A California EDD Audit is basically a check to see if your business is properly reporting and paying its payroll taxes. The audits often spring up when there are discrepancies in tax filings, problems with worker classification, and complaints from employees. In this article we’ll break down what you need to know about EDD audits – why they happen, what the process is like, the penalties for not complying and how you can prepare.
What You Need to Take Away
- EDD audits are mostly focused on payroll tax compliance, with the main triggers being tax filing errors, employee complaints and problems with worker classification.
- The audit process is pretty methodical, with steps like document requests, entrance interviews and potential on-site visits. You will want to make sure your business is prepared and cooperative.
- If you’re not complying with EDD regulations you can end up with serious financial penalties – so it’s worth keeping on top of payroll tax laws and getting worker classification right to keep your business afloat.
A Little Background on the California EDD
The California Employment Development Department (EDD) is in charge of making sure businesses are paying their payroll taxes in California. They were set up to enforce the state’s payroll tax laws, which means they help make sure businesses are paying the right amount of taxes. This includes collecting unemployment insurance, state disability insurance, employment training tax and personal income tax withholding.
The EDD conducts regular payroll tax audits, which are often called California EDD audits, to check that businesses are getting their tax reports right and paying the right amount of tax.
A focus of the EDD is getting worker classification right. If businesses get this wrong they can end up underpaying tax and not giving workers the benefits they are entitled to. This is a common reason for audits.
A Quick Look at California Payroll Taxes
California payroll taxes include unemployment insurance (UI), state disability insurance (SDI), employment training tax (ETT) and personal income tax withholding (PIT). Each of these taxes plays a different role, but the key thing is to get them right to keep your business compliant.
Unemployment insurance helps people who have lost their jobs get some financial support. Employers chip in to this fund through payroll tax contributions, which are based on how much the business pays its employees and its experience.
State disability insurance gives some workers a bit of their wages back when they are off work because of an illness or injury that isn’t related to their job. This is funded by the employer and the EDD is in charge of making sure it happens.
Employment training tax is a small tax paid by employers to fund training that helps workers get better skills. This is so the workforce can stay competitive in certain industries.
Personal income tax withholding means employers have to take some tax off their employees’ wages and send it to the EDD. This helps workers meet their tax obligations.
What Does the EDD Have to do with S Corps in California?
S Corps in California often have specific issues to deal with when it comes to the EDD – particularly when it comes to how the business owner gets paid. The EDD looks closely at whether the business owner is paying themselves a fair salary through payroll. This is a problem because if the business owner is classifying their income as a distribution (i.e. not through payroll) they may be under-reporting the wages that are subject to payroll taxes. This can lead to an audit.
The EDD expects S corporation owners to draw a salary that reflects their work for the company, a salary that will be reported on payroll tax returns and have payroll taxes withheld and paid. Unless you do this, the EDD will likely go back and call the distributions you made as wages, which may lead to serious extra tax liabilities, plus interest and penalties.
To avoid tax trouble, S corporation owners should make sure to keep a clear record of what they do, how they do it, and what they pay themselves.
It is important to note that the IRS rules require S corporation owners to receive “reasonable compensation” for services provided, which means paying a salary comparable to what similar positions would earn in the market. Failure to comply with these IRS guidelines can result in penalties and increased scrutiny from both the IRS and EDD.
Why California Businesses Get Audited by the EDD
The main thing the EDD is trying to do with these audits is to make sure businesses are paying their fair share of payroll taxes. They can pick just about anyone, big or small, to do this or they might even target you because of some complaint or issue that’s come up. The EDD has a team set up to investigate tax evasion and they use financial techniques to identify businesses that might have these issues.
Here are some things to keep in mind to avoid an audit:
- Make sure you’re up to date on all of California’s payroll tax regulations, because these can change all the time
- Understand that EDD wants you to pay the right amount to the right people, so they’re going to want to make sure you’re properly classifying your employees
- Be aware that S corporation owners who don’t pay themselves a salary via payroll often get audited. We are seeing this more and more in the CPA community.
The EDD Audit Process Explained
He are the steps of an ECC audit:
- You get an audit notice
- You fill out a pre audit questionnaire
- You get a chance to review things with the auditor – often this involves a meeting at your place of business
- The audit may come to your business with a team to review your records on-site.
When You Get Your First Audit Notice and What Happens Next
You will receive a letter telling you why you’re being audited. They will ask you to fill out a pre-audit questionnaire. This is a lengthy document that asks questions about your business and financial practices, and the more accurate and detailed you are, the better.
In the questionnaire, you’ll likely be asked about the type of business you’re running, the number of employees, the types of benefits you offer. You will also be required to gather financial records – like bank statements, pay records, and accounting ledgers to show the EDD.
The Auditor will typically be going over your records for a 3 year period.
Carefully organizing and presenting your documents will help the Auditor to verify that everything is correct and can make the audit process go smoothly.
Document Requests and Record Review
Once the pre-audit questionnaire is submitted, the next step involves providing the EDD with various documents for review. Typically, the auditor will request bank statements, canceled checks, pay records, 1099s, and W-2s. They may also ask for financial documents such as business ownership verification, general ledgers, annual financial statements, vouchers, and pay-out slips.
Entrance Interview and On-Site Visits
Once you’ve submitted all the necessary documents, an entrance interview will be scheduled. This is your chance to find out why the audit is taking place and what the Employment Development Department (EDD) is expecting from you. During the meeting, the Auditor will go over the audit process in detail and explain exactly what documentation you’ll need to provide.
On-site visits can also be part of the process, giving the Auditor the chance to check over the information that’s been provided and see your business operations up close. These visits are important for ironing out any immediate questions or concerns that the Auditor may have. To make the best of this phase, be as clear and concise as possible when answering any questions. This will help avoid any potential issues, including those related to verification audits.
Common Penalties for Non-Compliance
If you’re not following the EDD’s regulations you could be facing penalties that could really hit your business hard financially. These penalties include:
- a 25% penalty on the total tax amount due if you haven’t filed a return by the deadline in a Demand for Tax Return letter.
- a 5% surcharge on the unpaid tax amount if you haven’t paid on time or filed late.
- a monthly 0.5% penalty on the unpaid tax amount until the tax is paid in full.
If you bounce a check, you’ll get hit with a 2% penalty on amounts over $1,250 or a flat fee of $25 for smaller amounts. And if you’re supposed to be making electronic payments but fail to do so, you’ll face a 10% cost penalty on the amount not paid electronically, resulting in additional late payment fees on top.
Importance of Proper Worker Classification
Getting the classification of your workers right is crucial for complying with California state tax laws and making sure that your employees get the benefits that they’re entitled to – like minimum wage and overtime. Misclassifying workers can lead to a host of problems – including back taxes, penalties and fines – especially if you’re found to have deliberately misclassified people.
Deciding whether a worker should be classified as an employee or an independent contractor can be a real challenge and businesses need to assess each case individually, looking at factors like how much control you have over the work and the relationship between the worker and the business. One common trigger for audits is hiring former employees as independent contractors while they are getting unemployment benefits, as outlined in the California unemployment insurance code. Businesses need to be super careful about how they classify their workers.
It is important to note that the IRS often uses the findings from California EDD audits to assess federal payroll taxes, which means misclassification issues can lead to further federal penalties and interest.
Next Steps After the Audit
Once the EDD audit is all over, you’ll get a formal notice of the results. If they’ve decided you underpaid your payroll taxes, you’ll get a bill for the amount along with any applicable penalties and interest. You’ll have about 30 days to pay what you owe, or you will face even more penalties.
If you do think the EDD’s got it wrong, you have every right to appeal. It’s a formal process that involves filling in a petition and providing some supporting evidence to back up your claim. The EDD will review it and might even ask for a bit more info before making a final decision.
Summary
Dealing with an EDD audit can be a nightmare, but if you know what you’re in for and are prepared, it’s a lot less stressful. Keeping on top of your paperwork, making sure your employees are properly classified and generally keeping an eye on things can all help to avoid any potential problems.
Frequently Asked Questions
How far back can the EDD go?
The EDD generally looks back over the last three calendar years when it comes to auditing businesses in California. If there’s been some kind of cheating going on, they might go further back even further.
What can trigger an EDD audit in California?
An EDD audit can get triggered by a variety of things – for example, if you’re late paying your tax returns or paying your workers in cash. And if you get on the wrong side of an employee (for instance by firing them when they’re asking for time off) they might even report you to the EDD.
What triggers an EDD audit?
An EDD audit can be sparked by a tax discrepancy, an employee complaint, or a random check by the EDDs Task Force. Keeping on top of your paperwork and following all the rules will really help to minimize the chances of getting audited.
What documents do the EDD want during an audit?
During an EDD audit, you’ll typically need to produce bank statements, cancelled checks and pay records.
Are there specific EDD audit concerns for S corporations in California?
Yes. The EDD pays close attention to S corporations and whether the business owners are paying themselves a reasonable salary through payroll. If an owner classifies income mainly as distributions instead of wages subject to payroll taxes, this can trigger an audit. Properly reporting owner compensation as wages helps avoid potential penalties and ensures compliance with California law and IRS guidelines.
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