What Triggers an EDD Audit in California

Receiving notice of an EDD Audit in California can be a serious matter for any business. The California Employment Development Department (EDD) conducts employment tax audits to determine whether employers are properly classifying workers, reporting wages, withholding taxes, and complying with California payroll tax laws. Learn more about what triggers an EDD audit in California.

So, what triggers an EDD audit?

There is no single event that automatically causes every EDD audit. However, worker classification disputes, discrepancies in payroll reporting, unemployment claims, and other compliance issues can bring an employer’s practices under scrutiny.

At RJS LAW, our tax attorneys represent California businesses facing EDD audits, worker classification disputes, payroll tax assessments, and related employment tax controversies.

Understanding these seven potential red flags can help employers identify problems before an audit becomes a much larger tax issue.

1. Misclassifying Employees as Independent Contractors

Worker misclassification is one of the most significant issues employers can face during an EDD audit.

California generally applies the ABC Test to determine whether a worker is an employee or independent contractor, although statutory exceptions can require a different analysis, including the Borello test.

Under the ABC test, a worker is generally considered an employee unless the hiring entity establishes all three required conditions.

Calling someone an independent contractor or simply paying that person using Form 1099 does not by itself determine employment status.

If the EDD determines that workers should have been treated as employees, the employer may face assessments for unpaid payroll taxes, interest, and potentially penalties.

2. An Independent Contractor Files for Unemployment Benefits

A worker treated as an independent contractor (or who otherwise was reported as an employee on a business’ employment tax returns) may later file an unemployment insurance claim and identify the business as an employer.

This can expose a potential mismatch between the worker’s account of the relationship and the company’s payroll reporting.

The EDD compares information provided by claimants with employer wage information and can investigate when wages or employment records do not match.

For businesses heavily dependent on independent contractors, unemployment claims can therefore expose underlying classification issues.

3. Large Numbers of 1099 Workers

Using independent contractors is legal when workers are properly classified. But businesses should be prepared to substantiate those classifications.

A business with substantial payments to contractors — particularly workers performing services central to its operations — can face important questions under California’s worker-classification rules.

California also imposes reporting requirements for certain independent contractors. Businesses generally must report qualifying contractors to the EDD when they pay or contract to pay $600 or more in one year, subject to the applicable requirements.

4. Payroll Records Don’t Match EDD Filings

Inconsistencies are another significant concern.

During an employment tax audit, EDD auditors can reconcile payroll reported to the agency with an employer’s accounting records and examine whether wages and taxes were properly reported.

Discrepancies involving payroll records, wage reports, general ledgers, tax returns, bank records, or other accounting documents can lead to additional questions and potentially expand the scope of an examination.

Accurate, consistent records are one of an employer’s strongest defenses during an EDD audit.

5. Late or Missing Payroll Tax Returns and Deposits

California employers have specific filing and payment obligations.

Common EDD filings include DE 9, Quarterly Contribution Return and Report of Wages, and DE 9C, Quarterly Contribution Return and Report of Wages (Continuation). Employers are also responsible for making required payroll tax deposits.

Repeated late filings, unpaid liabilities, missing returns, or inconsistent reporting can create compliance problems that employers should address promptly.

Waiting until an audit notice arrives can make resolving historical payroll problems more difficult.

6. Paying Workers Off the Books or in Cash

Paying an employee in cash is not inherently illegal.

Failing to properly report those payments is another matter.

The EDD defines wages broadly, and payments can include checks, cash, electronic payments, payment-app payments, and the cash value of certain noncash compensation.

Businesses should maintain records capable of explaining payments to individuals who perform services. Unexplained transfers, cash payments, or payments recorded inconsistently can become significant during an audit.  As discussed above, an EDD audit can be triggered when a worker is not reported on a business’ payroll tax return files for Unemployment benefits.  These workers are often independent contractors who receive 1099s, but sometimes these workers are “under the table workers” who receive cash payments.

7. Worker Complaints and Wage Discrepancies

Workers themselves can expose payroll and classification inconsistencies.

For example, someone applying for unemployment benefits may report wages that do not appear in the employer’s reported wage records. The EDD provides procedures for investigating missing or incorrect wages and can contact an employer to obtain additional information.

Disputes involving whether someone was an employee or independent contractor can likewise put the underlying working relationship under examination.

8.  Workers Compensation Claims

Injured workers often find themselves seeking medical care for injuries connected with their work.  The workers or the medical care providers treating the workers may put in claims to an Employer’s workers compensation policy.  An EDD audit can be triggered if a worker or medical care provider files a workers compensation claim for a worker not reported on a business’ employment tax returns.

What Happens During an EDD Audit? What Triggers an EDD Audit in California

EDD employment tax audits generally examine whether workers were properly classified and whether payments to employees were correctly reported.

According to EDD guidance, an audit generally covers a three-year statutory period consisting of the 12 most recently completed calendar quarters, although an examination can sometimes extend beyond that period.

The auditor may review payroll records, general ledgers, bank statements, check registers, federal and state tax returns, Forms W-2 and 1099, contracts, invoices, and other business records.

When worker classification is disputed, the actual working relationship matters — not the classification label contained in a contract.

What Should You Do If You Receive an EDD Audit Notice?

Do not ignore it.

Before turning over records or responding substantively, employers should understand what the EDD is requesting, the period under examination, and whether potential worker-classification or payroll-tax issues exist.

RJS LAW represents employers throughout California in EDD audits, employment tax disputes, worker classification matters, assessments, and appeals.

Early legal and tax analysis can help identify exposure, organize the employer’s records, address classification questions, and develop a strategy for dealing with the EDD.

If your company has received an EDD audit notice or is concerned about its payroll practices, contact RJS LAW to discuss your situation with an experienced California EDD tax attorney. Serving San Diego and Southern California.

Frequently Asked Questions | What Triggers an EDD Audit in California

What triggers an EDD audit in California?

There is no single trigger for every audit. Potential issues can include worker classification disputes, inconsistencies between payroll records and reported wages, unemployment claims that reveal missing wages, and other payroll-tax compliance concerns.

How many years can the EDD audit?

EDD guidance states that employment tax audits generally cover a three-year statutory period consisting of the 12 most recently completed calendar quarters. However, an audit may sometimes extend beyond that period depending on the circumstances.

What happens if the EDD determines my independent contractors were employees?

The EDD may assess employment taxes associated with wages it determines should have been reported as employee compensation. Depending on the facts, interest and penalties may also apply. Because worker classification is highly fact-specific, employers facing a significant classification dispute should consider obtaining professional advice before responding to an audit.

Written by Joseph Cole, Esq., LL.M.