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The Ultimate Guide to California Payroll Tax Audits

Introduction to California Payroll Tax Audits

If you are an employer of any size, you have to file and pay payroll taxes — which leaves you vulnerable to being audited. In California, that means dealing with the Employment Development Division (EDD). 

The EDD likes to crack down on employers who aren’t paying the correct amount of payroll tax, especially for their independent contractors (1099 employees). Interestingly enough, the IRS generally does not get overly involved in payroll tax audits unless it is a criminal case involving gross under- or over-reporting.

The California Employment Development Department (EDD) is part of the Labor and Workforce Development Agency and has a wide mandate that includes collecting and administering employment-related taxes. They have the power to audit your company if they feel that you have misclassified workers in an attempt to avoid paying payroll taxes. 

In recent years, this has been a focus of the EDD and audits are common.

The Employment Development Department is the largest tax agency in California. Although it handles a variety of functions (the EDD has roughly ten thousand employees and an annual budget of roughly twelve million dollars), one of its primary functions is the administration and collection of payroll tax for the approximately seventeen million workers in California. 

As with the IRS, failure by employers to make payroll tax deposits is perceived to be a huge problem for California and, as a result, the Employment Development Department can take far-reaching and severe actions against businesses that do not meet their obligations.

Our California payroll tax attorneys recognize the seriousness of the business being involved in a tax dispute with or being investigated by the Employment Development Department. EDD agents are among the biggest threats to California businesses because of the approach they take toward collecting revenue for the state, often to the detriment of the taxpayer.

It is important to walk into any dealing with the Employment Development Department with a strategy to achieve the goals and minimize any potential damage that an agent can cause. We use our “business first” approach to solving problems to neutralize risk and protect the ability of your business to earn and generate income.

We realize that people have lots of questions when it comes to the EDD audit process, so we put together this guide as a resource to assist you in learning more about the process and in making the best decision about how to handle your California payroll tax audit. 

One of the key reasons that we publish these resources is to not only help our clients but anyone who is in need of help or at least a point in the right direction.

Regardless of whether or not you choose to retain our tax law firm or another California payroll tax attorney to help you, we want you to understand what you are facing walking into the audit. 

Even at the risk of giving away some of our secret sauce, we wanted to provide you with some of our California payroll tax audit strategies to give you the best possible footing in this process.

Thank you in advance for reading “The Ultimate Guide to California Payroll Tax Audits.” It was a labor of love and our law firm welcomes all questions, comments, concerns, and feedback that you may have about this free resource.

California Payroll Tax Audits: What You Need to Know

A California payroll tax audit is a lot like what it sounds like. The Employment Development Department (EDD) assigns a tax auditor to review your business’s payroll tax records to make sure that payroll has been properly reported and that California payroll tax has been properly paid. 

What you may not know is that the EDD is required to act on any leads it receives regarding possible payroll tax violations. That could be one of the reasons why your business was selected to be audited.

The good news about California payroll tax audits is that the audit process is pretty formulaic. During the audit, your business will be put through a series of stress tests and if you get to the other side, the audit is over and you end up unscathed. The problems surround going through the tests themselves. 

Although preparation for any California tax audit is important, preparation is pretty critical in the payroll audit world. There are so many little small errors that happen during a payroll tax audit and screening out these errors prior to the meeting with the auditor is really important in order to set yourself up for success. 

This article will outline what a payroll audit is, risks to business owners, what the auditors are looking for, independent contractors, settlements versus appeals, and why you may need an experienced tax attorney on your side.

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California Payroll Tax Audit Triggers

The key to an EDD audit is only to submit relevant documentation, meaning only records about employment-related issues.

Also, do not volunteer any information beyond what the auditor asks for. Any admission you make can count against you.

An audit is often triggered by a former worker applying for unemployment insurance, which is taken as an assertion that the person was an employee of your company and entitled to unemployment payments.

Instead of conducting a complete examination of the individual claim, the EDD will look into the status of all the independent contractors your company is using.

Audits can also be triggered by filing or paying late, making errors in time records or other statements or documents, or digital failures that cancel or delay payroll.

The California Payroll Tax Audit Tests

1. EDD Audit Payroll Verification Test

A payroll test is a verification of the business’s payroll posting system. The EDD auditor is making sure that payroll is being reported by the business accurately and properly.

What that essentially means is the EDD is going to compare their records to the records of the business in order to make sure the payroll journal matches what the EDD has on file.

What the EDD auditor will do in an independent contractor audit is request payroll records as a part of the initial document request you receive from the State of California. They will ask you for a copy of the business’s payroll journal during the audit period and the auditor will pick an employee at random and then the EDD auditor will check that employee’s W2 for the tax year and verify that with what the State of California has on file.

The EDD auditor will match the payroll tax returns and then go a step further. They will make sure that the information that was listed on the payroll tax returns (in California those are DE 9s and DE 9Cs) and match the information that was reported on the W2 to the IRS. Then the auditor will match that against the information that is in the payroll journal.

What the EDD auditor is doing here is essentially a multi-step check of the payroll records and the reporting to different agencies to see if there is any discrepancy.

When the EDD looks at the taxable wages for the employee, it is okay if there is a minor difference, which is usually attributable to an accounting error.

If you have hourly employees, there might be some discrepancy over the hours and that difference can be perfectly explainable, but a difference of more than 5 percent is really going to create a problem during the EDD payroll test.

During an EDD audit, the way we handle the payroll test internally at Brotman Law is that we go through and cross-reference the payroll journal against the W2s and against the payroll tax returns that were filed both with the IRS and with the Employment Development Department.

However, it is critically important that this be done in advance of the EDD audit, so you can have confidence in the information that you are about to present and can similarly screen out any issues.

As long as you complete this and pass your own test internally, you will pass the payroll test in your EDD audit.

Other things to note about payroll, make sure you look at issues that may be present when you have two different entities or a change in ownership during the audit period. In our experience, we see a lot of errors related to this.

Make sure to reconcile both entities against total filings for the business, explain changes in the employee situation (particularly applicable for businesses that use a lot of part-time or seasonal workers, and generally just be organized by consolidating records to the extent possible. Doing this will help you navigate through the EDD audit much more smoothly.


2. EDD Audit Payroll Tax Verification Test

In addition to the payroll verification test, the EDD will also look at personal income tax withholdings and make sure that the amounts listed match what the state has on file as well. Just to go back and clarify, the EDD audit is looking at the wages and the income that the people earned.

The EDD auditor is going through the payroll journal to make sure that the total wages are going to match. 

Just like with the income side of things, the EDD auditor is going to look at the tax that was withheld and make sure that matches for each employee. The auditor is going to go to the W2 and they are going to look at the federal income tax withheld and the state tax withheld on a payroll tax level.

Then, the EDD auditor is going to go through and look at the report fillings to the IRS and the State of California and then look at what was reported with the employee.

During most EDD audits, you will see that the EDD will ask for a W4 in a payroll tax audit. What they are doing is looking at the information that the employee reported to the employer originally.

The EDD auditor is verifying any exemptions and any marital status, and basically verifying that there has been proper withholdings on the employee’s end. The auditor is verifying that to check on the employee’s records and to make sure the employer’s records are correct.

After doing a sample of an employee, the EDD will usually go a step further and they will reconcile the total payroll to total wages in order to make sure that those amounts match as well. Usually, there is a year-end summary that is performed that is filed with the state. In California, that is called a DE 9.

The EDD auditor will verify that information and that it matches the payroll journal just to make sure that the total payroll is accurate. The auditor will take a sample and then verify that sample against the total.

As long as you can do the same thing prior to the audit, essentially pre-auditing tax withholdings, the result should come out fine during the EDD audit.

Occasionally, the EDD will break it down on a quarter-by-quarter basis. The auditor will actually go through and look at wages that were being reported within a given quarter, and they will go quarter-by-quarter for a year or for a half year, and then run the verification test that way. 

The auditor will go back and look at what was reported on the payroll journal and will compare that information to what was reported on the payroll tax returns.

As we have said before, if everything matches, the test is passed and you have no problems. If the records do not reconcile properly, then it will usually trigger opening other years, and the EDD auditor will go through and verify everything on an actual basis.

In most situations, though, you are going to see consistent reporting between payroll tax

that was reported and wages that were reported. It is only when you have a situation where there has been poor financial controls, or there has been a change in accountants where you may have some reporting discrepancies.


3. The General Journal/Ledger and Internal Accounting Test

The next test is a review of your general journal/general ledger and bank statements to see if there are any payments that were made that should be reclassified into taxable wages. 

On a high level, the auditor’s review falls into two categories 1) payments that are personal in nature (and should be reclassified as taxable wages) or any payment to an officer or employee that should be reclassified as taxable wages (distributions, bonuses, etc.), 2) unreported payments to others that should be reclassified as taxable wages.

Reimbursements, for example, are one target of the journal test. One of the biggest problems that we come across in payroll audits is employee reimbursements and independent contractor reimbursements. 

Often, what will happen is an employee will get paid a normal paycheck and then they will spend their own money outside the context of the business to buy materials, to buy supplies, go to the post office, do whatever.

The business will write the employee a check out of their operating account and not run it through payroll.

As this progresses, and depending on the size of business and how often the employees are counted on to front their own expenses, you could have several large checks being issued to employees that on the surface would look like compensation on the surface level.

However, you are going to have to dive into those payments specifically to find out if they are truly reimbursements (non-taxable) or disguised payments for services (taxable). And not to mention the fact that we have not discussed whether or not the business can even substantiate these reimbursements.

The truth of the matter when it comes to reimbursements is that businesses tend to keep poor records and they do not save the substantiation because they have written a check and have a corresponding accounting entry.

Once the employee has been paid out, the reimbursement is just simply verification for the owner so that the owner knows that the employee did actually incur those expenses. Once the issue has been settled with the employee, the business generally does not think about keeping the substantiation.

In these cases, it is critically important to be prepared to discuss these items in the audit and have as much detailed information surrounding the reimbursements as possible.

Actual receipts are not critical, but having information and having those expenses look credible in an audit is a must in order to not have them treated as taxable wages.

How do you do this? You can rely on the testimony of the employee or obtain written statements about the nature of the expenses being reimbursed. You can talk about the materials that were purchased, especially if reimbursements are an industry standard.

You can try and obtain third-party invoicing depending on what it is. However, gather as much outside information that you can and/or try to screen out whether this is a potential audit issue in advance.

Casual labor and employee reimbursements are always hot topics in payroll tax audits, so you need to be prepared going in as much as possible.


4. The Independent Contractor Test in California Payroll Tax Audits

This is, by far, the most troubling area of payroll tax audits for many businesses. To give some context, there are four separate classifications for workers: employee, independent contractor, statutory employee and statutory non-employee.

An employee is paid a regular salary and is afforded various state and federal protections in terms of their employment. Employers must pay state and federal income taxes on the employee’s behalf, and are liable for 50 percent of the FICA (Social Security and Medicare) taxes payable as well as the Medicare levy.

State and federal unemployment taxes are also the employer’s responsibility, although in California, employees are responsible for state disability tax.

An independent contractor is a self-employed person who is hired to complete tasks for the company. They are liable for their own taxes, both income and self-employment tax, which covers social security and Medicare. There is no unemployment tax payable as self-employed contractors are not eligible to receive unemployment benefits.

Statutory employees are independent contractors who are treated as employees for tax purposes. This situation arises where a worker is self-employed and has a measure of control over their working hours and conditions, but does business principally with a single employer.

For Social Security tax purposes they are treated as employees, but they do not receive employer benefits and employers do not withhold income tax.

Statutory non-employees are workers such as licensed real estate agents and direct sellers, where 90 percent of their income or more comes from sales commission rather than being tied to hours worked.

Income tax is not withheld on their behalf. They must be designated as holding this status via a written contract.

Determining Proper Classification

A written contract stating that your worker is an independent contractor is not sufficient to establish that status. Whether a worker is properly a contractor or an employee requires a finding of fact based on the particular case at hand.

In January of 2020, the California legislature passed AB5, which governed the relationship between companies and their workers. Basically what AB5 states is that unless a hiring entity can prove that a worker is truly independent according to three specific factors, that worker will be deemed to be an employee of the company itself.

The factors are,

1) The company must not have any commensurate control over the worker.

2) The worker’s services must be outside the core business for the hiring entity, and

3) The worker must maintain their own separate and independent business.

This was called the death of independent contractors in California because unless you qualify for one of the exemptions that is under the statute, pretty much, all workers fall within an AB5 framework and can be deemed employees.

It is only those who are truly providing outside services, like a bookkeeper or a CPA or a law firm or a videographer, that really qualify outside the scope of AB5. The statute is meant to pull as many people as possible into the employee relationship.

However, from a tax perspective, it does not really have any impact. The reality of the situation is that the EDD has been operating within an AB5 framework for quite some time.

What do I mean by that? The reality is that when you go through an employment tax audit, EDD is already looking at control. Control was a previous factor under the old test, and now the EDD is focused on if the worker is integral to the revenue generation function of the particular business.

If the worker helps you earn revenue and they are somewhat essential to your business, then they are your employee. The reality is that before AB5, California auditors and administrative law judges were already in this mindset.

You may be thinking, "What is going to happen now that I have to switch all my workers over to W2 and I am going to get audited?" The reality is you were probably going to get audited anyway.

California, through its enforcement actions, has been focused on this issue for quite some time and it is really important that you understand this framework going in. The reality of the situation is with most independent contractor audits for 2020 and beyond, the story is about damage control.

The reality is you probably will not beat this test unless you can show your workers are truly independent businesses and they fall outside the revenue generation framework. I want you to think outside the lines when it comes to tax on this issue and you need to be proactive as possible.

What You Will Learn in This Ultimate Guide

The following is a summary of each of the different chapters in The Ultimate Guide to California Payroll Tax Audits.



An Overview of the California EDD Payroll Audit Process

Chapter one continues with a discussion about the Employment Development Department, which is the governing tax authority over California’s payroll tax system.

We will contrast the differences between the EDD and the IRS, reviewing the types of taxes that the EDD is in charge of administering.

We will also briefly cover California payroll tax audits and discuss some of the problems that can occur when dealing with the EDD.


California Payroll Audit Strategies for the Independent Contractor

In this chapter, we share some of our secret sauce and the California payroll tax audit strategies that we use in our tax law practice.

One of the core strategies here is looking at prior case law and the EDD’s fact sheet that it publishes on its website to help define the position that the government may take in the audit and how you can counteract that.


California Payroll Tax Administration

The first thing to know is that every California employer is required by law to report information about new employees to the California New Employee Registry within 20 days of their first day of work.

In this chapter, I explain the California payroll tax administration system and your responsibilities as an employer.


California Payroll Tax Lawyer Representation in an EDD Audit

This chapter is all about the decision to hire a California payroll tax lawyer and what it is like to work with our firm.

By now, you have probably gotten a firm grasp for our strategy in California payroll tax audits, but we specifically discuss how working with a tax lawyer is different and what the cost structure is for hiring a lawyer to help you with your audit.


Federal (IRS) Payroll Tax

The difference between the IRS and the tax agencies of California is that the IRS is a single agency that administers federal taxes including federal income tax, Social Security and Medicare. It also collects federal unemployment taxes.

In this chapter, we are going to address the federal model, which the IRS administers payroll taxes as part of its responsibilities.

Later, we will contrast the California payroll tax system before moving on to our main topic of California payroll tax audits.


How to Pre-Audit Yourself in Advance of an EDD Payroll Tax Audit

While we have discussed the independent contractor portion of the tests that you will face in a California payroll tax audit, this chapter covers the analysis work that you can do on your records to help screen out any issues prior to your audit.

Essentially, we show you the same tests that the auditor is going to run and how to score yourself before the audit.


How to Prepare for a 1099 Independent Contractor Audit

This chapter deals with making sure you are properly prepared to defend your 1099 independent contractors.

First, you need to make sure that you are gathering any and all documentation about your independent contractors. We talk about the key supporting documentation that you will need and how to best prepare your files for the independent contractor portion of the audit.


How to Prepare for a Tax Auditor to Interview Your Independent Contractors

As opposed to documents, this section covers how to prepare the people involved to be interviewed by the California payroll tax auditor.

While you cannot control their testimony, you can do things to make sure that the narrative they tell the auditor is consistent with your facts.

In a worst case, interviewing your contractors will give you insight into potential problems down the road that you may have with the California payroll tax auditor.


Using 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 how much access to that information do they have.

This chapter gives a quick example how 1099 forms can be used to help instead of hinder you in a tax audit.


What Are the California Payroll Tax Penalties If I Do Not Pay?

In this chapter, I am going to talk about the EDD penalty structure, which paints a sobering picture for the non-compliant.

Substantial penalties may accrue to any employer who does not file correctly. This can leave you in a far worse situation than before.

We also take a look at the different penalties that exist when you fail to pay your California payroll taxes after the audit, such as with the trust fund recovery penalty. 


What Happens During a California Independent Contractor Audit?

In this chapter, I am going to walk you through an independent contractor audit, so you will know what you could be up against.

I have seen it before where business owners honestly believe that they are working with independent contractors, when the EDD sees things much differently.

If your business hires a lot of independent contractors, it would be a good idea to come and talk to me.


What Is A California Payroll Tax Audit?

I lead this chapter off by explaining the importance of being in control of the audit right out of the gate.

Other than in cases where there is some sort of fraud involved, the biggest risk by far in a payroll tax audit is the penalties because the EDD has some really nasty penalties.

In our tax law firm, we have seen situations with clients where the penalties would be four or five times the amount of tax.

Trust me, the more documentation you hand over to the audit, the greater the odds of them finding something to fine you for.


What is an Employment Development Department (EDD) Audit?

In this chapter, I am going to give you an overview of the EDD and the types of programs it finances with your payroll taxes.

While it might not make paying the EDD any easier, at least you will have some idea of where your dollars are going.

I am also going to get into payroll tax audits, which I can tell you, are no fun. There are a number of circumstances that can trigger an EDD audit and I am going to talk about the most common ones (and the most easily preventable).


What Records are Required for a California Payroll Tax Audit?

Of the different types of audits, payroll tax audits are usually the ones that have the most flexibility because in a payroll tax audit, the auditors are basically running tests.

This last chapter covers the laundry list of documents that auditors may want to examine and run through their tests.

I will also describe getting the audit period down to one test year and what documents you may want to toss that do not directly relate to the four tests that the auditor is going to put you through.

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