In 2025, the Employment Development Department(EDD) in California has stepped up enforcement, and the most common spark for the audit is worker misclassification. What often surprises businesses is that these problems frequently trace back to breakdowns in how their accounting firms handled classification, documentation, and payroll compliance.Firms serving clients in high-volume gig, logistics, delivery, or rideshare sectors are especially vulnerable. These industries depend heavily on independent contractors, and even small oversights can trigger audits that carry large costs and long-term fallout.
The Risk: Why EDD Audits Begin
EDD audits rarely come out of nowhere. They start with identifiable triggers mistakes in classification, lapses in payroll processes, or discrepancies that raise red flags. Accounting firms that understand and address these early warning signs can blunt the impact or avoid an audit altogether.
Misclassification Triggers Most Audits
When employers incorrectly classify workers as independent contractors instead of employees, it’s called “misclassification.” If this happens to you, you may still be able to get unemployment benefits. When employers incorrectly classify workers as independent contractors instead of employees, it’s called “misclassification.A single UI claim by a 1099 worker can trigger an audit automatically—the agency then reviews that employer’s records across multiple years. Once triggered, auditors examine payroll filings, 1099 issuance, and worker agreements.
If you think you’ve been misclassified, apply for benefits. We will let you know if you’re eligible.
To learn more about the difference between employees and independent contractors, visit the Employment Status Portal.
How to Apply for Unemployment Benefits
If you think you meet the eligibility requirements for unemployment benefits, including having been paid enough wages by an employer, the fastest way to apply is through UI Online. You can also apply by phone, or by mailing or faxing a paper application form. If you choose not to use UI Online, allow extra time for processing.
Late or missing payroll tax filings
Consistent late filing of payroll tax returns or delayed payment of taxes is a clear red flag for the EDD. Even minor delays can attract attention, and repeated delinquency significantly increases the likelihood of an audit. The EDD imposes penalties for late payments, which can escalate quickly, so timely compliance is crucial.
Discrepancies between reported wages and actual tax remittances
The EDD routinely cross-references data with other government agencies, such as the Internal Revenue Service (IRS) and the Workers’ Compensation Insurance Rating Bureau. If inconsistencies are found between the wages and taxes reported to the EDD and those reported to other agencies, it can trigger a crossmatch audit. Similarly, internal discrepancies within a business’s own EDD filings can also raise suspicion.
Inconsistent documentation or “verification” triggers that arise when submitted records conflict or are incomplete.
These issues, even if peripheral to classification, can broaden the scope of an audit and increase the pressure on the business and its advisors.
High-Risk Industries Are Under the Microscope
Certain fields get more attention because they rely heavily on flexible or gig-style labor. The individual is free from the control and direction of the hiring organization in connection with the performance of the work, both under the contract for the performance of the work and in fact.
- The individual performs work that is outside the usual course of the hiring entity’s business.
- The individual is routinely doing work in an independently established trade, occupation, or business that is of the same type as the work being performed.
Failing any one of these prongs pushes the worker into employee status under California wage orders. That makes thorough review mandatory for any client using contractors—especially where the contractor’s duties overlap with core business operations.
The ABC Test: Presumed Employee Status
California applies the ABC Test for most classification questions, meaning a worker is presumed to be an employee unless the hiring entity satisfies all three conditions:
The Consequences: Financial & Legal Fallout from EDD Audits
The fallout from an EDD audit that uncovers misclassification or compliance lapses is rarely limited to a single penalty. These audits can expose clients to layered liabilities, reputational damage, and future operational constraints.
Back Taxes and Multi-Year Exposure
Once EDD concludes that a worker was misclassified, it can assess back taxes over several years. This includes unpaid portions of Unemployment Insurance (UI), State Disability Insurance (SDI), Employment Training Tax (ETT), and any withholding required for personal income tax. The total can balloon quickly, especially if multiple workers are involved or if the audit spans an extended look-back period.
Civil Penalties for Willful Misclassification
Under California Labor Code § 226.8, deliberate misclassification triggers steep civil fines:
- $5,000–$15,000 per misclassified worker for a single violation.
- $10,000–$25,000 per worker if the employer has engaged in a pattern or practice of willful misclassification.
These penalties are imposed in addition to any assessed taxes, interest, or other charges.
Employers found to have intentionally misclassified workers must also publicly post notice about the violation and corrective actions taken.
Additional Penalties: Fraud, Late Payment, and Interest
- Late Payments
The penalty for late payments is calculated by the amount of time passed. The penalty is 2% for deposits up to 5 days late, 5% for deposits between 6 and 15 days late, and 10% for deposits over 16 days late. - Fraud or Misclassification of Employee
Employers may be fined $5,000 to $10,000 on top of any non-paid payroll taxes or late payments for fraudulent filings or misclassification of employees. Frequent audits can cause EDD audit penalties to increase to between $10,000 and $25,000. If the employer is unable to pay, EDD may seize personal assets. Filing for bankruptcy does not dismiss liability to the EDD. Payroll tax fraud, if determined to be with criminal behavior, may lead to incarceration. - Interest
Interest accrues daily and compounds on all unpaid tax and associated penalties (UI, SDI, ETT, PIT withholding). Rates adjust semi-annually; from July to December 2025, the rate is 7%, compounding daily.
| Overdue Date | Interest Rate | Daily Interest Factor |
| 07/01/25 to 12/31/25 | 7% | 0.000192 |
| 01/01/25 to 06/30/25 | 8% | 0.000219 |
Private Litigation: Wage & Hour Claims and PAGA Exposure
Beyond the administrative penalties from EDD, clients face private exposure. Misclassified workers can sue for unpaid overtime, meal and rest break violations, unreimbursed business expenses, and related wage-and-hour claims. Under the Private Attorneys General Act (PAGA), these suits can multiply liability dramatically, sometimes eclipsing the initial audit assessments.
What Accounting Firms Should Do: Proactive Strategy
Accounting firms are the first line of defense for clients. Waiting until an audit notice lands is expensive; taking action beforehand saves money, time, and reputation.
Conduct a Self-Audit Using the ABC (and Borello) Test
Firms should routinely review all independent contractor relationships. Apply the ABC Test—and where applicable, the Borello factors for certain professions—to every arrangement that could be ambiguous. This isn’t a one-time exercise; changes in how work is performed or in the underlying agreements should trigger renewed review.
Notify Clients and Correct Misclassifications
When problems surface, transparency matters. Immediately notify the client, outline the risk, and present a remediation plan. That plan may include:
- Amending prior filings (converting 1099s to W-2s where appropriate).
- Submitting corrected tax returns.
- Adjusting payroll processes to reflect proper withholding and reporting.
- Reissuing forms or retroactively correcting documentation.
Early correction can reduce the scope of potential penalties and position the client more favorably if an audit begins.
Engage Expert Counsel Early
The initial stages of an EDD audit—the entrance interview and document collection—set the tone. Having experienced legal counsel involved from the outset can narrow the audit’s breadth, preserve appeal rights, and ensure procedural fairness. Counsel can also help craft persuasive arguments for reduction or abatement based on corrective actions already taken.
Our Services for Accounting Firms and Their Clients
We provide a full-service solution to address classification risk before, during, and after an EDD audit.
EDD — Contact Payroll Taxes (employer support, audit inquiries, appeals, reconsideration)
This page provides official EDD contact points for payroll tax inquiries—including how to handle audit notifications, requests for reconsideration, and petition rights.
Full Audit Defense: From Entrance to Appeal
We guide clients through every step: preparing for the entrance interview, assembling and responding to documentation requests, negotiating appropriate classifications, and managing any resulting assessment notices. If an adverse finding occurs, we handle well-supported petitions, appeals, and mitigation requests.
Assessment Reduction & Appeals
When audits uncover issues, we help clients push back intelligently. Timely appeals and properly framed responses have produced mitigation results in every case where we’ve intervened, reducing assessments, penalties, or both.
Flat-Fee Pricing & Payment Plans
Clients get predictability. Our engagements are structured to avoid surprise bills and include flexible payment plans so that remediation and defense do not become a cash-flow crisis.
Post-Audit Compliance Support
Once the audit closes, the work isn’t done. We review and strengthen classification procedures, update internal protocols, and provide training on how to sustain compliance—especially around the ABC Test and documentation standards.
Preventative Classification Consulting
We help firms build enduring systems: contractor onboarding workflows, classification decision trees, periodic re-evaluation triggers, and payroll integration reviews. The goal is to reduce future audit risk by design.
Comprehensive Action Plan for Accounting Firms
| Action Step | Purpose |
|---|---|
| 1. Inventory 1099 Relationships | Review each contractor file—evaluate role, control, business independence, etc. |
| 2. Apply ABC Test (± Borello) | Use 2025 ABC criteria as codified in AB 5 and DE 44 guide for classification decisions. |
| 3. Client Communication Protocol | When in doubt, proactively alert clients and lay out reclassification or documentation plan. |
| 4. Document Correction Workflow | Collect firm-recorded errors → amend tax filings (DE 231MW procedures) → issue proper forms. |
| 5. Engage Legal Counsel | Ensure representation during EDD entrance interviews and appeal windows |
| 6. Establish Preventative Policies | Adopt classification checklists, employee-vs-contractor controls, and training protocols |
Don’t Wait
California employers—and their accounting firms—face heightened risk in 2025 from EDD’s increased enforcement targeting worker misclassification. The audit process is exacting, costly, and can stretch across multiple years and cases, leading to substantial back taxes, per-worker fines, and PAGA or wage‑hour exposures.If your firm has administered client contractor files or payroll operations that may expose clients to an EDD audit, don’t wait. Contact us today for expert support if your firm has made classification mistakes that could expose your client to an EDD audit and consult for audit defense, assessment mitigation, and future-proof compliance consulting.
