EDD Audit Penalties

The Employment Development Department (EDD) is a California government agency that administers employment service programs and controls and collects California’s employment payroll taxes. Additionally, EDD directs other tax and benefit programs including Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and enforces EDD audit penalties.

What Is an EDD Audit?
There are two main types of EDD audits: Verification EDD Audits and Request EDD Audits. Once either audit notice is received, companies typically have 30 days to respond.  Most EDD audit periods consist of the three most recent previous tax filings.

1. Verification EDD Audit
   Verification Audits are randomized; they are not triggered by any event or wrongful complaint. Rather, EDD uses this audit to verify that companies are in compliance. This keeps the integrity of the EDD in check and allows facilitation of their other services with the income generated from payroll taxes.
   
2. Request EDD Audit
   Under its Unemployment Insurance benefits program, EDD reviews and audits business benefit reports to ensure unemployment recipients are eligible for benefits. During these audits, the EDD may see an unemployment claim for an “employee” classified as a 1099 (IRS Form 1099) employee or an independent contractor. As 1099 employees are ineligible for unemployment insurance, applying for those benefits often triggers the EDD to investigate the discrepancy. Audits may also be initiated due to late payroll tax returns filings, late payment of payroll taxes, failure to pay employee wages timely with proper payroll stubs, and/or collect and remit SDI taxes.

Types of Misclassifications: The Difference Between 1099 and W-2 Employees
The classification criteria for 1099 contractors and W-2 employees drastically changed in California with the passage of Assembly Bill 5 (AB5) in 2020.

1. 1099 Contractors
A 1099 is given to people who provide services to a company (client) but are employed by a different company. By example, John owns ABC Landscape and provides gardening services to Landmark Buildings. ABC Landscaping would receive a 1099 from Landmark Buildings for its services with no payroll withholdings removed.

Under the AB5 rules, the California Department of Industrial Relations requires 1099 employees to satisfy the following three requirements:

• The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
• The worker performs work that is outside the usual course of the hiring entity’s business.
• The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Failure of a contractor to meet one or more of the requirements would result in being classified a W-2 employee.

2. W-2 Employees
In general, W-2 employees work directly for a company and do not meet the above requirements. Thus, if John wore a Landmark Buildings uniform, used Landmark’s tools, and was responsible for standard working hours, John would be a W-2 employee.

W-2 employees receive more benefits than 1099 contractors. California requires employers of W-2 employees to provide regular pay periods with properly prepared pay stubs, sick leave, vacations, health insurance, workers compensation, and unemployment benefits.

With the passage of AB5, more workers are now classified as W-2 employees than 1099 contractors. This is significant as employers of W-2 employees are required to pay payroll-related taxes for every employee plus bear the cost of additional non-payroll benefits.

Some contractors do not want to be classified as employees, despite the additional benefits, as they may lose the ability to write-off business expenses. Such groups are working to modify AB5 through a proposed Proposition 22 ballot initiative which attempts to exempt companies who have “gig” workers from AB5.

Commonly Misclassified Employees:

Under AB5, commonly misclassified workers may include:

• Construction Workers
• Truck Drivers
• Delivery Drivers
• Rideshare Drivers
• Musicians

Conversely, before AB5, many office workers were classified as 1099 contractors so the employer could avoid paying payroll taxes and benefits.

What Does an EDD Audit Look Like: What Should the Taxpayer Expect?
The EDD will mail an official audit notice and a standardized request for documents covering a specific period to the principal place of business or residential address.

The next course of action is to gather and organize all requested documents relating to your company’s employees. This usually includes Forms W-9, 1099, W-2, and other payroll information including taxes withheld and paid on behalf of any employees.

The auditor will prepare a final determination including possible EDD audit penalties and fines. Upon receipt of an audit notice, it is recommended to obtain the services of a qualified tax attorney who will review your specific circumstances, represent you before the EDD, and accept or appeal the audit.

Types of EDD Audit Penalties

1. Late Payments
   The penalty for late payments is calculated by the amount of time passed. The penalty is 2% for deposits up to 5 days late, 5% for deposits between 6 and 15 days late, and 10% for deposits over 16 days late.
2. Fraud or Misclassification of Employee
   Employers may be fined $5,000 to $10,000 on top of any non-paid payroll taxes or late payments for fraudulent filings or misclassification of employees. Frequent audits can cause EDD audit penalties to increase to between $10,000 and $25,000. If the employer is unable to pay, EDD may seize personal assets. Filing for bankruptcy does not dismiss liability to the EDD. Payroll tax fraud, if determined to be with criminal behavior, may lead to incarceration.

Refer To EDD Website for Resources
For more information on EDD audits, visit the EDD official website at: https://edd.ca.gov   Employment Development Department | California.

Need Help with An Audit or Have Questions/Concerns?
If you have received an audit notice from the EDD or have any questions about the process of an EDD audit, schedule your free consultation with the team at RJS LAW via the website or by calling (619)595-1655. Our tax team is here to help determine your best course of action.

Written by Judith Jeremie

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