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Ways to Mitigate Your Risk of an EDD Audit

Man on a table with a laptop

If you utilize contractors in your business, you are responsible for all of their financial, legal, and administrative paperwork. One of the most important responsibilities you are in charge of is withholding employment taxes and remitting them to the appropriate agencies. Failing to do so (or improperly filing) can result in a federal audit, penalties and interest, back wages and taxes — and in California, an Employment Development Department (EDD) audit.

The EDD is permitted to conduct payroll tax audits on any business operating within California, and you should take great caution to avoid an EDD audit because of the assessments and potential penalties that will directly affect your business. Here are some ways to help protect your business and avoid an EDD audit.

Classify Your Employees Correctly

One of the most common items that trigger an EDD audit is when an independent contractor attempts to claim unemployment benefits, workers’ compensation, or disability benefits. Independent contractors are not employees, and therefore, they cannot receive these benefits. If they try to do so, this will raise a red flag with the EDD.

Determination between an employee and an independent contractor is factored by “direction and control”: an employee has little control over how, when, and where work is performed, whereas an independent contractor is in control of all of these elements. If you have misclassified an independent contractor as an employee – whether intentionally or unintentionally – you could face an audit and penalties from the EDD.

If you are uncertain how to classify a worker, the IRS can help. Fill out IRS Form SS-8, and the government will determine the worker’s status as either an independent contractor or an employee.

Pay Wages and File Taxes Accurately

In addition to paying your employees and your contractors their correct wages, you must also follow federal guidelines for minimum wage and overtime unless they are exempt. When compared to other states California has stricter minimum wage laws which increase minimum wage on January 1 every year, effective starting January 2017.

As an employer, It is also your responsibility to withhold the proper amount of income and employment taxes from your employees, as well as payroll taxes (which includes Social Security and Medicare taxes). Independent contractors, on the other hand, are responsible for filing these taxes on their own. An independent contractor who becomes an employee (and thereby receives both Form 1099 and Form W-2) may raise suspicion as to why that worker was not classified as an employee for the entire time.

Be Fair to Your Workers

Employees or independent contractors can also notify the EDD of improper payment or classification. They can file an official complaint with the California Department of Labor’s Wage and Hour Division, or they can anonymously tip off the IRS — who will then notify the EDD. An independent contractor can also fill out an IRS Form SS-8 if he or she believes they were incorrectly classified.

Disgruntled ex-employees or former independent contractors may also notify the EDD if they felt that they were not paid in a timely fashion.

Don’t Lie to the Government

Paying workers under the table is a practice that leads to fraud investigations and an audit by the EDD. Similarly, reporting wages different than what was paid constitutes fraud in the eyes of the EDD. You must take care to report accurate wages and start dates for your employees to avoid any discrepancies with the EDD.

You May Receive a Random Audit

The EDD performs random audits, so you could be fully compliant and still receive an audit notice. With an EDD audit, an auditor will request access to relevant documents including (but not limited to) federal and state income tax returns, IRS Form 1099 and information returns, payroll records, financial statements, check registers, ownership verification, and bank statements. You should have a system in place to keep these important documents organized and handy in case of an EDD audit.

If you face an EDD audit for any reason, you should contact a professional tax attorney at Milikowsky Tax Law for assistance. We can ensure you are properly prepared and represented during your EDD audit.