California state payroll taxes are governed by the California Employment Development Department (EDD).  The EDD is California’s third largest taxing agency.  It has the responsibility of administering the collection, accounting, and enforcement functions of four basic employment taxes: unemployment insurance tax, employment training tax, disability insurance tax, and personal income tax.

Audit in red


If your business receives an audit notice from the EDD, all four of these taxes will likely be investigated. If your business has been selected for an EDD audit, it is absolutely critical that you seek legal representation from an aggressive business defense attorney who can negotiate effectively with EDD payroll reporting agents. Without protection from a knowledgeable legal representative, you greatly increase your risk of being burdened with significant  financial liabilities, and if fraud is alleged, you could even find your company at the center of a criminal investigation carried out by EDD’s Investigation Division.

EDD Audit Selection Factors: Independent Contractor Status

Many EDD audits arise when a former worker, which the business classified as an independent contractor, files for unemployment insurance.  Since unemployment insurance only applies to employees, this will likely raise a red flag at the EDD.  The EDD may ask the former worker whom they worked for, if they have a license to do business in the state of California, and related questions in an attempt to determine if the business misclassified the worker as an independent contractor.  If the EDD has enough concern to flag your entity’s file, it may provoke an audit, also known as a “status audit.”

The EDD and IRS follow similar rules when determining whether a worker should be classified as an independent contractor or employee during a status audit or California payroll tax dispute.  However, there are also some significant differences.  For example, while the IRS applies the “right-to-control” test, which focuses on 20 factors that are examined in making a determination, the EDD first applies three statements:

  1. The worker can quit or be terminated at any time, without being legally obligated for failure to complete the job.
  2. The manager (or designated person) assigns, reviews, and supervises the individual’s work.
  3. The worker performs services that are part of the regular operation of the State agency.

If these three statements are found to be true, then the EDD presumes the individual is an employee.  If the veracity of these statements is in question, the EDD turns to a list of 24 elements used to investigate the worker’s status as an employee or independent contractor.  These elements include, but are not limited to:

  • Whether the worker is engaged with a separate company or occupation in addition to their main occupation.
  • Whether the worker relies on his or her own tools, equipment, and/or work environment.
  • Whether or not the worker is typically supervised.
  • How much control the worker has over his or her services.
  • The degree of specialized skill which is required to adequately perform the worker’s services.
  • How long the worker renders his or her services.  This helps the EDD gauge whether the work was done on a single-project, isolated basis (indicating an independent contractor), or was performed continually (indicating employee status).
  • The manner in which the worker was paid.
  • Whether the worker and employer both feel they are engaged in an employee-employer relationship.  While this factor is not considered to be a sufficient gauge in its own right, it can make an impact on the EDD’s determination.
  • Whether the worker has the authority to make business decisions which could result in loss or profit, discounting sheer time investment.

Will the IRS Get Involved?

The EDD tends to be more aggressive than the IRS, due to the absence of a California equivalent to Section 530 of the Revenue Act of 1978, which provides reasonable basis and safe harbor rules for treating workers as independent contractors.  If your business is found guilty of misclassifying employees as independent contractors, paying workers cash “under the table,” failing to file 1099 forms, or making other attempts to conceal the existence of workers, your business can be responsible for paying up to three years of back employment taxes on the incorrectly classified or unreported wages.

It is also very important to keep in mind that there is increasing cooperation between the EDD and the IRS when it comes to status audits and payroll tax disputes. Most of the time, the IRS will not consider or review the results of an EDD audit until it is finalized.  The IRS may choose to conduct a full scale examination on its own, or take the work papers of the EDD audit and base its assessment upon their findings.  When handling an EDD audit, you must always be aware of the possibility of IRS involvement, as well.

Status or California payroll tax dispute audits and appeals are very complicated.  They require knowledge of California tax law, as well as an understanding of the procedures of the EDD.  If your business has received an EDD pre-questionnaire, questionnaire, or audit notice, Bellatrix PC can help.  Our law group can be your voice throughout the audit proceedings, and will explain step-by-step what typically occurs during the California EDD audit process. We will explain potential outcomes and how to handle each possibility.

To arrange for a private legal consultation, call the business defense lawyers of Bellatrix PC right away at (800) 449-8992.

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