What Is an EDD Audit?

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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.

The Biggest Risk in a California Payroll Audit

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. Those penalties really amplify the amount of the liability.

When we are looking at a payroll tax audit, our focus is really on penalties and what we can do to eliminate them, or at the very least, mitigate them. Number two, the risk in an EDD audit is if it turns into a fishing expedition. The auditor, if left unchecked, will ask for all sorts of things and will go through them with a fine-tooth comb. This naturally, as you can imagine, leads to more penalties

This creates a lot of back and forth and back and forth. However, much of this can be really mitigated if you pre-audit the situation and know what you are walking into. If you come into the audit with a very well-defined plan and a very well-defined presentation, you can lead the auditor through the audit — you are controlling the flow of information.

Controlling the flow of information in a payroll tax audit is the best thing that you can do. In a California payroll tax audit, remember that an ounce of prevention is really worth a pound of cure.