As a business owner in California, it’s essential to be aware of the Employment Development Department (EDD). They’re the state taxing authority and the enforcers of California’s tax laws. Failure to follow legal practices can lead business owners to tax audits.
The Employment Development Department (EDD) can audit your business for as far back as three years (and more in some fraud cases)—the good news: most audit risk can be reduced with disciplined compliance and smart documentation. Fortunately, we have five ways to mitigate the risk of an EDD audit that can help you.
Correctly Classify Your Employees
One of the fastest ways to prompt an EDD audit is to classify employees incorrectly. As an employer, you must categorize workers as employees or contractors. One of the differences is that you pay employees wages, and they’re typically under a contract that explains their role within the company. In contrast, contractors are free from the control and direction of the hiring entity.
The Legal Foundation
Under the California Unemployment Insurance Code (CUIC) and related statutes, the EDD is authorized to audit employers to ensure that:
- Workers are properly classified as employees rather than independent contractors
- Wages and payroll taxes are correctly reported and withheld
- Benefit programs such as unemployment insurance (UI) and state disability insurance (SDI) are protected.
The EDD’s own Employment Tax Audit Process document explains that audits “verify compliance with the CUIC, ensure workers are properly classified … and protect workers’ rights to receive benefits.
Why Worker Misclassification is a Red Flag
California uses the ABC-test (since Jan 1, 2020) for most workers:
- A) Free from control and direction of the hiring entity in performing work.
- B) Performs work outside the usual course of the hiring entity’s business.
- C) Engaged in an independently established trade or business.
If you cannot comfortably say “yes” to all three, the worker likely should be treated as an employee. The EDD watches this closely.
Why classification drives audit risk
Misclassifying workers as independent contractors is one of the top EDD audit triggers. If a person performs services that look, operate, and are controlled like employment, the EDD may reclassify them as an employee—creating retroactive payroll tax, penalties, and interest.
Typical Audit Timeline
- Notification: Businesses receive a letter from the EDD informing them they have been selected for audit.
- Entrance interview: The auditor will talk to you or your representative, explain scope, and request records.
- Records examination: The auditor reviews payroll journals, tax returns, classification decisions, and supporting documents.
- Proposed Notice of Assessment (PNA): If violations are found, a PNA is issued summarizing liabilities, then a final Notice of Assessment (NA) may follow.
- Appeal process: Employers have rights to appeal EDD assessments via the CUIAB or superior court.
Practical steps to get classification right
- Map your roles to the tests. For each contractor role, create a one-page memo applying DE 38 factors (and where applicable, the ABC test exceptions) to your facts.
- Fix what you can, now. If you control schedules, tools, or results, or the services sit in your “usual course of business,” convert to payroll and correct forward.
- Use contracts that reflect reality. Contracts should align with actual practices (e.g., business autonomy, substitution rights, clear deliverables).
- Maintain proof. Keep engagement memos, W-9s, invoices, business licenses, and project scopes to evidence bona fide contractor status.
Want a second opinion on a borderline role? Our unemployment and payroll team can review your contractor matrix and flag what an EDD auditor will likely challenge.
Scope & Audit Period
Most EDD audits cover the three most recently completed calendar years (12 quarters), though this can be expanded if non-filing or fraud is suspected.
Fairly Pay Wages
Another thing that can alert the EDD is inaccurate wage payments. It’s critical to stay updated with federal guidelines for minimum wage and overtime. California has strict minimum wage laws that all employers must follow compared to other states. Failure to pay an employee an appropriate hourly wage will trigger an EDD audit.
Wage compliance prevents cascading issues
Under- or misreporting wages causes two problems: (1) it affects employee benefit eligibility and (2) it skews payroll tax contributions—both are audit magnets.In California, there are four state payroll taxes. Two are employer paid and two are withheld from employee wages.
Employer paid:
- Unemployment Insurance (UI)
- Employment Training Tax (ETT)
Withheld from employee wages:
- State Disability Insurance (SDI)
- Personal Income Tax (PIT)
Use official references to align your practices:
- Payroll Taxes – EDD gives the state’s view of UI, ETT, SDI/PFL, and PIT withholding obligations.
- The Employers’ Bill of Rights (DE 195) explains the audit process from the employer lens, including what information auditors can request and what rights you have when disputes arise.
Accuracy checklist for wages
- Classify pay types correctly. Salary, hourly, commissions, bonuses, tips, stipends, and non-cash compensation must be recorded and reported based on state definitions.
- Track overtime and premium pay precisely (California rules differ from federal).
- Pay stubs must itemize hours, rates, and deductions; retain copies.
- Reconcile payroll to the general ledger every quarter to catch mismatches before EDD does.
- Mirror what you report. W-2 amounts, quarterly returns, and internal ledgers must agree.
Accurately File Taxes
It’s your responsibility as an employer to withhold correct income, employment, and payroll taxes. In addition to accurately filing taxes, you must file quarterly reports with EDD and provide the required documents and forms. Submitting late, incomplete, or inaccurate forms can raise suspicion, prompting an audit.
Filing precision is your first line of defense
Late filings, wrong rates, and incomplete schedules are common triggers. Anchor your procedures to EDD’s own guides:
- Tax Audit Guidelines (DE 40). This is the playbook auditors use—study it like your team’s SOP.
- Audit Process Overview (DE 231TA). Understand stages, document requests, and how examiners evaluate records.
- File & Pay (e-Services). File tax returns and wage reports, make payments, update your employer payroll tax account, and more! Visit e-Services for Business for information on features, benefits, and access to additional resources.
Quarterly ritual (what to do every filing cycle)
- Rate verification: Confirm your UI/ETT rate from the latest EDD rate notice before you run payroll.
- Pre-file tie-out: Reconcile gross wages, taxable wages, withholdings, and deposits; compare to the ledger.
- Attachment hygiene: Double-check schedules and any amended returns; incomplete attachments cause needless notices.
- Deposit calendar: Lock due dates into shared calendars with reminders; require screenshots or EFT confirmations.
- Variance log: If totals don’t match prior quarters, document a reason (new headcount, bonus cycle, reclassifications). You’ll thank yourself in an audit.
If you receive a confusing EDD notice (rate, balance due, or document request), involve counsel early—small response errors can widen an audit’s scope.
Keep a Record of Everything
One of the best things you can do is to keep a record of everything. From accurate payroll and tax records to subcontractor agreements, it’s best to document all business activity within your company. It’s important to note that the EDD performs random audits. But if you’re following the best business practices and keeping current records, you won’t have to worry about penalties from the EDD.
Documentation wins audits
EDD audits are retrospective. If your files are thin, auditors can estimate liability—often aggressively. Build a file that tells a clean story:
- Payroll & tax: Registers, quarterly returns, EFT proofs, W-2/W-3, DE 9/DE 9C, year-end summaries.
- Employees: I-9s, W-4/DE 4, offer letters, timecards, schedules, pay-rate change forms, separation docs.
- Contractors: W-9s, SOWs, invoices, business licenses, communications proving business independence.
- Finance: General ledger, bank statements, canceled checks, wire confirmations.
- Policies: Handbooks, expense and overtime policies, remote work agreements.
Retention & organization standards
- Retention period: Keep payroll tax and classification records at least four years (many keep six).
- Two-tier backups: Cloud + offline or separate cloud tenant. Encrypt sensitive data.
- Index by quarter: Audits are quarter-driven; keep a “Q-packet” per quarter with returns, deposit proofs, registers, and reconciliations.
- Evidence memos: When you make a judgment call (e.g., contractor vs employee), save a dated memo citing DE 38 factors. Auditors appreciate contemporaneous reasoning.
Avoid Fraudulent Practices
Paying workers under the table or reworking timesheets to avoid paying overtime are fraudulent practices that will result in an EDD audit. It’s always best to accurately pay and report everything because committing fraud is a serious federal offense. Not only can you risk losing your business, but you can face legal consequences.
Culture and controls that reduce fraud risk
- No “off-books” wages—ever. All compensation must route through payroll with proper withholding.
- Centralize contractor onboarding. Legal or HR should approve every contractor engagement and apply DE 38 uniformly.
- Segregate payroll duties. Preparation, approval, and payment should involve different people.
- Hotline & amnesty. Encourage staff to report errors early; fix and disclose before an auditor finds them.
- Quarterly compliance reviews. A 60-minute check each quarter (rates, totals, classifications, variance log) pays for itself.
If you discover past issues (unfiled returns, contractor reclassification, or under-withholding), talk to counsel about remediation strategies before responding to any agency letter.
Conclusion
The EDD is California’s taxing authority that all businesses need to be aware of and follow the best legal practices. To avoid an audit, always refer to our list of five ways to mitigate the risk of an EDD audit. However, if you’re facing an audit and need a tax audit defense lawyer, contact Pershing Square Law Firm. Our team of experienced lawyers can help you face an EDD. If you have any questions, call us today!