Relying heavily on independent contractors instead of properly classifying workers as employees often leads to unpaid payroll taxes and missing benefit contributions, as well as a high risk of an EDD Audit. Because of this risk, the EDD keeps a close eye on contract‑based staffing and frequently audits businesses to make sure the correct unemployment, disability, and payroll taxes.
An EDD audit is essentially a review of a business’s records to verify workers are properly classified, wages are accurately reported, and all required payroll taxes have been paid on time. Failing to meet EDD standards can lead to steep penalties, back taxes, and legal consequences.
What Triggers an EDD Audit
Businesses can find themselves subject to an EDD audit for various reasons, some of which are more common than others. Awareness of these triggers is the first step in prevention.
Independent Contractor Misclassification
This is, by far, one of the most frequent and impactful triggers for an EDD audit. California has stringent rules for classifying workers as independent contractors versus employees, primarily governed by the “ABC Test” and, in certain circumstances, the “Borello Test.” If a worker was paid as an independent contractor and later files for unemployment benefits, it triggers a signal to the EDD of potential employee misclassification issues. If your business relies heavily on independent contractors and lacks W-2 forms for employees, it may raise red flags with the EDD.
Inconsistent Reporting
Inconsistent reporting of worker classifications, such as filing both W-2 and 1099 forms for the same individual or switching between classifications over time, can trigger scrutiny from the EDD.
Late Filings and Payments
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 pay on time.
Employee Complaints
Disgruntled current or former employees can trigger an EDD audit by filing complaints. These complaints can range from alleged unpaid wages, disputes over benefits, to claims of misclassification. The EDD is authorized to investigate such complaints, and they often lead directly to an audit.
Discrepancies in Reported Wages or Taxes
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.
Random Selection
While less common than specific triggers, the EDD does conduct random “verification audits” as part of its general compliance efforts. These audits are not initiated by a specific event or allegation but are part of the EDD’s strategy to ensure overall adherence to payroll tax laws.
Understanding Worker Classification under California Law
The ABC test (since January 1, 2020)is used to determine if an individual is an employee or an independent contractor in California. Under the ABC Test, a worker is presumed to be an employee unless the hiring entity satisfies all three of the following criteria:
| Prong | Criteria | Description |
| A | Free from control and direction | The worker must perform work free from the hiring entity’s control, both under the contract and in practice. This includes control over how, when, and where the work is performed. |
| B | Outside the usual course of business | The work performed must be outside the hiring entity’s regular business operations. For example, a plumber hired by a software company is likely outside its usual course of business. |
| C | Independently established trade or business | The worker must be customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. This requires evidence of an independent business entity, such as a business license or marketing efforts. |
The hiring organization must show that all conditions of the ABC test are met in order to classify the individuals as independent contractors, unless there is a statutory exclusion or exception.
ABC Test Exceptions
The ABC test applies by default, but for certain jobs, industries and contracting relationships, the Borello multifactor test applies.
For more information on employment status, visit the Employment Status Portal.
App-Based Drivers
Proposition 22 added sections 7451 through 7452.5 to the Business and Professions Code which makes app-based drivers for network companies independent contractors and not employees or agents if the network company meets certain conditions beginning December 16, 2020.
Statutory Employment
A statutory employee is defined as an employee by law under a specific statute.
For more information on statutory employment, refer to Information Sheet: Statutory Employee (DE 231SE)(PDF).
Exempt Employment
Certain employees and specific types of employment are not subject to one or more payroll taxes, which include:
- Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and Personal Income Tax (PIT) Withholding.
- For more information on exempt employment, refer to Information Sheet: Exempt Employment (DE 231EE)(PDF).
What Actually Happens During an EDD Audit
Entrance Interview and Entity Verification
Audits begin with an entrance interview intended to explain the process, gather details about your business structure and operations, and estimate how long the audit will take. Auditors verify your business entity type (sole proprietor, corporation, etc.), start dates, and whether your business is a functioning operation, sometimes including site visit.
Examination of Books and Records
EDD examines corporate accounting records including check registers, canceled checks, general ledger, payroll journals, W‑2s, Form 1099s, tax returns, licenses, and written agreements They reconcile reported wages to EDD’s payroll records for at least four representative quarters.
Worker Relationship Investigation
Auditors ask why certain workers classified as independent contractors and analyze your documentation, conversations, and the facts of the working relationship, including whether written contracts reflect reality.
Exit Interview and Resolution
Before concluding, auditors hold an exit interview to review findings and discuss factors supporting classification determinations. If liability is found, they inform you about assessment amounts, possible penalties, and appeal rights.
Red Flags and Common Missteps in Classification
- Heavy reliance on contractors performing core business tasks (e.g. non‑tech contractors at a tech firm) despite having guiding control or supervision over them.
- Lack of written contracts or evidence of an independently established business, such as license, multiple clients, own equipment.
- Misuse of dual classification, such as issuing both W‑2s and 1099s for same individuals.
- Contracts stating contractor status don’t guarantee proper classification: actual working conditions control the determination.
Risks and Penalties from Misclassification
Payroll Tax Deficiencies
If workers are reclassified as employees, employers can owe unpaid contributions for unemployment (UI), disability (SDI), and payroll taxes. The removal of the SDI wage cap effective January 1, 2024,means that employers may owe much larger amounts than in previous years, especially for high-income workers. According to the Employment Development Department (EDD), failure to properly withhold and remit these taxes can result in significant assessments that include back taxes, interest, and fines, even if the misclassification was unintentional.
Civil and Statutory Liability
Misclassification can expose employers to lawsuits for unpaid wages, overtime, meal/rest breaks, reimbursement of expenses (Labor Code § 2802), plus PAGA penalties and employers’ attorneys’ fees. In addition, employees can bring Private Attorneys General Act (PAGA) claims, which allow for civil penalties on behalf of the state.
Auditor-Imposed Penalties
- 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.
For more information on EDD audits, visit the EDD official website at: https://edd.ca.gov Employment Development Department | California.
Follow‑Up Audits
If workers found misclassified remain on payroll or are rehired similarly, EDD may later audit post-assessment periods. Even if you appeal successfully, you may owe taxes for subsequent periods unless reported as employee from time of determination onward.
Prevention Strategies and Best Practices
Use the DE 38 Worksheet or Request a Ruling
Apply the EDD’s DE 38 Employment Determination Guide to evaluate each relationship. If classification remains unclear, file DE 1870 to request an official EDD ruling within 60 days, provided no open audit exists.
Comply with Independent Contractor Reporting
If you pay an individual $600 or more per year, file Form 1099‑NEC/MISC, DE 542 to EDD within 20 days, and submit a DE 9/9C wage report. Late or false reports may incur $24–$490 penalties.
Maintain Accurate and Ongoing Records
Keep detailed payroll ledgers, general ledger, bank statements, canceled checks, contracts, licenses, invoices, W‑2/W‑4 and 1099 forms. Update classification decisions whenever roles or conditions change.
Conduct Regular Internal Audits
Have legal or tax advisors review contractor relationships annually using both the ABC Test and the Borello Test. Be especially cautious in industries under scrutiny, such as hospitality, trucking, and tech, where misclassification risk is highest.
Educate and Train Business Stakeholders
Ensure leadership, hiring managers, payroll staff, and HR know classification rules and document procedures. Even well-intentioned mistakes without sufficient evidence of independent business status can lead to liability.
Limiting the Exposure
Misclassifying independent contractors in California can expose a business to back taxes, penalties and private wage-and-hour claims, and the exposure usually spans several years rather than one. Reviewing contractor arrangements against the ABC Test before a notice arrives is the practical way to limit it.
Some occupations sit outside the ABC Test entirely, and our note on the exceptions to AB5 sets out which. If a client or your own business has already received a notice, our payroll tax audit team works on classification disputes and audit defense.
