Tag Archive for: EDD Audit

California CPAs should ask their clients who hire 1099s if they have a contractual agreement, invoices, licenses, insurance, and an EIN.

Certified Public Accountants (CPAs) have the most insight into their business owner clients’ daily transactional history. You may find that your clients who have 1099 contractors are now in the grey area of worker classification since it was redefined by AB-5 in January 2020.  

Under the new bill, all workers are automatically classified as W-2 employees unless they meet all three of the following criteria

  1. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact
  2. The worker performs work that is outside the usual course of the hiring entity’s business
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

We frequently see cases of inadvertent contractor misclassification that are flagged by The Employment Development Department (EDD). EDD audits are most commonly triggered by: 

  • Independent contractors filing for unemployment benefits 
  • Employee complaints 
  • Late tax filings 
  • Random verification audits 

If the agency finds any misclassified workers during the audit, it results in fines, fees, and penalties that can be damagingly high if left unaddressed. 

Keeping this in mind, here are questions you can ask your clients to ensure that their 1099s are correctly classified, and help your clients reduce the risk of an EDD Misclassification Audit: 

  • Do your 1099s do similar jobs to your W-2s?
  • Do you have a contractor agreement with all of your 1099s?
  • Do your contractors Invoice you?
  • Does your contractor have a license?
  • Do they have insurance? 
  • Do they have an EIN?

Here’s an overview of how each question can provide more insight for your clients. 

Do Your 1099s do Similar Jobs to Your W-2s?

1099 independent contractors who perform similar jobs as W-2 employees may be considered an employee during an audit unless there is a clear distinction between the two. Make sure there are clear distinctions between the two. The W-2 employee works regulated hours, has specific job functions, is provided work equipment, and is told when and how to perform their job duties. They also receive employee benefits and do not have a clear end date for the work performed. 

On the other hand, 1099 independent contractors have flexible working hours, flexible job requirements as dictated through the contract, must provide their own working equipment, can work for multiple employers at the same time, and are not directly managed on job functions. They do not receive employee benefits and have a clearer job end-date. 

For example, one of your business owner clients may have a marketing coordinator who is classified as an employee. Your client may want to hire a marketing agency for a website redesign as a 1099 independent contractor. While both the marketing coordinator and the marketing agency perform job functions under the marketing umbrella, their job functions and classifications are different. 

The coordinator develops and executes the client’s marketing strategy specifically for your client’s company for as long as they work in that specific role. The hired marketing agency will perform the website redesign for your client until the project is complete. Once finished, the partnership is completed. While the marketing agency is working on your client’s website redesign, they can simultaneously work for other companies. 

Do You Have a Contractor Agreement With all of Your 1099s?

The independent contractor agreement outlines specific details for the job the independent contractor will perform. It is the working arrangement between the client and the contractor that typically includes:

  • A description of the job or service provided by the contractor
  • Payment details (this can include information about retainers, deposits and billing) 
  • The length and term of the project or service 

Do Your Contractors Invoice You?

Invoices help keep records of payments, type of work performed, and hours worked. Having organized records of invoices between the contractor and the client helps EDD verify that the independent contractor is indeed an independent contractor. 

Clients who put 1099s on scheduled payroll put themselves at risk for a misclassification audit. W-2 workers should be placed on payroll, not 1099s. 

Does Your Contractor Have a License?

Some workers (such as healthcare professionals and construction workers) are required to provide proper licenses to work. Failing to hire workers with proper licensure can open your client’s business to hefty fines and penalties from EDD. 

If your client hires contractors who don’t have licenses do they have: 

  • A website?
  • A social media presence? 
  • A marketing budget?

These are all important factors to consider. 

Do They Have Insurance? 

Independent contractors provide their own insurance to cover liability, worker’s compensation, or other risks to help them protect their business. If your client is insuring their independent contractors, this is a sign they may actually be W-2 employees. 

Do They Have an EIN?

An EIN is an Employer Identification Number. This is a unique tax identification number for businesses in the United States to pay state and federal taxes. Asking independent contractors without an EIN to provide one is a simple way to further ensure they are 1099s.

All of these factors add up to a robust defense against a misclassification audit by EDD. By fixing any misclassification errors ahead of time, CPAs can save their business owner clients the hefty fines and penalties associated with EDD audit findings. Want to learn more about the EDD audit process? 

Read our article on what to expect in an EDD audit here. 

 

California CPA's should ask their clients the right questions to help them avoid triggering an EDD audit

infographics

California Assembly Bill 5 (AB-5) took effect on January 1, 2020, and is the new standard by which employers must classify employees. Small business owners (SBOs) should familiarize themselves with AB-5 and the ABC test to avoid employee misclassification and potential penalties from the Internal Revenue Service (IRS).

What is Assembly Bill 5 (AB-5)?

Assembly Bill 5, commonly referred to as AB-5, is a piece of legislation that extends employee classification status to some independent contractors, requiring that hiring entities reclassify these workers as employees based on the strict criteria outlined in the ABC Test.

What Caused Assembly Bill 5?

Assembly Bill 5 was inspired by the April 2018 Dynamex Case—when Dynamex reclassified all employees (previously classified as W-2s with all the associated perks) as independent contractors to save employee costs– before being signed into law by Governor Gavin Newsom in September 2019.

Read on to learn how Dynamex ruined it for everyone.

What Businesses Does AB-5 Affect?

AB-5 affects all small businesses and small business owners. Most prominently, AB-5 impacts SBOs who hire 1099 independent contractors and their operations in California.

How Does AB-5 Affect Businesses?

Through AB-5, the California Employment Development Department (EDD) places the burden of proof on businesses to show that workers are correctly classified as 1099 contractors.

The misclassification of employees can lead to:

  • High fines
  • Penalties
  • And back tax payments

How Do I Correctly Classify 1099 Independent Contractors?

AB-5 introduced the ABC test as a stricter guideline to determine how to classify a worker as a 1099 independent contractor. 

What is ABC Test?

Check out our video below for an in-depth explanation of the ABC Test.

The ABC test is a set of requirements that the worker must meet to be classified as a 1099 independent contractor instead of a W-2 employee. The worker must meet all three criteria of the ABC test to be correctly classified as an independent contractor:

  1. The worker is free from the control and direction of the hiring entity in connection to the performance of the work.
  2. The worker performs work that is outside the usual course of the hiring entity’s business.
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If the contractor fails to meet any of the criteria in the ABC test, they are automatically classified as a W-2 employee instead.  

How To Meet The ABC Test Criteria 

When classifying your 1099 independent contractors according to the ABC Test, gather the following information to make sure they are classified correctly.

The First Criteria

  • Gather information on project deliverables and how they are delivered.
  • Have your contractor submit an invoice.
  • Keep correspondence about project timelines recorded in a clear and accurate manner.
  • Ensure you’re not placing requirements on your 1099 contractors regarding how they perform their work. For instance, do not tell the workers what to do or specify reporting requirements. 
  • Document and file scope of work (SOW) from your contractor.

The Second Criteria

  • Compose a definition of your contractors’ line of work.
  • Compose your definition of your business’s line of work (i.e. what products or services does your company provide?)

The Third Criteria

  • Verify if your 1099 has insurance.
  • Ask if they have a legal entity.
  • Check if they have associations, unions, or other affiliations.
  • Review their professional certifications.
  • Gather their business card, website, and a list of other clients the contractor has worked for.

What is the Borello Test?

Before AB-5 was signed into law, the Borello test was used to determine if an employee should be classified as a 1099 independent contractor or a W-2 employee. The Borello test was established by the Supreme Court in S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989). The test relies on 13 factors to determine employee classification.

Even with new AB-5 regulations, the Borello test can still be a useful resource to help classify employees.

EDD provides the full Borello test worksheet with the following questions to help guide classification:

  1. Do you instruct or supervise the person while he or she is working?
  2. Can the worker quit or be discharged (fired) at any time?
  3. Is the work being performed part of your regular business?
  4. Does the worker have a separately established business?
  5. Is the worker free to make business decisions that affect his or her ability to profit from the work?
  6. Does the individual have a substantial investment in their job which would subject him or her to the financial risk of loss?
  7. Do you have employees who do the same type of work?
  8. Do you furnish the tools, equipment, or supplies used to perform the work?
  9. Is the work considered unskilled or semi-skilled labor?
  10. Do you provide training for the worker?
  11. Is the worker paid a fixed salary, an hourly wage, or based on a piece-rate basis?
  12. Did the worker previously perform the same or similar services for you as an employee?
  13. Does the worker believe that he or she is an employee?

Answering “yes” to questions 1-3 would provide a strong indication that the worker is an employee. Answering “no” to questions 4-6 would indicate that a worker is not in business for themselves and would likely classify as an employee. Questions 7-13 indicate important factors to be considered.

While answering “yes” to any one of the questions may indicate that a worker should be classified as an employee, no single factor is enough to determine classification independently.

The full worksheet provided by EDD provides further clarification on certain factors and circumstances.

If completing the provided worksheet does not provide sufficient clarification for employers, EDD also offers the ability to request a written ruling by completing a seven-page form called Determination of Employment Work Status. The form supports any business entity looking to determine if a worker is an employee or an independent contractor.

How Do I Avoid Misclassification?

You can avoid misclassification by carefully analyzing the arrangement you have with your worker in relation to the guidelines described in the ABC test and regulations set forth by AB-5.

To learn more, read on about how to hire an independent contractor.

Small business owner responds to EDD audit

Now that the April filing deadline has passed, small business owners may be asking: what’s next?

As tempting as it may be to put off thinking of taxes until next year, some small business owners may be required to respond to an California’s Employment Development Department (EDD) audit.

Read on how to learn common EDD audit triggers and and how to respond.

What is a CA EDD Audit?

EDD conducts an audit to determine if the employer has paid the full and correct amount of taxes due under California law.

What Triggers EDD Audits?

The following circumstances most commonly trigger EDD audits:

  • An independent contractor filing for unemployment
  • The EDD verification process
  • Late filing of tax returns or late payment of taxes
  • Failing to pay wages on time or collect SDI and PIT

Many verification EDD audits are conducted on a random basis. These audits are not based on any assumptions of inaccurate or incomplete information. Additionally, EDD has the power to audit a company if they believe the business has purposefully misclassified workers in an attempt to avoid paying payroll taxes.

However, many legitimate businesses are unintentionally misclassifying employees. Many of these misclassifications are a as a result of new, strict worker classification regulations, related to Assembly Bill 5 (AB-5).

What is AB-5?

AB-5 is a piece of legislation that extends employee classification status to some independent contractors and gig workers depending on the qualifications outlined in the ABC test. AB-5 went into effect on January 1st, 2020, and changed how Small Business Owners (SBOs) who hire independent contractors operate in California.

Learn more about how this law came into effect, and how Dyanmex ruined it for everyone, here. 

How Can AB-5 Lead to the Misclassification of Employees?

AB-5 introduced the ABC test as a stricter guideline to determine how to classify workers as 1099 independent contractors. A worker must meet all three criteria of the ABC test to be classified as a 1099 independent contractor instead of a W-2 employee. The worker must:

  1. Be free from the control and direction of the hiring entity in connection to the performance of the work.
  2. Perform work that is outside the usual course of the hiring entity’s business.
  3. Be customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If the contractor misses one of the criteria in the ABC test, they should be classified as a W-2 employee.

Learn more about AB-5 and the ABC test, here.

What Happens If I Misclassify an Employee?

Employee misclassification can lead to several unfortunate outcomes, including fines and penalties.

With the new regulations, employee misclassification is more common for small businesses. As an example, let’s examine the case study of one of our clients, Ryan Brown, who misclassified his workers and was faced with EDD audit.

Check out the video below!

Meet the Client: Ryan Brown

Ryan Brown owns a construction company in Oceanside, California. His business classified a portion of the staff as 1099 independent contractors and the rest as W-2 employees.

How Can the Misclassification of W-2 Employees Happen?

The services of the hired independent contractor must be consistent with all three of the criteria established by the ABC test or they are automatically classified as a W-2 employee.

In Brown’s case, he didn’t realize that the independent contractors were providing the same services as the W-2 employees. Therefore, the employees he classified as independent contractors didn’t meet the second requirement, “[workers] perform work that is outside of the usual course of the hiring entity’s business.” Thus, all staff members should be classified as W-2 employees–any worker the business claimed was an independent contractor was misclassified.

What Triggered Brown’s EDD Audit?

EDD conducted a random site sweep of Brown’s business. This sweep resulted in EDD finding misclassified workers.

What Happened When Brown Contacted Milikowsky Tax Law?

Brown called Milikowsky Tax Law and set an initial meeting. Before signing any kind of retainer, John started making calls to learn more about the audit and what steps they needed to take immediately to protect the business and provide accurate information to EDD and CSLB.

What Were the Results of Brown’s EDD Audit?

After less than a month, EDD sent a final letter indicating the decision– minor fines were due, the case was closed. For Brown, the results–and knowing his business was going to be fine– provided a sense of relief.

Ryan’s results are both exceptional and the kind of outcome our team strives for with every client. And while we can’t promise any client’s outcome will be the same as another, we can say with utmost assurance that the team at Milikowsky Tax Law is your relentless advocate in the face of EDD, CSLB, and IRS audit.

Right of Control: Who has it and How Does EDD Determine 1099 Status?

When determining whether your workers should be classified as employees or independent contractors, it’s critical to ensure that you are closely following the Employment Development Department’s (EDD) strict guidelines. 

On the simplest level, proper classification is determined by whether or not the principal, or employer, holds the “right of control.”

What is “Right of Control?”

Right of control is determined by who holds the “right to control the manner and means” by which work is performed. 

A corporate administrative assistant, for example, reports directly to an executive who manages their work. Likely they work a classic Monday through Friday, 9 to 5 schedule. When they want to go on vacation, they have to request time off or let their manager know in advance. 

Now consider an app-based rideshare driver. When they’re available to work, they log into the app and begin work. Perhaps after a couple of hours, they decide they need a break, they disable the app and log off for a break. While they are required to abide by the rules and regulations set in place by the company that they work for, their hours and responsibilities are not deliberately determined by the company overall. 

How does EDD determine 1099 status?

EDD utilizes the right of control as an initial way to classify workers. They take things one step further by providing a worksheet that employers can utilize to help clarify discrepancies. 

Since January 2020 the new ABCs of worker classification has been implemented to try to simplify the process of determining worker classification.  Under the ABC test, a worker is considered an employee and not an independent contractor, unless the hiring entity satisfies all three of the following conditions:

  1. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  2. The worker performs work that is outside the usual course of the hiring entity’s business; and
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Since the passing of the AB_5 gig worker bill, there have been multiple rounds of exceptions, exclusions, and widespread confusion about how the rules affect real-life business scenarios.  In cases of confusion, the original 13 point Borello test is still the fallback. 

The questions posed in the EDD Borello criteria include the following 13 elements to provide additional support in determining workers’ proper classification. They include the following: 

  1. Do you instruct or supervise the person while he or she is working? 
  2. Can the worker quit or be discharged (fired) at any time?
  3. Is the work being performed part of your regular business?
  4. Does the worker have a separately established business?
  5. Is the worker free to make business decisions that affect his or her ability to profit from the work?
  6. Does the individual have a substantial investment in their job which would subject him or her to the financial risk of loss?
  7. Do you have employees who do the same type of work?
  8. Do you furnish the tools, equipment, or supplies used to perform the work?
  9. Is the work considered unskilled or semi-skilled labor?
  10. Do you provide training for the worker?
  11. Is the worker paid a fixed salary, an hourly wage, or based on a piece-rate basis?
  12. Did the worker previously perform the same or similar services for you as an employee?
  13. Does the worker believe that he or she is an employee?

Answering “yes” to questions 1-3 would provide a strong indication that the worker is an employee. Answering “no” to questions 4-6 would indicate that a worker is not in business for themselves and would likely classify as an employee. Questions 7-13 may indicate important factors to be considered. While answering “yes” to any one of them may indicate that a worker should be classified as an employee, no single factor is enough to determine so independently. 

The full worksheet provided by EDD provides further clarification on certain factors and circumstances. If completing the provided worksheet does not provide sufficient clarification for employers, EDD offers the ability to request a written ruling by completing a Determination of Employment Work Status

In cases where EDD initiates a worker classification audit, employers can be required to retroactively prove that their workers were correctly classified at 1099 contractors vs W-2 employees.  At  Milikowsky Tax Law we are experts in EDD audit defense.  Our team works with you to ensure that your audit does not spread to other areas, that EDD understands the scope and function of your unique business and that you are only liable for back fines and fees on those workers who are indisputably misclassified.  

We have represented hundreds of businesses and individuals audited by EDD, CSLB, CFTB, and IRS. Our team is dedicated to ensuring you get the best result and that your audit does not permanently negatively impact your business or your life. Reach out to our team for more information. 

Make sure you provide the list of employees, by wage category, including their wages and their job description with the corresponding code description.

We partnered with benchmark commercial insurance to discuss how audits relate to workers’ compensation. Benchmark offers a boutique approach to serving their clients through providing and maintaining commercial and personal insurance policies. Their goal is to establish comprehensive risk management and accident-avoidance programs to help prevent claims from arising. Get to know benchmark here

Watch our full video on how audits and workers’ compensation relate to one other in our video below.

 

 

How do Audits Relate to Workers’ Compensation?

Under a workers’ compensation policy, a policyholder is required to verify with the workers’ compensation carrier the actual wages that were paid to W-2 employees. In cases of hiring 1099 independent contractors, if they do not have workers’ compensation, the policyholder must verify the policy term. 

Most often, the audits triggered by workers’ compensation issues are referred to as wage verification protocol. The most important thing to remember about wage verification protocol when it comes to a workers’ compensation carrier, is making sure that you are providing the list of employees, by wage category, including their wages and their job description. In the provided list, make sure that each job description matches the code description in which you have them classified. 

During the process, your attorney should be reviewing the schedule with you before submitting the verification to the agent (auditor). Reviewing the schedule helps avoid having to reclassify wages in a higher-rated code post wage verification protocol. 

 

What is the wage verification protocol?

When the Employment Development Department (EDD) notifies business owners of the verification protocol, they send a letter in the mail. When business owners partner with our Milikowsky Tax Law team, we research the hired independent contractors that meet the criteria to be correctly classified as 1099 workers. In this process, we find:

  • Business reports 
  • Background reports 
  • Verify EAM and DBA
  • Business license 
  • EIN number
  • Social media accounts 
  • Website, if they have one (sometimes freelancers use Fiverr or Yelp pages instead)

Sometimes, during the verification process, EDD will notify business owners that workers were misclassified as independent contractors and should actually be classified as full-time W-2 employees. All of the information we gather on each individual worker helps build a case with EDD that the hired 1099 independent contractor is properly classified as such. 

The writeup we create for each worker is included in our initial response to EDD. When the auditor receives it, they don’t have to pursue the same research we already completed. While they will still need to verify our findings, the auditor will not have to develop their own theory about classification because we’ve already given them the story and the answer. This process is easier for the auditor to see versus when they are given information without a story behind it. 

There are tips and tricks to help business owners avoid feeling blindsided through the audit process either by EDD, CSLB, or by their workers’ compensation carrier. We’re here to help before business owners ever get to that process. Learn more about What to Expect in an EDD Audit here.

 

We partnered with benchmark commercial insurance to discuss how audits relate to workers’ compensation.

A 2021 EDD Audit will include classification criteria from the Borello Test and the ABC Test

Watch our video below to learn how the last 12 quarters affect your EDD audit criteria.

Have You Received an EDD Audit Letter?

The California Employment Development Department (EDD) sends audit letters through the mail. If you receive an audit letter, you have 30 days to reply. Typically, the agency audits back three years from the most recent tax filing. However, EDD sometimes will audit the previous year’s tax filings.

Right now, for example, an EDD audit period would span from 2018 to 2021; the standard 12 quarters (three years time). At this time, that means that your audit process will include the years before AB-5 was signed into law and those years after. EDD audits in 2021 will look different because of the two different verification methods: AB-5 and the Borello test.

What is AB-5?

The law in California named AB-5, effective January 1st 2020, changed the way EDD classifies workers as either W-2 or 1099s. Before January 1st, 2020,  the old rule, the Borello test, was in effect. The Borello test was broader and in the grey zone on who could be classified as a 1099 contractor.

In the case of current California EDD audits, auditors are making determinations on both the old rule for the appropriate time period and on the new ABCs of contractor classification as set forth in AB-5.

Because of this, in some cases, there may be a worker who is classified as an independent contractor under the old rule, and as an employee under the new rule because they don’t meet the more stringent requirements.

According to the California Department of Industrial Relations, workers are employees, not independent contractors unless all of the following requirements are met:

  • “The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  • The worker performs work that is outside the usual course of the hiring entity’s business
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.”

Under AB-5’s rules, 1099 contractors have to meet all three of the ABC’s of contractor classification to be considered to be a 1099 contractor. If they fail to meet even one classification, they’re automatically classified by EDD as a w-2 employee.

In audits that misclassification is proven, EDD can assess you for payroll taxes and penalties, and interest calculated based upon total payments made.

What is an Unemployment Audit?

Unemployment audits, otherwise known as Unemployment Insurance (UI) benefit audits, are also performed by EDD. The federal-state unemployment insurance system provides temporary wage replacement for those who have lost their jobs. The EDD conducts benefit audits periodically to protect the integrity of the UI program.

These audits aid in lowering employee UI costs. New employees are assigned a 3.4% UI rate for two to three years of employment, which fluctuate after that set time depending on your contribution to UI benefits. EDD can take from 1.5% to 6.2%, but the taxable wage limit caps at $7,000 per calendar year.

EDD benefit audits are conducted on a daily, monthly, and quarterly basis to ensure that UI is distributed to eligible claimants only. They are done by matching the information provided by employers against information provided by individuals who have filed a UI claim.

There are four types of unemployment benefit audits:

  • New employee registry benefit audit
  • National directory of new hires
  • Quarterly wage earnings
  • Interstate crossmatch

If you receive a benefit audit, respond with the completed audit form within 10 days of receiving the notice. For more information on the different types of EDD benefit audits, read our “What is an EDD Benefit Audit?” article.

What Should You Ask Yourself Before an Audit?

Before your company experiences an EDD audit, take the time to go through a profile for your 1099 contractors to ensure they have a legitimate business.

Questions to Ask:

  • Do they have clients?
  • Do they advertise?
  • Do they have their own website?
  • Do they have a business license, tax certificate, or EIN?

For some California cities, if you do business in that city, you’re required to get a business license specific to that location. For instance, if you’re a subcontractor performing work in multiple cities because you have a job that happens to be, for instance, in Del Mar (which is in San Diego and in Riverside), your subcontractors may need to get licenses just to complete that job.

To check the status of your contractor’s license, visit the California Contractors State License Board (CSLB) website. There, you can input your independent contractor’s eight-digit license (located on the contractor’s plastic pocket license), and the website will check if they are licensed under CSLB. The agency will then check the contractor’s:

  • License number
  • Business name
  • Personnel name
  • Home Improvement Salesperson (HIS) number
  • HIS name

Contractors’ licenses can expire or be revoked in the middle of a job so we recommend diligently checking that each contractor has a current license. This will help avoid the fines and penalties of an EDD audit. Click here to learn CSLB’s 10 tips for hiring a licensed contractor.

How Do I Verify My Worker’s Status?

If you are unsure of the correct worker classification there are services that will run independent contractor reports to verify the status of your 1099 hires as legitimate 1099 contractors.  Then you as a business owner can make an informed decision before an audit begins.

If your report uncovers that your workers are misclassified, you can then take the next steps to correctly classify them, or work together with your workers to ensure they then meet the criteria to become a 1099 contractor.

EDD audits are time-consuming and a hassle. Business owners undergoing an EDD audit should be prepared for each step of the process. Read our article on what to expect in an EDD audit for more information.

 

workers must meet all three criteria of the ABC test to be classified as an Independent Contractor

what is the process of an edd audit

If your business is experiencing an EDD audit, it’s important to know what to expect. Founder and managing attorney at Milikowsky Tax Law, John Milikowsky, breaks down the EDD audit process and the frequently asked questions that come with an EDD audit. 

What you can expect from us, whether you have a balance owed to the IRS or the State of California, an EDD audit, or a criminal matter, is a dedicated and passionate team of people who have a lot of expertise to help resolve your issues. Our process is very simple, but it’s very different from many other law firms.”

What is the EDD audit case process at Milikowsky Tax Law?

“We don’t simply submit records to the government. We analyze everything. We use a lot of data analytics to really understand your business. A lot of us, including myself, have run companies before, so we understand what you’re going through. 

We have a lot of business experience. We know exactly what to look for, and we can anticipate the questions the government’s going to ask and we’ll build strategies and defenses in advance.

Once we’ve looked at all your records and identified potential issues, we identify strategies to navigate around them. At that point, we execute on our findings and work toward a resolution for your case.

EDD Audit Step by Step Guide

If you are being audited by EDD, you will receive a letter of inquiry.  Upon receiving this letter, the clock starts counting down.  You have a limited about of time in which to respond.

Our process begins with an interview, in person or over Zoom in which we get a good understanding of your business.

We gather documents to begin to analyze everything.

  • Your accounting records
  • Your transactional documents
  • Interviewing your workers, 
  • Interviewing other business associates

After our internal analysis, we give you a debrief and provide a roadmap of how the case will likely proceed. 

Once we collect and analyze your information, build the narrative around why your contractors are correctly classified and how your business is structured, we begin to communicate with the government. 

Are All Audits the Same?

Whenever an audit is initiated, the audited party will receive a letter from the government requesting records for a “routine investigation”. In the case of EDD audits, the process is usually initiated by a red flag that you have misclassified your workers. Some of the ways the agency can be alerted to this are:

  • A 1099 contractor filed for unemployment
  • A competitor raised a complaint
  • You were subject to a random site sweep by EDD or Contractors State Licensing Board (CSLB)
  • Your payroll records did not match your IRS filings and the agencies communicated.

How is an EDD audit case resolved?

Edd audits require a lot of negotiation and communication because each business is structured differently, workers perform different jobs and the rules from classification have changed even within the 12 quarter audit period as it stands in Q4 of 2021. 

The final resolution comes in the form of a letter from the government that say either there is nothing owed, you owe fees penalties and back taxes or, there was an error in your favor. 

EDD Employee Misclassification Audit

As a business owner the best way to prepare for, or avoid entirely, an audit from the Employment Development Department (EDD), is to make sure that you’re correctly classifying your employees. Whether your employees W-2 or 1099 employees or a combination of both, it’s important to ensure that they are correctly classified as such. The misclassification of workers, whether mistakenly or purposely, may result in significant consequences for your business.

When do Misclassification Audits Happen?

Misclassification audits happen when EDD suspects you of incorrectly classifying your employees or contract workers. There are a number of different scenarios that may trigger an EDD audit. If one of your employees was incorrectly classified as a 1099 independent contractor and they file for unemployment, worker’s compensation, or disability, it may likely attract attention from EDD.

Additionally, EDD may be made aware of a potential issue if an employee or other source reports your business for improperly classifying employment status. That being said, even if you’re confident that you’ve classified all of your employees correctly and no employees have reported you, there’s still always a possibility that EDD might choose to audit your business. EDD consistently audits companies at random to ensure that businesses are complying with proper employment regulations. 

Preparing for your Upcoming Audit

The EDD audit process starts with the mailing of the notification of the audit. This notification informs your business that EDD intends to audit your payroll taxes. This initial documentation should include a detailed list of documents that EDD will want to review so that you can begin to gather the information they’ll need. It also includes questions for you to answer as they prepare to begin the audit process. 

Once you have received notification of an upcoming audit from EDD, you can begin collecting the requested information to make the audit as seamless as possible. It is best to solicit assistance as soon as you receive the notification of your upcoming audit. Experts such as those at Milikowsky Tax Law can support you through the audit process to ensure that you are protected to the best of your ability. 

EDD Audit Process

It’s important to be as compliant as possible when working with your EDD auditor. Making things more difficult will only continue to complicate the audit process further. It’s best to offer neither inadequate information nor unsolicited information throughout the audit process.

Typical EDD audits assess a business’s previous three years of payroll tax records. However, this can be extended to older records if the auditor deems circumstantial. 

There are various ways that an auditor can classify various employees. There is always a possibility that an auditor can utilize various factors of classification to favor EDD against the interests of the business being audited. The support of an experienced tax attorney can assist in protecting your business against such actions. 

After the Audit

The consequences of an audit range depending on what the outcome is. Unintentional misclassifications often result in a $50 fine for each employee that was wrongfully classified as an independent contractor.

Your business may also receive the following penalties:

  • 1.5% of employee wages to compensate for income tax withholding
  • 40% of employee payroll taxes
  • 100% of matching employer payroll taxes plus interest on each of these penalties
  • Failure to Pay Taxes penalty of 0.5% of the unpaid tax liability for each month of delinquency

Intentional misclassification often results in more serious penalties including 20% of wages paid and 100% of payroll taxes. In more severe cases, businesses may be charged up to a $1,000 fine per misclassified worker and up to one year in prison. Overall, California employers may see fines of up a total of $25,000 per misclassification violation.

If you need help preparing for, or navigating an audit from EDD, contact our team of experts at Milikowsky Tax Law.

A woman reading a book

California Assembly Bill 5 (AB5) has built-in exemptions for many businesses.  We say “Not So Fast”! Even exempted industries have to adhere to the old 13 point Borello criteria for classifying 1099 contractors.  So, while many business owners are celebrating the free pass the AB-5 exemptions seem to offer, take a step back and review the 13 points to ensure your 1099 contractors are still correctly classified. 

Assembly Bill 5 (AB-5), “The Gig Work Bill” fundamentally changed the way hiring companies must think about worker classification. The wrong choice can mean thousands of dollars owed to IRS, EDD, and CA State entities for back payroll taxes, worker’ compensation, fines, and fees. 

AB-5, which went into effect on January 1, 2020, impacts how companies classify workers and how those companies manage and verify workers who are currently recognized as 1099 contractors. The new rules tighten the definition of independent contractors and require employers to examine 1099 contractors from 3 key facets, “The ABCs” to determine whether or not their workers should be reclassified as full-time W-2 wage-earning employees.

In the past, the rules were lengthy (click here to view our infographic relating the old Borello 13 point criteria to the new ABCs of worker classification) However, since January 1, 2020, the new ABCs of worker classification are the standard and many business owners are viewing their workforce in a new light.

The intention behind AB-5 is to prevent employers from taking tax shortcuts as well as to protect workers who do not choose to work part-time or be a part of the gig economy.  1099 workers do not earn benefits such as health insurance, PTO, and unemployment insurance.  The exchange is that they do set their own hours and determine their own rates for services provided. Many employers have classified workers as 1099s  to avoid additional W-2 wage earner costs.  Because of this, CA EDD is on the lookout for misclassifications. 

Occupational Exemptions

  • Doctors, surgeons, dentists, podiatrists, psychologists, or veterinarians performing professional or medical services provided to or by a health care entity;
  • Lawyers, insurance brokers, architects, engineers, private investigators, or accountants;
  • Securities brokers/dealers or investment advisers and their agents and representatives registered with SEC, FIRA, or State of CA
  • Real estate agents, repossession agencies, direct-sales persons, commercial fishermen;
  • Individuals performing services under a contract with a licensed “motor club.”

Professional Services Exemptions*

  • marketing professional
  • human resources professional
  • travel agents 
  • graphic designers
  • graphic artist
  • fine artist
  • freelance writer
  • barber or cosmetologist 
  • esthetician
  • electrologist
  • manicurist
  • payment processing agent
  • IRS licensed tax professional

Referral Agency Exemption

  • graphic design
  • photography
  • tutoring
  • event planning
  • moving
  • minor home repairs
  • home cleaning
  • errands
  • furniture assembly
  • animal services 
  • dog walking
  • dog grooming
  • web design
  • picture hanging
  • pool cleaning
  • yard cleanup

Construction Industry Exemption *Construction is a particularly challenging area for exemptions take care

  • Subcontracts must be in writing and the subcontractor must be properly licensed
  • The subcontractor must be “customarily engaged in an independently established trade”—like a carpenter, plumber, or electrician
  • The subcontractor must be licensed by the Contractors State License Board
    • *NOTE the additional requirements for the construction industry exception
  • The subcontractor must maintain a business location, separate from the hiring entity
  • The subcontractor must be free to hire and fire its own workers
  • The subcontractor must assume financial responsibility for mistakes in written warranties or indemnity agreements, or as evidenced by insurance or bonds
  • Special restrictions apply to truck services

The team at Milikowsky Tax Law has resolved over 300 EDD Audits/ Investigations for business owners in California.  If you have multiple contractors and fall into an exempted category, or if EDD has reached out to you regarding an audit,  call our EDD experts today to review your case.

1099 Audits

How to navigate AB-5

Assembly Bill 5, which required companies to reclassify most independent contractors as employees, is hurting employees. California’s new AB-5 and Gig Workers Bill has employers concerned since it is unknown what EDD will do next. The bill that passed a few months back was already affecting business owners. Now more than ever, the effects are magnified due to the impact of COVID-19. Most recently, EDD requires all employers to review the classification of their workers resulting in many being relabeled as employees rather than independent contractors. This is where employers need to STOP what they are doing because there is another way to verify your contractor’s 1099 status. 

Evaluate the current status of your workers

Ensuring that all of your workers are classified correctly is one of the strongest ways to reduce your risk of an EDD audit. Worker misclassification causes a large portion of California EDD problems. It can be confusing for small business owners to accurately determine whether a worker is an employee (receiving a W-2) or an independent contractor (receiving 1099).

Employees are subject to the control, jurisdiction, and oversight of the company, but contractors typically perform specialized work or projects under a contract. Contractors also set their own hours and negotiate their own pay, and they have little oversight, guidance, or disciplinary action from you or your business. If you blur these lines and treat your independent contractors like your employees, EDD might consider this as participating in an employer-employee relationship.

If you are unsure whether someone who works for you is an employee or an independent contractor, consider the questions provided by the California Department of Labor Standards Enforcement (DLSE). The DLSE Classification Test asks questions such as: does the work require a special skill; how much control do you have over how the work is performed; who provides the materials or equipment necessary, and/or are the costs related to these materials reimbursed; how permanent is the relationship; and others that can help you make a clear distinction. You may also file Form SS-8 with the IRS to help determine the classification of your worker.

If your worker does not pass the ABC test

There are two immediate actions you can take as their employer. 

  1. Classify them as a Full-Time employee OR
  2. Change your work agreement in a way that allows them to pass the ABC test.

Navigating an Audit

If EDD finds that you owe an assessment, you have a right to appeal the results of the audit. To move forward with an appeal, you should seek the help of a professional tax attorney who understands the nuances of the appeals process and can represent your best interests. If you don’t feel confident handling your EDD audit alone, reach out to a tax attorney from the beginning — a professional with expertise in tax audits can help you navigate communicating with EDD and providing the required records to help the audit go as smoothly as possible.

The best prevention technique, of course, is to properly classify your workers in the first place. If you’re unsure of the correct category for some of your workers, IRS can assist with Form SS-8, designed to determine worker classification. Those workers who are not contractors (i.e., all W-2 employees) must have the proper income taxes and payroll taxes withheld and remitted. In the event of an audit, a professional tax attorney is your greatest ally. 

If you need help preparing for or navigating an audit from IRS or the state of California, contact our expert team at Milikowsky Tax Law.