step involves the EDD audit itself. During this period, the EDD auditor might ask for further clarifications regarding the classification of workers, the proper monitoring and reporting of payroll taxes, and details concerning termination and misconduct. This stage involves plenty of discussion and requests for additional information.

After this, the EDD auditor makes an assessment based on his or her discoveries and put together a proposed notice of assessment (PNA), which the owner of the business must then review. If the entrepreneur disagrees with the PNA, then he or she may provide more information to try to change the decision. In the end, the auditor will probably defend their decision and the PNA then becomes a notice of assessment (NA). This is typically what happens.

The final stage in the EDD audit is the appeal to the California Unemployment Insurance Appeals Board. This appeal may be brought if the entrepreneur does not agree with the NA. There is a tight deadline to file an appeal on the EDD audit decision, and many business owners do not meet the deadline. This makes paying the EDD inevitable. If timely payments are not made on the EDD audit decision, then there can be serious penalties and sometimes liens as well as dangers related to personal liability.

EDD Audit Penalties in California

EDD audit penalty generally include a 10% added if any part of the tax deficiency resulting form taxpayer’s intentional or negligent disregard for payroll law. The maximum penalty is 25%. In addition, the California Franchise Tax Board imposes a penalty equal to 0.5% of the total unpaid tax for each month after the initial 5% penalty. Employers may be fined $5,000 to $10,000 on top of any non-paid payroll taxes or late payments for fraudulent filings or misclassification of employees.

If an employer makes a late payment, the California EDD audit will determine fines based on the amount of time passed. There is a 2% penalty for deposits made 5 days late. The penalty is 5% for payments made between 6-15 days late. If the payment is late by more than 16 days, then the penalty is 10%.

If an employer fails to pay tax 10 days after the Internal Revenue Service (IRS) sends a notice, then there is a 15% penalty added to the tax debt.

If an employer misclassified employees, the EDD audit imposes penalties for state employment tax and state income tax. This means that an employer may receive a $5,000 fine for each misclassified employee. This would include 1.5% of the employee’s federal income tax liability and 20% of that employee’s Social Security tax withholdings.

Employers may also face a $5,000 and $15,000 fine for misclassification of employees at the state level. If the audit discovers that the misclassification was intentional, then the fine is increased to $10,000 and $25,000. If, however, the employer can prove that the misclassification was genuinely accidental, then the fine may be reduced.

There may be even more penalties if the employer has not kept records or issued wage statements.

What Is an EDD New Employee Registry Benefit Audit?

The New Employee Registry (NER) benefit audit depends on the information that California employers give to the Employment Development Department. This process is federally required. This type of EDD audit is meant to figure out whether employees receive unemployment insurance (UI) benefits. Often, employees get these benefits after returning to work but do not report their earnings.

This means that if an employee received unemployment insurance benefits and did not report earnings, an EDD new employee registry benefit audit may be triggered. Let’s say a former worker applied for unemployment benefits but was hired by your firm as a 1099. This can lead to a misclassification audit by the EDD. The EDD’s commission will take at look at the worker’s classification. This is because 1099 workers are not eligible for employment insurance after finishing work with that employer. 1099 workers are also ineligible for workers’ compensation because they have other clients and set their own work hours.

A new employee registry benefit audit may also be triggered by quarterly wage earnings that an employer reports to the EDD. This would happen if an employee received benefits while working and did not report these earnings.

The Employment Development Department will use an interstate cross-match if an employee received benefits while working in another state. This means the commission will compare wages earned from other states each quarter. If an employee is getting a benefit that does not belong to California, then the commission might send a new employee registry audit notice. If an employer overpays employees, this action can also result in an audit, as well as fines and penalties.

Sometimes, an anonymous source will file a complaint with the Employment Development Department against a business or company. This can lead to an audit. The EDD is authorized to pursue these complaints and see if there are grounds for an audit. From the employer perspective, if an employee filed a complaint against his or her company, then the employer should consider hiring a certified public accountant (CPA) or a tax lawyer. They will help prepare the employer for the audit.

To fight a California EDD audit, the first step you should take is to contact a EDD tax attorney. Attorney, Brad Nakase, has extensive experience as a payroll tax audit defense lawyerAfter an employer has received notice of an impending audit, he or she should begin to collect necessary records. It is essential to be organized. Preparation and organization are crucial to avoiding fines and penalties. There are certain areas to focus on.

Independent Contractor Agreements

You must report independent contractor information to the EDD within 20 days of either making payments totaling $600 or more or entering into a contract for $600 or more with an independent contractor in any calendar year, whichever is earlier. If a business has hired independent contractors at any time in the past or present, then it is very important to review the terms and conditions of written agreements between them and the company. In fact, if one’s company is currently doing business with independent contractors, it is advisable to enter into a written agreement with them as soon as possible. When conducting an EDD audit, one of the things the Employment Development Department will examine is the relationship between an employer and his or her employees, as well as an employer with any independent contractors he or she hires. A written agreement can help prove the nature of a working relationship, defining its specific status and terms.

For a relationship between an employer and an independent contractor, there are certain elements that should be included in such a written contract, as well as elements that should be excluded. The point of the contract is to prove that the working relationship between parties is not one between employer and employee.

There are certain provisions that would appear as red flags to the Employment Development Department. These include if the employer makes the contractor work during certain times of day or requires their attendance at company meetings. Other red flags would be the employer making the contractor submit a time sheet or preventing them from working for others.

Supporting Documentation

During an EDD audit, it would greatly benefit the employer to demonstrate that the independent contractor owns or runs his or her own business separate from that of the employer.

How can this be proven?

Evidence of an independent contractor being distinct from an employer can be demonstrated via a completed Form W-9, a business card, letterhead, invoice, or a business license for each independent contractor that has provided services to an employer’s business. Of course, it is possible that an employer can get a hold of these documents in the process of an audit. However, this depends on the status of the relationship between the employer and the independent contractor. If the relationship has soured, it may not be possible to obtain some of these documents, or at least not without going to significant trouble. In general, it looks better to the EDD audit if an employer has already obtained these documents at the beginning of a working relationship rather than on an as-needed basis during an active audit.

Quarterly Employment Tax Returns

Every business owner should ensure that employment tax returns are filed on time, before they are due. If tax returns are filed late, this can serve as evidence of poor financial bookkeeping, which looks bad to the Employment Development Department. Also, an employer who files late might also end up with a tax liability for a quarter that otherwise might not have been included.

1099 Forms

Let’s say that at the end of an EDD audit, the Employment Development Department determines that some of an employer’s independent contractors have been misclassified and are actually employees. The EDD audit will conduct an assessment and determine the amounts that should be paid to those independent contractors. An employer will not only face penalties and interest in this scenario. The employer will also have to pay the four kinds of California employment taxes that he or she would be liable for.

Of these, normally personal income tax is the largest amount. However, if the employer’s business has submitted the correct 1099’s to each independent contractor, then the employer can file a signed declaration of this to the EDD. The EDD will then remove that section of the assessment and the corresponding penalties. This amount could add up to more than half of the assessment.

Records of Cash Payments

It is important that a business keeps records of cash payments made to a person or entity. These records would need to document the following information:

  • Whom the cash was paid to
  • What services or goods were purchased
  • When it was paid
  • Where the goods or services were delivered
  • Why cash was used
  • How much was paid at any specific time

Keeping these records is important because if cash was paid to someone and the business cannot come up with a valid reason for the payment, the EDD will assume the payment was for services. They will then assess payroll taxes based on the amount paid.

What Occurs When a Business Owner Gets Audited by the EDD?

If a business owner receives an audit, he or she may face penalties as well as interest on the taxes that he or she owes the state. The fines he or she may face include a certain amount of unpaid taxes and set amounts for each instance of independent contractors or unreported employees.

How Can an Employer Avoid an Audit from the EDD?

There are a number of ways to avoid an EDD audit. Among the ways to steer clear of the EDD is to properly classify employees, be fair with workers, pay their workers and submit taxes appropriately, and be honest with the government. However, if the audit is random in nature, then there can be no avoiding it.

How long does EDD have for audit?

The statute of limitations for a California EDD audit must be within three years after the day of the month following the close of the calendar quarter during which the liability occurred. While the statute of limitations for California EDD audits is three years, the EDD audit statute of limitation may be extended to eight years involving fraud or intent to evade an employer’s EDD payroll tax responsibilities in some cases.  If the business owner did not file a payroll return for a select period or the EDD suspects fraud, the statute of limitations for an EDD audit might be extended for up to eight years or longer.

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