Guide To California EDD Payroll Audit Process

Receiving a notice from the California Employment Development Department (EDD) can be stressful and worrisome. What did you do wrong with your payroll filing? Were the issues actual mistakes, or did fraud occur somewhere down the line? You might not be able to get the answers you want immediately, but you should consult an EDD audit attorney to discuss the process and ensure you are represented by an experienced firm.

Consulting with an experienced EDD audit lawyer can benefit your company in two ways: help to limit the penalties placed on your business and prevent the auditor from reviewing your documents unchecked. An attorney will fight to reduce or eliminate penalties while also making sure the auditor does not go through your documents without being questioned.

Why are Employers Audited by the EDD?

The EDD audits employers because its primary responsibilities are to administer the state payroll tax laws and collect payroll taxes from all of the employers in California. These taxes include two that are paid directly by California employers and two that are collected from employees and then paid by employers on behalf of their employees. The four taxes include the following:

• Employment Training Tax (ETT): This tax is paid by employers and goes towards
  a program for training workers in specific industries.
• Unemployment Insurance (UI): This tax is paid by employers and helps to cover
  the unemployment benefits program of California.
• Personal Income Tax (PIT): This tax is paid by employees based on their income
  earned.
• State Disability Insurance (SDI): This tax is paid by employees and it covers the
  cost of disability benefits for California workers who suffer an illness or injury on
  the job.

As you can imagine, an audit conducted by the EDD is done in order to determine whether or not a company has paid the correct amount of taxes according to California tax law. The audit will review the direct liability of the employer and if it has withheld the proper amount of taxes from its employees.

What Triggers an EDD Audit?

An EDD audit can be triggered for any of the following reasons:

• A worker mentions that they are an employee instead of a contractor
• Errors found in time records, statements, and other documents
• Paying or filing late
• Canceled or delayed payroll due to technical difficulties

EDD Audit Types

The EDD has two types of audits: the verification audit and the request audit. The verification audit is much less stressful than the request audit. If your company has been sent notice of a verification audit it simply means that the company was randomly selected for this audit and there is no assumption of wrongdoing. The selection guidelines for a verification audit include the following:

• The number of workers at the company
• The size of the payroll
• The type of industry
• The geographic location
• Liability present within a set period
• Any combination of the above requirements

A request audit is the more serious of the two audits conducted by the EDD. When a request audit is initiated it means that there has been an assumption of wrongdoing by your company. The EDD has information triggering the audit that was obtained by an investigator or provided by a former employee.

When a company is targeted for an EDD audit, the EDD will send a package that includes the following:

• The EDD audit letter
• A pre-audit questionnaire
• A pre-printed request for your company’s records pertaining to a set timeframe

The minimum request for documents by the auditor will ask for the following items:

• Check registers and stubs
• Verification of business ownership
  • City business license
  • California Department of Tax and Fee
  • Administration number
  • Any license required to operate your
  • business, such as a liquor license, California
  • Contractors State License, etc.
  • Written agreements (such as Partnership
  • Agreement or Articles of Incorporation)
• General ledger and journal
• Canceled checks
• Bank statements
• Pay-out slips and vouchers
• Annual financial statements
• 1099s

Records required for verification of payroll include the following federal employment tax reports:

• Wage and Tax Statement, Form W-2
• Employee’s Withholding Allowance Certificate, Form W-4
• Employer’s Quarterly Federal Tax Return, Form 941
• Employer’s Annual Federal Unemployment Tax Return, Form 940

State employment tax reports required for verification of payroll include:

• Quarterly Contribution Return and Report of Wages, DE 9
• Quarterly Contribution Return and Report of Wages (Continuation), DE 9C
• Quarterly Contribution and Wage Adjustment Form, DE 9ADJ
• Tax and Wage Adjustment Form, DE 678
• Employee’s Withholding Allowance Certificate, DE 4

The package might also include a request by the auditor to extend the EDD audit statute of limitations period, which is typically for a period of three years. It is in your best interest to show all of these documents to your EDD audit attorney as soon as possible. The EDD likely won’t notify your attorney with copies of these documents. Your tax attorney will also need to sign the EDD Power of Attorney.

How to Prepare for an EDD Employment Tax Audit

Once you have been notified of an EDD employment tax audit, you should begin preparing immediately. The auditor will want to receive the requested documents as soon as possible so they can begin the audit without much delay. You should do the following in preparation for an EDD audit:

• Review all of the company’s independent contractor agreements
• Obtain documents from contractors to prove they own their own business
  (business card, W-9, invoice, letterhead, or a business license)
• File your quarterly employment tax returns on time
• Deliver your 1099s on time to contractors
• Keep records of all cash payments

What are Auditors Looking for During the EDD Audit Process?

EDD auditors will be looking for four issues during the EDD audit process, including the following:

• Taxable wages that were reported by the company
• The amount of tax paid by the company
• Payments made that could possibly be reclassified as taxable wages
• Misclassification issues

The California EDD Audit Process

After the notice of an audit is sent, an entrance interview will be scheduled. At the entrance interview, the auditor will meet with you and your lawyer. This meeting happens before any review of financial documents occurs. The auditor will explain the reason for the audit, explain the process, obtain information about the business and its records, and answer any questions you have.

Once the entrance interview is complete the auditor will then begin the actual audit of your company’s records. The auditor might require additional clarifications from you regarding tracking payroll, reporting payroll, classifying workers, and employee records that document how misconduct or termination are handled.

The EDD auditor will attempt to verify the following during the audit:

• That you own the business and the type of business it is registered as (sole
  proprietorship, partnership, corporation, other)
• That individuals compensated for services performed have been properly classified as independent contractors or employees
• Discuss unreported payments made for personal services and the nature of the
  relationship between the employer and the recipient of the payment
• That the acknowledged gross wages and taxable wages were reported correctly
• That the employer has correctly reported and withheld personal income tax wages that were paid to its employees

It’s important to note that the information gleaned by the EDD in the audit will be shared with the IRS due to an exchange agreement. The IRS can then use the shared information in its own tax program.

After the auditor has all of the documents and information needed, they will issue a proposed notice of assessment (PNA). You will be able to review the PNA and request changes made to it, however, the auditor is likely to keep the PNA as-is and then issue a notice of assessment (NA).

How Long Does an EDD Audit Take?

This is a difficult question to answer because the audit process doesn’t always play out the same with each business being audited. The length of the audit depends on your level of cooperation, how quickly you submit the requested documents to the auditor, and your ability to find the information the auditor needs. But, for the most part, the audit should not last longer than six months to complete.

Results of an EDD Audit

Once the audit has been completed, the auditor will discuss the findings of the audit with you and your lawyer. An EDD audit will have one of four outcomes, including the following:

• The audit is labeled as no-change, which means that there are no differences found
• An audit labeled as an overpayment, which means you will be issued a refund or a credit
• An audit labeled as an underpayment, which means the difference will be assessed
• An audit labeled as an overpayment and an underpayment

Appeals for an EDD Audit Decision

The Employer’s Bill of Rights provides you the opportunity to appeal the decision of an EDD audit. You can file a petition with the California Unemployment Insurance Appeals
Board for reassessment of the audit findings. A hearing will then be scheduled with an Administrative Law Judge.

What are the EDD Audit Penalties?

Once an audit is finalized and the appeals process is complete, the EDD will demand that all penalties, interest, back taxes, and fees are paid within 30 days. The EDD will assess a 10-percent penalty if the amount cannot be paid in full within 30 days. In most audits, the penalties will be more than the taxes owed by the business.

Can I Settle with the EDD?

You have the option to propose a settlement with the EDD, but it is recommended you do so with the help of a tax attorney. A settlement should be a significant offer so that the EDD settlement officer considers accepting it. The officer’s job is to consider the consequences of litigation and how the case can avoid going to court. If your settlement offer is accepted, you will be able to skip the appeals process. Acceptance of the settlement does not mean you are free of liability in the case either, so be prepared to face some penalties from the EDD.

Seek EDD Audit Representation Today

You are not required to have an attorney represent you when being audited by the EDD, but with any tax issue, it is in your best interest to have legal representation. A tax attorney from Abajian Law will be able to review the case, help you provide the correct documents, and ensure that your rights are protected throughout the EDD tax audit process. Call our office at 818-396-5059 today to schedule an appointment with an experienced tax attorney.