The key to an EDD audit is only to submit relevant documentation, meaning only records about employment-related issues.
Also, do not volunteer any information beyond what the auditor asks for. Any admission you make can count against you.
An audit is often triggered by a former worker applying for unemployment insurance, which is taken as an assertion that the person was an employee of your company and entitled to unemployment payments.
Instead of conducting a complete examination of the individual claim, the EDD will look into the status of all the independent contractors your company is using.
Audits can also be triggered by filing or paying late, making errors in time records or other statements or documents, or digital failures that cancel or delay payroll.
A payroll test is a verification of the business’s payroll posting system. The EDD auditor is making sure that payroll is being reported by the business accurately and properly.
What that essentially means is the EDD is going to compare their records to the records of the business in order to make sure the payroll journal matches what the EDD has on file.
What the EDD auditor will do in an independent contractor audit is request payroll records as a part of the initial document request you receive from the State of California. They will ask you for a copy of the business’s payroll journal during the audit period and the auditor will pick an employee at random, and then the EDD auditor will check that employee’s W2 for the tax year and verify that with what the State of California has on file.
The EDD auditor will match the payroll tax returns and then go a step further. They will make sure that the information that was listed on the payroll tax returns (in California those are DE 9s and DE 9Cs) and match the information that was reported on the W2 to the IRS. Then the auditor will match that against the information that is in the payroll journal.
What the EDD auditor is doing here is essentially a multi-step check of the payroll records and the reporting to different agencies to see if there is any discrepancy.
When the EDD looks at the taxable wages for the employee, it is okay if there is a minor difference, which is usually attributable to an accounting error.
If you have hourly employees, there might be some discrepancy over the hours and that difference can be perfectly explainable, but a difference of more than 5 percent is really going to create a problem during the EDD payroll test.
During an EDD audit, the way we handle the payroll test internally at Brotman Law is that we go through and cross-reference the payroll journal against the W2s and against the payroll tax returns that were filed both with the IRS and with the Employment Development Department.
However, it is critically important that this be done in advance of the EDD audit, so you can have confidence in the information that you are about to present and can similarly screen out any issues.
As long as you complete this and pass your own test internally, you will pass the payroll test in your EDD audit.
Other things to note about payroll, make sure you look at issues that may be present when you have two different entities or a change in ownership during the audit period. In our experience, we see a lot of errors related to this.
Make sure to reconcile both entities against total filings for the business, explain changes in the employee situation (particularly applicable for businesses that use a lot of part-time or seasonal workers, and generally just be organized by consolidating records to the extent possible. Doing this will help you navigate through the EDD audit much more smoothly.
In addition to the payroll verification test, the EDD will also look at personal income tax withholdings and make sure that the amounts listed match what the state has on file as well. Just to go back and clarify, the EDD audit is looking at the wages and the income that the people earned.
The EDD auditor is going through the payroll journal to make sure that the total wages are going to match.
Just like with the income side of things, the EDD auditor is going to look at the tax that was withheld and make sure that matches each employee. The auditor is going to go to the W2, and they are going to look at the federal income tax withheld and the state tax withheld on a payroll tax level.
Then, the EDD auditor is going to go through and look at the report fillings to the IRS and the State of California and then look at what was reported by the employee.
During most EDD audits, you will see that the EDD will ask for a W4 in a payroll tax audit. What they are doing is looking at the information that the employee reported to the employer originally.
The EDD auditor is verifying any exemptions and any marital status, and basically verifying that there have been proper withholdings on the employee’s end. The auditor is verifying that to check on the employee’s records and to make sure the employer’s records are correct.
After doing a sample of an employee, the EDD will usually go a step further and they will reconcile the total payroll to total wages in order to make sure that those amounts match as well. Usually, there is a year-end summary that is performed that is filed with the state. In California, that is called a DE 9.
The EDD auditor will verify that information and that it matches the payroll journal just to make sure that the total payroll is accurate. The auditor will take a sample and then verify that sample against the total.
As long as you can do the same thing prior to the audit, essentially pre-auditing tax withholdings, the result should come out fine during the EDD audit.
Occasionally, the EDD will break it down on a quarter-by-quarter basis. The auditor will actually go through and look at wages that were being reported within a given quarter, and they will go quarter-by-quarter for a year or for a half year, and then run the verification test that way.
The auditor will go back and look at what was reported on the payroll journal and will compare that information to what was reported on the payroll tax returns.
As we have said before, if everything matches, the test is passed, and you have no problems. If the records do not reconcile properly, then it will usually trigger opening other years, and the EDD auditor will go through and verify everything on an actual basis.
In most situations, though, you are going to see consistent reporting between payroll tax
that was reported and wages that were reported. It is only when you have a situation where there have been poor financial controls, or there has been a change in accountants that you may have some reporting discrepancies.
The next test is a review of your general journal/general ledger and bank statements to see if there are any payments that were made that should be reclassified into taxable wages.
On a high level, the auditor’s review falls into two categories 1) payments that are personal in nature (and should be reclassified as taxable wages) or any payment to an officer or employee that should be reclassified as taxable wages (distributions, bonuses, etc.), 2) unreported payments to others that should be reclassified as taxable wages.
Reimbursements, for example, are one target of the journal test. One of the biggest problems that we come across in payroll audits is employee reimbursements and independent contractor reimbursements.
Often, what will happen is an employee will get paid a normal paycheck and then they will spend their own money outside the context of the business to buy materials, to buy supplies, go to the post office, do whatever.
The business will write the employee a check out of their operating account and not run it through payroll.
As this progresses, depending on the size of the business and how often the employees are counted on to front their own expenses, you could have several large checks being issued to employees that on the surface would look like compensation on the surface level.
However, you are going to have to dive into those payments specifically to find out if they are truly reimbursements (non-taxable) or disguised payments for services (taxable). And not to mention the fact that we have not discussed whether or not the business can even substantiate these reimbursements.
The truth of the matter when it comes to reimbursements is that businesses tend to keep poor records and they do not save the substantiation because they have written a check and have a corresponding accounting entry.
Once the employee has been paid out, the reimbursement is just simply verification for the owner so that the owner knows that the employee did actually incur those expenses. Once the issue has been settled with the employee, the business generally does not think about keeping the substantiation.
In these cases, it is critically important to be prepared to discuss these items in the audit and have as much detailed information surrounding the reimbursements as possible.
Actual receipts are not critical, but having information and having those expenses look credible in an audit is a must in order to not have them treated as taxable wages.
How do you do this? You can rely on the testimony of the employee or obtain written statements about the nature of the expenses being reimbursed. You can talk about the materials that were purchased, especially if reimbursements are an industry standard.
You can try and obtain third-party invoicing depending on what it is. However, gather as much outside information as you can and/or try to screen out whether this is a potential audit issue in advance.
Casual labor and employee reimbursements are always hot topics in payroll tax audits, so you need to be prepared going in as much as possible.
This is, by far, the most troubling area of payroll tax audits for many businesses. To give some context, there are four separate classifications for workers: employee, independent contractor, statutory employee, and statutory non-employee.
An employee is paid a regular salary and is afforded various state and federal protections in terms of their employment. Employers must pay state and federal income taxes on the employee’s behalf and are liable for 50 percent of the FICA (Social Security and Medicare) taxes payable as well as the Medicare levy.
State and federal unemployment taxes are also the employer’s responsibility, although in California, employees are responsible for state disability tax.
An independent contractor is a self-employed person who is hired to complete tasks for the company. They are liable for their own taxes, both income and self-employment tax, which covers Social Security and Medicare. There is no unemployment tax payable as self-employed contractors are not eligible to receive unemployment benefits.
Statutory employees are independent contractors who are treated as employees for tax purposes. This situation arises where a worker is self-employed and has a measure of control over their working hours and conditions but does business principally with a single employer.
For Social Security tax purposes, they are treated as employees, but they do not receive employer benefits and employers do not withhold income tax.
Statutory non-employees are workers such as licensed real estate agents and direct sellers, where 90 percent of their income or more comes from sales commission rather than being tied to hours worked.
Income tax is not withheld on their behalf. They must be designated as holding this status via a written contract.
A written contract stating that your worker is an independent contractor is not sufficient to establish that status. Whether a worker is properly a contractor or an employee requires a finding of fact based on the particular case at hand.
In January of 2020, the California legislature passed AB5, which governed the relationship between companies and their workers. Basically, what AB5 states is that unless a hiring entity can prove that a worker is truly independent according to three specific factors, that worker will be deemed to be an employee of the company itself.
The factors are:
1) The company must not have any commensurate control over the worker.
2) The worker’s services must be outside the core business for the hiring entity.
3) The worker must maintain their own separate and independent business.
This was called the death of independent contractors in California because unless you qualify for one of the exemptions that is under the statute, pretty much, all workers fall within an AB5 framework and can be deemed employees.
It is only those who are truly providing outside services, like a bookkeeper, a CPA, a law firm, or a videographer, that really qualify outside the scope of AB5. The statute is meant to pull as many people as possible into the employee relationship.
However, from a tax perspective, it does not really have any impact. The reality of the situation is that the EDD has been operating within an AB5 framework for quite some time.
What do I mean by that? The reality is that when you go through an employment tax audit, EDD is already looking at control. Control was a previous factor under the old test, and now the EDD is focused on if the worker is integral to the revenue generation function of the particular business.
If the worker helps you earn revenue and they are somewhat essential to your business, then they are your employee. The reality is that before AB5, California auditors and administrative law judges were already in this mindset.
You may be thinking, “What is going to happen now that I have to switch all my workers over to W2 and I am going to get audited?” The reality is you were probably going to get audited anyway.
California, through its enforcement actions, has been focused on this issue for quite some time and it is really important that you understand this framework going in. The reality of the situation is with most independent contractor audits for 2020 and beyond, the story is about damage control.
The reality is you probably will not beat this test unless you can show your workers are truly independent businesses and they fall outside the revenue generation framework. I want you to think outside the lines when it comes to tax on this issue, and you need to be as proactive as possible.