What Triggers an EDD Audit in California?

If your business is currently facing an audit from California’s Employment Development Department (EDD), it’s crucial to understand what led to this scrutiny. Knowing the reasons behind the EDD audit not only helps you navigate the audit process effectively but also allows you to identify any potential compliance issues unrelated to payroll tax liability that could put your business at risk.

Why Does the California EDD Audit Employers?

The California EDD plays a vital role in administering the state’s payroll tax laws and collecting payroll taxes from employers. This includes managing four distinct tax types, two of which employers pay directly, and two that employers collect and remit on behalf of their employees:

Unemployment Insurance (UI): An employer-paid tax designed to cover the costs of California’s unemployment benefits program.

Employment Training Tax (ETT): An employer-paid tax that supports a state training program for workers in specific industries.

State Disability Insurance (SDI): An employee-paid tax that funds California disability benefits for workers who experience injuries or illness.

Personal Income Tax (PIT): An employee-paid tax on earned income.

When the Employment Development Department conducts an audit, its primary objective is to ascertain whether an employer has fully met its payroll tax obligations under California law. This includes evaluating the employer’s direct tax liability and ensuring compliance with withholding requirements for SDI and PIT taxes, which must be withheld from employees’ compensation. As outlined in the EDD’s Information Sheet for the Employment Tax Audit Process:

“The payroll tax audit [EDD audit] verifies compliance with the [California Unemployment Insurance Code (CUIC)], ensures workers are properly classified, payments made to employees are properly reported, and protects workers’ rights to receive benefits.”

What Triggers California EDD Audits?

The Employment Development Department (EDD) plays a crucial role in California’s financial ecosystem, as payroll taxes collected by the EDD significantly contribute to the state’s funding. To ensure compliance with payroll tax laws, the EDD employs a proactive approach that includes conducting audits and initiating collection procedures. However, due to the vast number of employers across the state, it is impractical for the EDD to audit every California business on an annual basis. Consequently, EDD audits are typically initiated based on various triggers and criteria, including:

The EDD Verification Process

The EDD conducts “verification audits” as part of its routine procedures, selecting employers either at random or based on specific predetermined criteria. These verification audits are not necessarily prompted by any specific events or allegations of wrongdoing but serve as a means to uphold tax compliance.

Independent Contractor Filing for Unemployment

 An alarm bell for the EDD is often sounded when an individual, previously classified as an independent contractor, files for unemployment benefits. Such a claim suggests a potential misclassification of employment status, which can raise concerns and prompt the EDD to investigate further.

Late Filing of Payroll Tax Returns or Late Payment of Taxes

 Employers are required to adhere to strict deadlines for filing payroll tax returns and remitting tax payments. Failure to meet these deadlines can trigger an EDD audit. Late payments are not only subject to interest but may also result in penalties. Even if the delinquency is not immediately detected, it may come to light during an audit.

Delayed Payment of Wages or Failure to Collect and Remit SDI and PIT

 Employees who do not receive their wages promptly or suspect issues with the withholding and remittance of State Disability Insurance (SDI) and Personal Income Tax (PIT) may report their concerns to the EDD. Such reports can initiate EDD audits to investigate potential violations and ensure that employees’ rights are protected.

In summary, the EDD diligently pursues its mission of upholding payroll tax compliance in California. While audits are a key tool in achieving this goal, they are not conducted randomly but are triggered by specific events, criteria, or reports. Employers should remain vigilant in meeting their payroll tax obligations to avoid the scrutiny and potential consequences of an EDD audit.

The EDD Audit Process: What You Need to Know

The Employment Development Department (EDD) audit process is a structured procedure aimed at businesses rather than individuals. It involves several crucial steps that taxpayers should be aware of, including the issuance of an audit notice, an entrance interview, the review of financial documents, requests for additional clarifications, and the issuance of a proposed notice of assessment (PNA). Let’s delve deeper into each stage of this process:

1. Mailing of an Audit Notice

The commencement of the EDD audit process begins with the receipt of an audit notice sent to businesses via mail. This notice serves as an initial alert to taxpayers, outlining the purpose of the audit and the documentation required as supporting evidence. It also provides an explanation of why your business has been selected for an audit, along with a set of preparatory questions to assist taxpayers in gearing up for the audit.

2. Entrance Interview

Following the issuance of the audit notice, the EDD schedules an entrance interview. The primary objective of this interview is to ensure that taxpayers understand the audit’s rationale and process. During this session, EDD agents elucidate the steps involved and gather essential information about the company. It is advisable to consult with a certified public accountant or an experienced tax attorney before engaging in the entrance interview, as their expertise can be invaluable in navigating this critical stage.

3. Review of Financial Documents

Subsequent to the entrance interview, the EDD requests various financial documents with supporting evidence to aid in the resolution of the audit. These documents may encompass business ownership verification, registries, bank statements, canceled checks, general ledger entries, annual financial statements, vouchers, pay-out slips, and 1099 forms. Providing these documents is pivotal as they form the basis for evaluating your records and reaching an informed decision.

4. Request for Additional Clarifications

In cases where inconsistencies are identified within the provided records, the EDD may request additional documents to address these disparities. These could include employee classification records and details pertaining to payroll tracking. It is crucial to maintain consistency in the information you provide, as discrepancies may lead to fines and penalties. Additionally, you may be required to provide documents illustrating how your business handles contract termination and employee misconduct, as well as your interactions with employees and any unreported payments for personal services.

5. A Proposed Notice of Assessment (PNA)

Following a thorough review of the documents submitted, the EDD issues a proposed notice of assessment (PNA). This document is sent to taxpayers for their examination and review, affording them the opportunity to request any necessary changes or revisions.

The duration of the audit process varies from case to case and largely depends on the level of cooperation and the ease with which necessary information can be obtained for the auditor. It is prudent to consult with a tax attorney to ensure that your interactions with the EDD during the audit process are handled strategically and that potential issues are mitigated effectively.

Facing an EDD Audit? Our Southern California Tax Attorneys Are Here to Assist.

In summary, if your business is undergoing an EDD audit, our tax attorneys can provide expert guidance in dealing with the Employment Development Department. 

To learn what to expect in a California EDD audit, read our article, here.