Sam Brotman, JD, LLM, MBA November 23, 2020 22 min read

What Is an Employment Development Department (EDD) Audit?

The Employment Development Department, or EDD, is one of the largest California state departments and is responsible for administering the payroll tax regulations for California businesses and individuals

Payroll taxes administered by the Employment Development Department (EDD) include the following:

  • Employment Training Tax (ETT)
  • Unemployment Insurance (UI)
  • Personal Income Tax (PIT)
  • State Disability Insurance (SDI)

Employment Training Tax provides funds for training employees in specifically targeted industries to make California more competitive in business. It is withheld at a rate of 0.1 percent with a taxable wage limit of $7,000 for 2016.

Unemployment Insurance, also taxed at a rate of 0.1 percent and a limit of $7,000, is part of a national program administered by the U.S. Department of Labor to provide temporary payment to individuals who are unemployed through no fault of their own.

Both the ETT and the UI are employer contributions.

Personal Income Tax is levied on the income of California residents and income derived from the state by non-residents. The tax rate is determined by the employee’s Withholding Allowance Certificate (W-4 or DE 4). There is no taxable wage limit or maximum tax.

The Employment Development Department (EDD) and Franchise Tax Board (FTB) use these taxes to provide resources for state public services such as schools, public parks, roads, and health and human resources.

State Disability Insurance provides temporary benefit payments to workers who have non-work related disabilities and also is the source of Paid Family Leave benefits. The tax rate is 0.9 percent, with a wage limit of $106,742.

PIT and SDI are both withheld from employee wages and submitted by the employer to the Employment Development Department (EDD) and the Internal Revenue Service (IRS).

Most employers file and submit payroll taxes semi-weekly or monthly, although smaller businesses can pay on a quarterly basis. Very small employers can file once a year.

AB 1245 requires all employers electronically to submit employment tax returns, wage reports, and payroll tax deposits to the EDD. Before then, payroll taxes can be submitted via electronic funds transfer, credit card, and direct deposit.

Employment Development Department (EDD) Calculations, Exceptions, and Exemptions

There are special rules for family members who work for you, non-profit organizations, and special exclusions. Some employment types are not subject to PIT withholding, but wages may still be reportable.

People receiving work-relief or work-training financed by any government agency and inmates of a custodial or penal institution are exempted from ETT, UI, and SDI withholdings.

A business owner can apply for a waiver from paying payroll taxes due to reasonable cause, statutory exceptions or undue hardship. Each waiver is considered on a case-by-case basis.

Calculating withholding can get tricky when you must take into account holidays, terminations, leaves of absence and other delays. Communication between the HR benefits specialist and the payroll office is crucial for keeping tax withholding on track.

The EDD and the IRS Are Not Alike

The tax regulations in California are comparable to the federal tax rules but not identical.  There are different rules pertaining to family leave and who is held responsible for non-payment of corporate employment taxes. 

There are also subtle differences in how each defines employee classification.

Where and When Problems Occur

Employee Classification

Employee classification is the area that causes the most problems for business owners. Both the IRS and the EDD are very interested in whether a worker is classified as an employee or as an independent contractor.

An employer must withhold, file, and pay employment taxes for an employee, but not for an independent contractor. The EDD looks at the employer-employee relationship to determine classification.

If a person who hires an individual to perform services has the right to exercise control over the manner, method, mode and means of how the service is performed, the worker is an employee.

Late Filing and Payment

If you file or pay payroll taxes late you are out of compliance and will owe penalties and interest on the amount of tax you owe.

Miscalculations, Underpayment and Changes to the Business

If you miscalculate taxes, you will still be assessed a penalty if you underpay. If you try to conceal the existence of a worker by paying in cash and failing to file a Form 1099, you are also in trouble.

Changes to the business, like closing or expanding, must also be reported for the appropriate amount of taxes to be calculated and submitted without fear of penalty.

Employment Development Department Audits

The key to any Employment Development Department audit is to make certain all records submitted are relevant to the EDD. Any records that do not pertain to employment-related issues are not relevant.

Documents that can be requested include:

  • Check registers and stubs
  • Bank statements and canceled checks
  • General ledger and journal
  • Annual financial statements
  • Vouchers and pay out slips
  • Forms 1099

The EDD can decide to audit if a worker makes the case that he or she is an employee rather than an independent contractor (typically found out when the employee tries to apply for unemployment insurance).

Other triggers for an audit include:

  • iling or paying late
  • Errors in time records or other statement or documents
  • Digital failures that cancel or delay payroll

What Is a California Payroll Tax Audit?

The last few chapters served as background for how our federal and California state payroll tax systems work and now we are about to dive into the heart of our discussion concerning California payroll tax audits.

A payroll tax audit is exactly what it sounds like. It is the government coming in and doing a check to make sure that your company’s payroll tax was being paid properly.

From a practical perspective, there are a couple of different ways where payroll tax audits go awry. First, is in the reporting of the actual payroll. The government is going to first check whether the proper amount of payroll was reported to California.

Second, is in the reporting of how the tax was calculated. For most businesses, especially if they are using a third-party payroll service, the state is not going to find too many errors. Most people report payroll correctly and then the tax calculations are fairly automatic.

Seems pretty straight forward, right? Actually, the devil is in the details when it comes to a California payroll tax audit. The payroll and tax paid calculations from the W2s and California payroll tax filings is not exactly what they are going after. For most businesses, errors do not exist in these areas (although it does happen especially where there are hourly employees or other variables). Rather, the critical questions that usually get asked in a payroll tax audit is whether or not there are payments that were made outside of payroll that should have been taxed.

Generally speaking, it is these two categories that represent the risk for most businesses in a California payroll tax audit. The first category is if payments on the general ledger are being made to either A) the officers, which should have been taxed as wages and therefore subject to payroll tax or B) payments being made to others which should have been categories as taxable wages.

The second area is the California tax auditors targeting independent contractors and 1099 workers. This has gotten a lot of press recently because of the passage of AB5 in California. The state government is taking great effort on their part to scrutinize independent contractor relationships and reclassify those individuals as employees. So, it is through these tests that the government is going to subject a business to scrutiny and potentially assess a liability that is much higher than what is originally reported.

Why Did Your Business Get Selected for a California Payroll Tax Audit?

There are a variety of factors that get you in the crosshairs of a payroll tax audit. Some of those are innocent factors and some of those are not so innocent factors. The EDD operates on, what they call, a lead system. In order for a payroll tax audit to happen, a lead needs to get generated from somewhere.

California Payroll Tax Audit Triggers - the EDD's lead system.

The EDD in California operates under what is commonly referred to as a “lead” system. The Employment Development Department has a computer system that generates leads for its district offices in order to follow up on taxpayers to determine whether or not they are going to audit them. 

There are a lot of things that can trigger a lead. For example, unemployment claims filed by 1099 workers trigger EDD leads all the time. Another example could be if you are going through a workers’ compensation audit or a wage and hour audit with the EDD; sometimes those will trigger a referral. The EDD also gets leads from their underground economy unit, which is for taxpayers who are not filing or reporting properly.

You can have a lead issue for issuing too many 1099s over W-2s and what too many is, is anybody's guess. You could have a lead issue for being in a certain type of industry. You can have a lead issue for somebody calling and saying that you are employing employees as independent contractors or if the government sees a huge change in your payroll from year-to-year and so forth.

There are a variety of things that make up the EDD's lead system. Here is the issue. From a statutory perspective, the EDD is required to follow up on any leads it gets. So, even if the lead is bogus, the EDD will follow up on it in some way, shape or form. In many cases, this is what leads to a payroll tax audit. And, not all of these factors are things that are in your control

Usually, the EDD will follow up on leads by sending you a pre-audit questionnaire and making a decision whether or not to audit you. You need to be very careful if you receive a pre-audit questionnaire because what it likely means is that a lead was generated in the EDD system and they are following up with you in order to assess your viability for a payroll tax audit

It is important to understand at the outset what probably got you triggered and that is the area that the auditor is likely going to focus on. The auditor is still going to go through their process and go through the tests involved in the EDD audit, but they are going to be focused on the area that is the biggest cause for concern.

By understanding what that area is and how it relates to you as a company, then you can work to mitigate that issue and increase your likelihood of success that you will pass the EDD audit with flying colors.

How to use the EDD lead system against the tax auditor in a California Payroll Tax Audit

Depending on the strength of the lead, the auditor may or may not know information about your case ahead of time. The first call on the audit is to figure out exactly what the auditor knows about the case. How much third-party information have they gathered and what access to that information do they have. A lot of times what you are going to find is-- or especially early in the process, the auditor has not done the due diligence necessary to really investigate the client's circumstances. They are following up on a lead, there is usually a triggering issue, they've been assigned to the case and they have to go through the process of documenting a report and going from there.

Here is how you can deal with an issue that you suspect is the lead issue in the context of the payroll tax audit.

Step one, figure out what the auditor knows about the client.

Step two, repeat back what you know about the client to set the framework and the auditors mind for how they run their audit.

For example, take a client we had who issued a high amount of 1099s for a business. They have six employees, they happened issue 30 1099s in the year in question. The auditor says, we asked the auditor, "Hey auditor, do you have any idea why the client is being audited?" They say, "Well, it appears that the client is issuing a large amount of 1099 based on the number of employees they have."

"Okay. Let me just explain to you. We thought this was going to be an issue ahead of time. I just want you to know that the business in question uses a lot of independent things to help them do their job. They've also 1099'd their landlord, they've 1099-ing their SEO company, they're 1099-ing in their bookkeeper. I'll probably get 1099 at the end of the year. but anyway, that's why it has nothing to do with their employees or employees of employees.

They've got the same six people working in the business that have been working in the business for the last three years. One or two come and go but everything's pretty fine. But just so you know, we've got this 1099 issue addressed. We don't think there's going to be any real problems in the audit."

You see what we just did there? Is I've just set an expectation to the auditor. The auditor now has a fact in their mind. It's an unverified fact but I've already stated a position. I've already started crafting a narrative to the auditor.

Assuming that I can present evidence that will back up that narrative, the auditor is going to start to believe that story, the more the auditor believes your story, the deeper they go down the rabbit hole then they are going to basically mitigate any issues in their own mind without you having to do it for them. This will speed up the pace of your audit, this will get you through your general ledger test a lot quicker

This will get you through 1099 tests quicker because if the auditor believes your story, just like when you believe things, you have confirmed a belief that you think is true and you go from there. After you've explained the position, after you've set the auditor mind, then you're going to want to go through the author's initial document request. Hopefully, you're going to want to try-- Most audit request for three years. Hopefully, you want to try and limit the scope of the document request to one year for the client’s sake and your own,

Two Common Problems for Taxpayers in California Payroll Tax Audits

The first and biggest problem is the misunderstanding that the taxpayer has by thinking that just because they did not do anything wrong, there is no risk associated with the audit. That is a fallacy because a lot of times the EDD is auditing somebody because they have a reasonable suspicion that something they are doing is not correct. It is very important for the taxpayer to understand what their risk is in the beginning of the audit and then take step things to mitigate that risk during the audit process.

The second common problem that we have in audits is with independent contractors. A lot of times the clients will insist that their independent contractors are really independent contractors, but the problem is that because of what the independent contractor says or does, or because of the circumstances of the situation, it actually convoluted the analysis.

The EDD is very aggressive towards the classification of workers. Whenever possible, it tries to classify workers as employees and the presumption is that they are employees, unless the taxpayer can demonstrate evidence to show that they are not.

Those by far the most common problems with EDD audits and those are the things that you should work to mitigate. That list is not exhaustive, as there are a lot of other factors that go into the payroll tax audit analysis and things that tend to be problems for taxpayers.

Most importantly, pre-audit yourself and if you have a good presentation, you can usually screen out most of the issues before they could pop up and then before they create financial liability to you or your company.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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