Why Does EDD Do a Benefit Audit?

The EDD conducts benefit audits to help pay Unemployment Insurance benefits to only eligible claimants only, prevents fraud in the UI program, and helps companies control UI costs. The EDD’s responsibility is to collect payroll taxes and conduct payroll audits of businesses.


Author: Brad Nakase, Attorney

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What triggers an EDD audit?

Employee benefits, registry, and an independent contractor filing for unemployment can trigger an EDD audit. EDD benefit audits are conducted regularly to ensure that Unemployment Insurance is distributed to eligible claimants.

For example, Felix is the owner of a small construction business that works on building residential houses. Recently, Felix received a notice from the EDD that indicated it would perform a benefit audit. Felix is confused as to why he has been selected for this kind of audit. Then he remembers a contractor he hired a few months ago to do some work for his company. He suspects that the contractor has misclassified himself as an employee to apply for unemployment insurance. This, Felix thinks, would have triggered an EDD benefit audit. Felix wonders if this is the primary reason that the EDD does benefit audits, or if there are other motives behind it.

What Happens When You Get Audited by the EDD?

When California business owners receive an audit notice from the Employment Development Department (EDD), their first instinct may be to worry. Nobody enjoys the idea of an audit, or what it implies. In California, EDD investigators look into business owners’ unpaid payroll taxes. If taxpayers do not agree with the assessment, then they can go through the California EDD audit process, which will investigate any potential or alleged violations.

The EDD studies business tax records to set apart independent contractors from classified employees. This means that a California business owner may face an EDD audit notice if he or she hires an independent contractor. This, of course, is only one of the reasons that an audit might be triggered.

First, let us go over what an EDD audit really is.

What Is an EDD Audit?

An EDD audit is also known as a payroll tax audit. The audit is a process that ensures workers are properly classified in a business. It also makes sure business owners are complying with the California Unemployment Insurance Code (CUIC).

An audit is triggered when the state government wants to ensure that business owners are properly reporting payments made to employees, as well as protecting employees’ rights to benefits. As in the case of Melinda and Manuel, a worker may apply for unemployment insurance, claiming that he or she was actually an employee and not an independent contractor as they were treated. In this case, an EDD audit may be triggered.

The purpose of EDD audits is to discover inconsistences and figure out if the employer is fully paying California payroll taxes.

What Can Trigger an EDD Audit?

An EDD audit may be triggered for many reasons. These include employee benefits, an independent contractor filing for unemployment, and registry. All of these may trigger an investigative audit from the EDD. Also, employee complaints, late filing of taxes, random verification, and failure to pay wages on time can trigger an EDD audit. Below, we will discuss some of these common triggers.

  • EDD Benefit Audit

One of the duties of the Employment Development Department is to collect and conduct payroll tax audits of companies and businesses. Benefit audits are really the EDD and employers combining forces to sniff out potential fraud. This particular audit process ensures the unemployment insurance fund’s integrity and thoroughness. This type of audit happens on a quarterly, weekly, and daily basis for employment tax. It usually results in the discovery of benefit overpayments.

What might trigger an unemployment audit like this? Usually, the EDD will select employers at random for this audit. Companies and businesses will be picked at random to undergo the process. Statistically it is unlikely that a business owner’s company will be randomly selected, but it can still happen to anyone.

In the event of this audit happening, the Employment Development Department may wish to investigate workers’ compensation insurance. If this happens, the company will receive a notice from the EDD declaring their intention of auditing the business. While the EDD will examine benefits, it may also conduct an audit to reclassify employees.

When an audit happens, the EDD commission will put together a task force to discover inconsistencies in employers’ practices. These inconsistencies will trigger an audit that is used to prevent fraud. The EDD sends agents from the task force to interview a company’s employees about their work and the company’s practices.

  • 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 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 attorney. They will help prepare the employer for the audit.

  • National Directory of New Hires

This type of audit is based on information provided by employers across the country to figure out if a claimant received Unemployment Insurance (UI) benefits while working and did not report their work and earnings. This is used for quarterly audits.

  • Interstate Crossmatch

The EDD cross-matches wages earned in different states to see if a claimant received benefits while working in another state. This is performed on a quarterly basis. If the EDD determines that a person has received benefits that they should not have, or if they were overpaid, then they will be charged that amount in addition to any relevant penalties.

What Is the EDD Audit Process?

If the Employment Development Department opens an audit, the process will start with the assigned EDD commission issuing an audit notice. It should be noted that the commission does not audit individuals, only businesses. Important steps in the auditing process include an entrance interview, review of financial documents, requests for clarifications, and a notice of assessment. It is also possible to appeal EDD audits.

Let us now review the major steps of an EDD audit.

  • Mailing an Audit Notice

The Employment Development Department will let taxpayers know that their payroll taxes are being audited. Taxpaying employers will receive a notice by mail. They will then respond by providing documents and evidence, also by mail.

An EDD notice will usually offer a list of documents that the commission would like for companies to provide as supporting evidence. There will also be information about why the employer received the audit from the commission. The notice will also include a list of questions to prepare the owner(s) prior to beginning the audit.

  • Entrance Interview

Once the Employment Development Department issues an audit notice to a business, the commission will schedule an entrance interview. This interview is meant to help business owners understand the reasons behind the audit. The assigned agent will explain the audit process and gather required information about the business.

This is the appropriate time for business owners to ask questions about the process. It may be helpful to engage a certified public accountant or tax lawyer prior to the entrance interview.

  • Review of Financial Documents

This is the time when the Employment Development Department will ask for financial documents containing supporting evidence. These documents may include ownership verification, stubs and registries, bank statements, canceled checks, and general ledgers. Also, the commission might want annual financial statements, pay-out slips, vouchers, and 1099 forms.

The purpose of providing these documents is to allow the commission to examine and assess a business’ records prior to making a judgement.

  • Request for Clarifications

It is possible that the EDD commission may ask for more documents to clarify inconsistencies in a business owner’s records. Some of these additional documents may include employee classification records as well as information regarding payroll tracking. If the commission finds that the information an employer provides is inconsistent, then there may be consequences. These consequences may include fines and penalties.

An employer may offer documents that detail how the business deals with contract termination and employee misconduct. Unreported payments for personal services is a topic that may come up, as well as one’s relationship with employees.

  • Proposed Notice of Assessment (PNA)

Once the EDD auditor has received and assessed the employer’s documents, the commission will issue a proposed notice of assessment (PNA). The PNA is sent to the employer so that it available to access, study, and request changes.

How long does all of this take? It varies for everyone and depends on an employer’s cooperation and ability to produce information for the auditor. A tax lawyer can help an employer minimize admissions.

Filling Out an EDD Pre-Audit Questionnaire

A pre-audit questionnaire is meant to bring out admissions and gives auditors the necessary information for an audit plan. This form will ask an employer whether the business operates year-round, full-time, or seasonally. It will also ask for a description of the business.

The form also asks about services provided and the number of employees a business has. It will also want to know what employee benefits are provided. This questionnaire form has several sections.

Let’s review them.

  • Business Description

The pre-audit questionnaire asks for a description of the company in order to understand the nature of the business. The Employment Development Department uses this information to learn about the specific business model. Any incorrect or inconsistent information can result in penalties or fines.

  • Company Services and Employees

The EDD pre-audit questionnaire also asks about the company’s offered services and the number of employees it has on staff. The EDD uses this information to review the classification of the company’s employees. It is best to offer the EDD as complete an explanation as possible, as well as any helpful supporting documents as evidence.

  • Bookkeeping

Part of the EDD’s pre-audit questionnaire asks for information regarding the company’s accounting process, or its bookkeeping. The EDD will want to study any staff accounting records. It might be a good idea to offer information on bookkeeping records for each employee.

  • Employee Benefits

The pre-audit questionnaire will also ask for information about employee benefits in order to assess tax returns. It is best to provide this information on the form, because being prompt can lead to quick resolutions.

The Meeting with an EDD Tax Auditor

When an employer meets with a tax auditor, they will go over document assessment and audit results. The auditor will also review the reasons for the audit and go over the required documents and records. Most companies will hire an employment attorney to help with the EDD audit, and collect documents.

The auditor will need the business’ financial documents to examine. The auditor will confirm the business ownership and type of company for the income tax return. They will also confirm that all employees and workers are classified correctly.

The meeting may also address unreported payments made for personal services. It might also cover an employer’s working relationship with employees. The commission will also endeavor to ensure that the employer has withheld and reported personal income tax (PIT) and state payroll taxes on employee wages.

Again, before meeting with an EDD tax auditor, it may be beneficial to consult with an experienced tax attorney or certified public accountant.

What Are California Audit Penalties?

If an employer makes a late payment, the California EDD 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 misclassifies employees, the EDD audit issues 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.

How to Prepare for an Audit

After 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

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 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 ahold 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 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 audit, the Employment Development Department determines that some of an employer’s independent contractors have been misclassified and are actually employees. The EDD 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.

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What is an EDD Audit?

An EDD audit is a payroll tax audit initiated when a former worker you classified as an independent contractor applies for unemployment with EDD.  The EDD thinks you misclassified the worker as an independent contractor and audits your company. 

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