EDD Audits: A Cautionary Tale

No one wants to find themselves under audit.  Whether from IRS, EDD CFTB, or other government agencies, audits are stressful and time-consuming. When it comes to facing an audit, how you react at the start of the audit can make all the difference.  Some business owners feel that it is an overreaction to call a lawyer, or that it is somehow an admission of guilt.  In cases of government audits, it is wise to bring in qualified counsel at the start of the audit to prevent the audit from expanding to other areas beyond the initial scope. The importance cannot be underestimated, don’t wait until your situation has gotten out of control to bring in a qualified tax attorney. 

Allow us to present two scenarios culled from multiple cases we have encountered in the case of EDD and other government audits. In our first example, the client came to us for support immediately upon receiving notice of their audit. The second example reflects a client who first brought on a criminal defense attorney without a specialty in tax audits. 

Case Study 1 (the safe route)

Our first client case study features “Ryan”, a business owner in the construction field whose company has grown quickly over a short period of time. His business was the subject of a construction site sweep resulting in an audit by the Employment Development Department (EDD).  EDD auditors arrived at Ryan’s home, called his business associates, and sent aggressive letters to his business and residence alarming him, his business partners, and his family.  Ryan researched EDD audits and saw that the vast majority of EDD audits result in fines of over $200K, a business-breaking amount for the small business he owned and operated. Ryan immediately reached out to the team at Milikowsky Tax Law through a google search for EDD audit representation. 

Our first step was to take a deep dive into the areas of the business that were being audited. As is often the case with the construction industry, employing 1099 contractors was at the root of the audit. Employee misclassification is routinely the cause of an EDD audit, whether from an EDD site sweep or a contractor whose services are no longer required filing for unemployment.  In the latter case, that filing immediately triggers a contractor classification audit, even if the filer did so in error, unwitting of the consequences to the business.  In other cases, competitors will file complaints against a business to tie them up in red tape and audit troubles (though those cases are thankfully rare).  Whatever the trigger, once an audit has begun there are strict rules around when documentation must be provided.  Failure to adhere to these deadlines results in forfeiture of your case and often in high monetary penalties and required business restructuring. 

Because we are highly experienced in EDD audits, the team at Milikowsky Tax Law was able to reframe Ryan’s situation to EDD.  As in many cases, assumptions are made about business structures that are, at times, not correct.  Among other details, verification, and understanding of the unique situation of this case, we were able to correctly classify the few workers who were incorrectly classified and help Ryan stay in business.*

Case Study 2 (a cautionary tale)

The second client case study we are sharing took a different route than the case mentioned above. While Ryan immediately took action to contact our team of EDD, IRS, and government audit experts, this second client did not do the same. 

Let’s call this client, “Joe”. Joe also owns a construction company and received a letter, call and visit to his workplace letting him know he was being audited not only for worker misclassification but also licensing problems.  Joe’s first response was to ask his brother-in-law what to do.  The advice he got was to contact a criminal defense attorney. While a criminal defense attorney may be a helpful resource in the event of a criminal investigation, in this case, the attorney had no experience with EDD audits. 

When this client began working with their criminal defense attorney, they were advised to reach out and speak to EDD themselves. Choosing to take this action ultimately incriminated  Joe further. Speaking with EDD as a layperson, inexperienced in the intricacies of EDD’s audit processes and procedures leaves the door open for missteps and in this case, further incrimination. 

In their direct conversations with EDD, Joe willingly provided additional documentation to EDD that opened up investigations into other areas of his business financial dealing, other groups of employees/ 1099 contractors and worsened his audit dramatically. The criminal attorney did little research into the business structure, did not interact with EDD or IRS, and, as the deadline for high fees and criminal charges approached, Joe reached out to us.  

With weeks left in the allocated time period, we did hours of research into Joe’s business setup, his contractors, the services he provides, and how his workers are classified, not only as individuals but as groups by their functions.  We build a case for some reclassification and some dismissal and spend hours of time on the phone with EDD and IRS negotiating the settlement.  With only 3 days until Joe’s high fines and possible jail time were to be inflicted, both government agencies settled.  Joe is still in business, though the fees he had to pay were higher because of the additional audits on top of the initial inquiry.   

One of the best ways to avoid the potential of an EDD audit is to ensure that your workers are correctly classified. Improperly classifying workers as 1099s when they should be W2s is an easy trigger for EDD to audit your business. If you’re unsure of how your workers should be classified, we can help. 

Our got1099 team completes quarterly reports that help identify potential issues that could flag your business for an audit. If issues are identified we can help provide advisement to adjust them before they’re identified as a greater issue in an audit. For more information or to get started, contact us today. 

*This and all case studies on the website are not promises of results.  Cases vary widely and individual situations must be looked at with the full context in order to determine the correct path forward.  Not a guarantee of results.