Employment Development Department's Employment Tax Audit Process
The California Unemployment Insurance Code (CUIC) and the Government Code authorize the Employment Development Department (EDD) to conduct payroll tax audits of businesses operating in California. The payroll tax audit provides education outreach to employers regarding their state employment tax obligations and ensures that benefit coverage is provided for workers who are entitled to such coverage under the law.
Generally, EDD employment tax audits cover a three-year period, comprising the 12 most recently completed calendar quarters. However, in some situations, such as when no returns were filed, the audit period may be longer.
First, the auditor will conduct an entrance interview with employer or with his or her designated representative to explain the purpose of the audit and its process, gather general information about the operation and organization of business and accounting records, and will answer any questions. Only then auditor will review records. Payroll systems to be checked by EDD can be as basic as a manual system with only a check register and individual earnings records or as complex as a computerized double entry system on an accrual basis. Provisions of the CUIC require employers to keep payroll records providing a true and accurate account of all workers (employed, laid off, on a leave of absence, or an independent contractor) and all payments made. Consequently, the type of system taxpayer should use should meet the needs of your business and EDD requirements. Requirements are explained in EDD's California Employer's Guide.
The auditor will review employer's books and records to:
- Verify the business ownership and type of entity (sole proprietorship, partnership, corporation, other).
- Verify that all individuals paid for services have been properly classified as either employees or independent contractors in accordance with the provisions of the CUIC and the common law test as applied by the California Supreme Court.
- Discuss any unreported payments made for personal services and the nature of the working relationship(s) with employer and the worker(s). Based on the facts obtained from the records, input from employer, and discussion(s) with the worker(s), the auditor will determine whether the worker(s) are employees or independent contractors.
In addition, if employer's account has been selected for a complete audit, the following tests will be performed:
- Verification that employer's acknowledged gross wages and taxable wages have been properly reported.
- Verification that employer has correctly withheld and reported personal income tax for wages paid to employees.
Please note that the EDD's employment tax audit information will be made available to the IRS under an exchange agreement, and the IRS may use the information in the administration of its own tax program.
An audit begins with the examination of records for a test year. The test year is generally the most recent completed calendar year. If differences are found in the test year, then the examination may be expanded to include the records for the entire period covered by the audit. To expedite the audit process employer must ensure that all records are available to the auditor.
Minimum Required Records During EDD Tax Audit
Sections 1085 and 1092 of the CUIC require all employing units to make business records available to the EDD during normal business hours. These records include:
- Check Registers, Check Stubs, Canceled Checks, and Bank Statements
- General Ledger and General Journal
- Annual Financial Statements (Income & Expense statements, Balance Sheet, etc.)
- Cash Payments Records (pay out slips and vouchers)
- Ownership Verification
- City Business License
- Board of Equalization Sales Tax License
- Any license required to operate business, such as a liquor license, California State contractor’s license, etc.
- Written Agreements (for example, Partnership Agreement or Articles of Incorporation)
- Federal/State Income Tax Returns
- Form 1099 Series, Federal Information Returns and Worksheets
Additional Records Required For Verification or Acknowledged Payroll
- Payroll records such as Payroll Journal, Individual Earnings Records, Payroll Summaries, etc.
- Federal Employment Tax Reports
Form W-2, Wage and Tax Statement
Form W-4, Employee’s Withholding Allowance Certificate
Form 941, Employer’s Quarterly Federal Tax Return
Form 940, Employer’s Annual Federal Unemployment Tax Return
- State Employment Tax Reports
DE 9, Quarterly Contribution Return and Report of Wages
DE 9C, Quarterly Contribution Return and Report of Wages (Continuation)
DE 9ADJ, Quarterly Contribution and Wage Adjustment Form
DE 6, Quarterly Wage and Withholding Report
DE 7, Annual Reconciliation Statement
DE 678, Tax and Wage Adjustment Form
DE 4, Employee’s Withholding Allowance Certificate
As part of the audit, the auditor will arrange for an exit interview, either in person or by phone, to review the audit findings, identify any other information that should be considered, and attempt to resolve disputed issues, if any. If employer does not reach an agreement with the auditor, he or she may request a pre-assessment conference with the supervisor of the auditor. The audit will result in one of the following outcomes:
- A no change audit, where no differences are found.
- An overpayment, where a credit or refund will be issued.
- An underpayment, where the differences will be assessed.
- Both an underpayment and overpayment.
If an assessment is issued, employer will receive information about appeal rights. Employer may petition for reassessment with an independent third party, the California Unemployment Insurance Appeals Board, for a hearing before an Administrative Law Judge.
What EDD Auditor is Looking for?
Generally, EDD requires its auditors to maintain good relationship with employer and staff, and answer all employer's questions. Below is general categorized list of what EDD Auditor is set to accomplish during an audit. Auditor will:
- Determine and verify by calendar quarter the amount of taxable wages paid or payable and the amount of contributions, interest, and penalties required under the CUIC.
- Determine if the employing unit (business entity, individual employer, or other) has made the proper withholding for State personal income tax as required by the CUIC and has accurately reported the withholding to EDD.
- Resolve obstructed benefit claims.
- Resolve wage-earner claims for refund under CUIC Section 1176 or proof of credit
- Establish liability under bankruptcy, probate, and assignment for benefit of creditors
- Assist other states in resolving discrepancies in reporting to their state.
- Enforce correct reporting in industries known to be incorrectly reporting or not
reporting specific wages or services.
- Follow up leads furnished by other Area Audit Offices, the public, or other offices
- Follow-up audits furnished by UEO.
- Assist compliance staff in reconciling Tax Automated System (TAS) generated estimated assessments issued for failure of the employing unit to file returns.
- A worker furnishes a form DE 230 as a potential employment tax audit lead and it is
forwarded by Audit Section to the appropriate AAO, ETCSO, or in certain situations
Please note that effective with the 3rd quarter 2014, late filing will incur a penalty of 15% (10% for periods prior to the 3rd quarter 2014) plus interest. Late deposit will lead to a penalty of 15% (10% for periods prior to the 3rd quarter 2014) plus interest. Wage Item Penalty - A wage item penalty of $20 ($10 for periods prior to the 3rd quarter 2014) per employee will be charged for late reporting or unreported employee wages.