What is a payroll tax audit?

In California, the Employment Development Department (EDD) conducts audits of payroll taxes across the state. During the audit process, the assigned agent looks at classification of W2 employees and 1099 workers, and whether the correct payroll taxes were collected on payments made to all workers. Business owners should ensure their business is prepared for an EDD tax audit and that they have adhered to the new ABCs of worker classification set out in AB-5. 

What triggers a payroll tax audit?

• Misclassified 1099 or W2 employees. 
• Independent contractors filing for unemployment- they are self-employed and do not qualify for unemployment benefits. 
• Someone reporting your business to EDD (justified or not).
• EDD conducting a random site sweep.
• Filing taxes late or not at all. 

How to prepare for a payroll tax audit?

If EDD decides to audit your business, they will send an Inquiry Regarding Records (DE996). This letter includes a questionnaire called the “Pre-audit Questionnaire” that you must complete. Read the letter fully and carefully, understand the extent of the audit, and respond within the time constraints to provide documentation to support any EDD requests. 

Prepare for your Entrance Interview 

You meet with the auditor during the entrance interview. The auditor assigned to your case explains the purpose of the audit, what the steps of the audit will be, and then they will ask you questions about your business. Be prepared with any questions you have for this meeting. Read here about top EDD audit questions to help guide you. 

Organize Records 

EDD will review your employee records to see if each of your workers was properly classified as either a W2 or a 1099. W2 employees are what are considered typical employees who work structured hours, receive benefits, and have taxes withheld from payroll. 1099 employees on the other hand are independent contractors hired on a contractual basis. 1099’s do not receive benefits nor have payroll taxes deducted from their paychecks. 

Have records organized ahead of time to make the process easier. Typical records EDD requests include: 

• Records of cash payments 
• Paystubs 
• Payroll records 
• W-2 and 1099 tax reports 
• Bank statements 
• General ledgers 
• Annual financial statements 
• Federal and state Income tax returns 
• Canceled checks 
• Check registers 
• Verification of business ownership
• Written agreements 

Understand Findings 

Once the audit is complete, the auditor will review the findings with you either in person or by phone. Audits can take about three months to complete and can take longer depending on the complexity of the case. 

Audits conclude through one of the following: 

• No change: Nothing was found and nothing is owed or overpaid.
• An overpayment was found: the agency will issue a credit or a refund of the overpayment 
• An underpayment was found: The auditor will go over the differences owed and any fines or penalties associated with the findings. 
• There is an overpayment and an underpayment: in these cases, one may offset the other or provide the business owner a refund. 

Open an Appeal 

You can appeal audit findings up to 30 days after the decision. This appeal can be made through the California Unemployment Insurance Appeals board to reassess the audit findings based on additional information. 

How far back can EDD audit?

EDD can audit tax filings for up to three years back (12 pay periods or quarters). Typically, the agency audits only the most recent year, however, an audit can look farther back if submitted records unearth information that causes the EDD to feel that there may have been misclassification or underpayment of payroll taxes in other time periods. If CA EDD finds that your business engaged in any criminal activity, the period in which they can audit can extend to eight years. 

How can a got1099 report help?

Misclassifying W2 and 1099 employees puts your business at risk for an EDD audit, high fines, penalties, and even jail time. Misclassifying a W2 employee as a 1099 or independent contractor, or vice versa, means payroll taxes are being incorrectly paid.  

Get ahead of an audit by verifying each employee. Our reports include verification of your workers’ EIN, business licenses, web presence, and more.  These reports help business owners to know if they have misclassified employees as contractors. With this information, you can make the proper changes to their employment status or ask them to reinstate expired business licenses, clarify their business status or register for their own EIN.

If this is done ahead of time, and EDD audits your business, you already have the records and reports ready to show that your workers are indeed correctly classified. Got1099 report recipients can also receive notifications if their 1099 independent contractor’s license has expired or has been revoked. 

Properly classify your workers with got1099 today.