When the Employment Development Department (EDD) hits your business with an audit, it can be expensive and emotionally taxing for you as an owner. Fortunately, you can prevent this from happening in a few ways. Read below for a quick guide to avoiding EDD payroll audits.
Classify Workers Correctly
It’s important for business owners to correctly classify workers as either employees or independent contractors. In California, employee wages are subject to state payroll taxes, while independent contractors are not. In general, workers are presumed to be employees unless they meet specific criteria that qualify them as independent contractors. There are various status issues to consider when making an employment determination:
ABC Test
The ABC test is used to determine if a worker is an employee or an independent contractor unless there is an exception. The worker is presumed to be an employee unless all three conditions are met:
- The worker 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 worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is routinely doing work in an independently established trade, occupation, or business that is of the same type as the work being performed.
Other Classes of Employees and Independent Contractors
- Statutory Employee: This is a worker who is considered an employee based on specific laws.
- Exempt Employment: Certain employees and specific types of employment are not subject to one or more payroll taxes, which includes Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and Personal Income Tax (PIT) Withholding.
- App-Based Drivers: App-based drivers providing services for network companies are generally considered independent contractors if the network company meets certain conditions.
For a deeper dive into proper classification, see our guide on EDD audits and worker classification issues, including red flags to avoid.
Pay Your Employees the Correct Wages
Understanding the different types of wages is important for accurate tax withholding and reporting. The amounts reported may be used to determine a claimant’s benefits. Proper reporting helps ensure that claimants receive the benefits they are entitled to.
Wages are what you pay your employees for their service, and can include:
- Salaries, hourly pay, piece rate, or payments by the job.
- Commissions and bonuses.
- Overtime and vacation pay.
- The reasonable cash value of compensation other than cash.
Wages are paid by check, cash, electronic debit, payment apps, or the fair value of noncash payments such as meals and lodging. Payments are wages even if the employee is a casual worker, a day or contract laborer, a part-time or temporary worker, or paid by the day, hour, or any other way.
Accurate Compensation Matters
Failing to record wages properly—or misinterpreting overtime and benefits regulations—can attract unwanted attention. Overpayments, misclassifications of wages, or failure to track wage elements accurately all pose audit risks.
Best Practices
- Follow California’s minimum wage laws and overtime rules closely.
- Ensure all payroll reporting accurately reflects bonuses, commissions, and non-cash compensation.
- Keep up with wage-related reporting requirements to avoid red flags.
Be Accurate With Taxes
You can prevent an audit if you appropriately withhold income, employment, and payroll taxes. However, you must file quarterly reports with the necessary documents and forms. Failure to submit them on time or with incomplete or inaccurate information can lead to an audit.
Payroll Tax Responsibilities
California employers are required to file and pay multiple state payroll taxes through the EDD, including:
- UI – Unemployment Insurance
- ETT – Employment Training Tax
- SDI – State Disability Insurance
- PIT – Personal Income Tax withholding
Any errors in rates, misfiling, or failure to pay can prompt an audit. Many small businesses get flagged due to inconsistent reporting or late tax deposits.
Staying Compliant
- Use the California Employer’s Guide (DE 44) to verify current payroll tax rates and procedures.
- Enroll in e-Services for Business to file returns, make payments, and avoid common submission errors.
- Keep consistent tax calendars and audit trails for all submissions.
Maintain Thorough Records
Maintaining thorough records of your business activity, including correct payroll and tax records and subcontractor agreements, is a good idea. Thanks to these records, the EDD will see that you run an ethical business, and you won’t incur any penalties.
Audit Readiness Through Documentation
EDD audits are typically retrospective—looking back at payroll records for up to three years. If your records are incomplete or disorganized, auditors may assume wrongdoing and assess penalties based on estimates. That makes documentation your first line of defense.
The EDD will expect access to:
- Employee and contractor lists
- Timecards and attendance records
- Payroll registers and tax returns
- General ledger and bank statements
- Canceled checks or pay stubs
- Copies of employment agreements
Audit-Proofing Your Records
- Create digital and physical backups of all payroll records.
- Retain files for at least four years, even if not legally required.
- Use tools like QuickBooks, Gusto, or ADP to automate audit logs.
- Review the EDD’s Tax Audit Guidelines to understand what documents may be requested.
Treat Your Employees With Respect
Focus on treating your employees well, particularly when it comes to their pay. Otherwise, they can file a complaint against you if they believe you treated them unfairly or are not following the law.
Employee Complaints Can Lead to Audits
One of the lesser-known triggers for an EDD payroll audit is an employee complaint. When workers feel mistreated, misclassified, or underpaid, they may report the employer to EDD or file for unemployment benefits that conflict with what the employer reported.
An audit often begins with one of these situations:
- A former contractor applies for unemployment benefits, prompting EDD to investigate classification.
- An employee files a wage complaint and reveals under-the-table payments or wage theft.
- A disgruntled employee reports violations anonymously.
Build a Culture of Compliance
- Be transparent about wages, benefits, and policies.
- Respect labor laws regarding rest breaks, sick leave, and workplace safety.
- Create clear reporting channels for employee concerns—and resolve them early.
- Review our guides like read our list of 5 practical ways to reduce the risk of an EDD audit, especially regarding wage reporting and documentation.
Conclusion
These issues can lead to an EDD audit, so treat your employees with respect to reduce the possibility of complaints.Contact Pershing Square Law Firm if you are looking for a tax audit lawyer who can help you challenge an EDD assessment of payroll taxes, income tax, and penalties. We have been able to reduce the assessment of all our clients who appealed in a timely fashion.