As a business owner, the best way to protect yourself against an audit conducted by the California Employment Development Department (EDD) is by correctly classifying everyone who works for you when it comes to payroll taxes.
Payroll taxes are a big deal in the State of California as Californians pay more in federal payroll taxes than the residents of any other state. In addition, a large portion of the state’s budget is made up of money collected as state payroll taxes. It is the responsibility of the California Employment Development Department, or EDD, to collect these payroll taxes, as well as enforce collection and conduct payroll tax audits of individual businesses.
When the EDD conducts a payroll tax audit, the primary concern of the auditor is to determine how you, the business owner, has classified the people who work for you. This classification determines the amount of payroll taxes that you pay, and any misclassification can mean that you are paying the EDD less money than you owe under the applicable laws. Obviously, this is a source of concern to the auditor. In addition, the IRS will very likely use the results of an EDD audit to assess its own taxes, interest and penalties on the federal level. In short, an unintentional misclassification of a single worker can end up being a costly mistake.
Employee vs. Independent Contractor and Misclassification
Misclassification of a worker is often unintentional and due to an erroneous understanding of what makes a worker an employee, rather than an independent contractor, in the eyes of the taxing authorities.
While determining the correct classification of a worker can sometimes be complex, a few general rules apply. First, you are responsible for withholding payroll taxes for an employee and paying employer payroll taxes, while an independent contractor is responsible for his or her own taxes. Second, simply put, determining who is an employee or independent contractor comes down to an issue of “direction and control”. Specifically, an employee has little to no control over how work is done, when work is done and where work is done. In addition, the work of an employee is controlled or supervised by a business owner or someone employed by a business owner for that purpose. This business owner or supervisor need only have the “right to control” for a worker to be regarded as an employee. An independent contractor does not labor under these restrictions. They largely maintain control over how, where and when the work is done, and they are not subject to direction or control. For example, a housekeeper or landscaper often works for multiple homeowners and businesses, provides their own tools and supplies and work when their schedule permits.
While the EDD and the IRS use a comprehensive list of factors to determine who is an employee and who is an independent contractor, no single factor controls the classification. It is very often a case by case factual determination. This means that misclassifying a worker can easily happen and when it does a single instance can cost a business thousands of dollars.
Commonly, an EDD audit is initiated when a former worker who was classified by you as an independent contractor, applies to the EDD for unemployment. Because unemployment is only available to employees of a business, this former worker is affirmatively claiming that they were an employee. Audits can also be triggered by filing payroll tax returns late, or paying payroll taxes late, paying workers in cash, firing a disgruntled worker who reports you to EDD, or not paying wages to workers timely.
The EDD Audit Process
The EDD audit process begins with the mailing of a notification of an audit. This notification is meant to put a business on notice that the EDD intends to audit their payroll taxes; and, it usually contains a list of documents that the auditor wants the business to produce, along with a list of questions that need to be answered before the actual audit begins.
The document list can include requests for time-specific bank and financial statements, canceled checks, check registers, ledgers, journals, pay records, 1099s, W-2s and EDD’s Quarterly Contribution Return and Report of Wages (Forms DE-9 and DE-9C). The list of pre-audit questions is to help the auditor come up with a game plan for the audit. It’s also designed to get you to make admissions regarding your specific payroll practices.
It never pays to take an adversarial position with an EDD auditor. Being difficult or obstructionist will only hurt your overall position. That being said, you don’t want to be too helpful. Giving an auditor more information than they have specifically asked for can be as dangerous as not giving the auditor enough information.
Typically, the auditor will be examining a specific three-year period of payroll tax records. However, if circumstances and evidence dictate, that three-year period can be extended further back in time.
Regarding worker classification, an auditor has the ability to apply a wide variety of factors when making a determination of whether a particular worker was an employee or an independent contractor. Keep in mind that an auditor may use these factors to gain a classification that works in favor of the EDD and against the interests of an individual business. Also keep in mind that even if the EDD classifies a worker one way, the IRS can classify that same worker differently, and vice versa.
After the Audit Concludes
Once the formal audit is concluded, one of several results will be obtained:
- Overpayment of taxes with a refund being issued to a business;
- Underpayment of taxes with the difference between what was paid and what the EDD determines is owed being charged to a business;
- Overpayment and underpayment of taxes; or
- No differences found, i.e., a no change audit.
If a business is found to have underpaid their payroll taxes, the EDD will demand payment of the taxes determined to be due plus interest and penalties. Payment is due within 30 days of demand. If full payment is not made within this time frame, a 10% penalty will be added to the amount owed. However, a taxpayer may appeal the EDD determination if the taxpayer believes it to be in error for one reason or another. If the EDD makes a finding of underpayment, the IRS will usually adopt the findings of the EDD and assess their own taxes, interest and penalties.
As you can see, the California EDD audit process can lead to substantial liabilities for a business. An experienced California payroll tax attorney can help guide you through the audit process, using specific knowledge of employment tax laws, rules and case law to help you achieve the best possible results. Contact us today for a free and confidential consultation.