Employment Development Department (EDD) performs many services, but their primary role that impacts small businesses is collecting and auditing payroll taxes. Employers pay payroll taxes for W-2 employees, but not for 1099 independent contractors. 

The line between an independent contractor and an employee was more concretely defined with the implementation of Assembly Bill 5 (AB-5). A worker must meet all three of the following criteria to be classified as an independent contractor: 

1. 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
2. The worker performs work that is outside the usual course of the hiring entity’s business
3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

Misclassification mistakes can oftentimes be exactly that – an innocent mistake. However, there are also instances where businesses have taken advantage of classifying employees as independent contractors to avoid paying payroll taxes and investing in employee benefits. This was the case with Dynamex– read the full story here. 

Purposeful and accidental employee misclassifications strip employees of their benefits and the government of their tax funding. In order to protect both, EDD performs misclassification audits on businesses that are flagged for potential misclassifications. The top 4 EDD audit triggers include: 

1. Independent contractors filing for unemployment
2. Employee complaints to EDD
3. Late filing of taxes
4. Randomized verification audits 

If EDD sends you a notice in the mail notifying you they want to audit your business, there is a limit to how far back they can audit. 

EDD Audit Statute of Limitaitons 

The government agency can audit your business EDD can audit your business 12 quarters back from the quarter in which the audit is started, however, audits can go back up to eight years in some cases. 

Watch our full video below to learn more.

Only cases involving fraud or intent to evade payroll taxes are not limited by that statute of limitations. In these instances, EDD can audit the business as retroactively as they deem.

Section 1132 of the Unemployment Insurance Code states: 

“Except in the case of failure without good cause to file a return or report, fraud or intent to evade any provision of this division or authorized regulations, every notice of assessment shall be made within three years after the last day of the month following the close of the calendar quarter during which the contribution liability included in the assessment accrued or within three years after the deficient return or report is filed, or was due, whichever period expires the later. An employing unit may waive this limitation period or may consent to its extension.

In case of failure without good cause to file a return or report, every notice of assessment shall be made within eight years after the last day of the month following the close of the calendar quarter during which the contribution liability included in the assessment accrued. An employing unit may waive this limitation period or may consent to its extension.”

How Long Do EDD Audits Take?

EDD audits typically last about three to nine months depending on a myriad of factors:

• How prepared and organized are you for the audit 
• If they find more information that may need to deepen the investigation 
• How backlogged the department is

Your auditor will have to review your records, federal income tax return, W-2s, payroll tax returns, 1099 forms, financial statements, and more. They also interview your 1099 independent contractors to cross-verify information. 

The more contractors you have, the longer the audit can potentially take. 

For more information on how a got1099 report helps business owners in the face of an EDD audit, read our article here. 

Article originally published on Milikowsky Tax Law.