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What to expect in an EDD Employment Tax Audit

Bryan Frey's Profile

What to expect in an edd employment tax auditThe EDD just hit me with an Employment Tax Audit. In my 15+ years of being a CFO at 5 companies I've never had one of these. What should I expect? How should my team and I prepare? Any lessons learned would be greatly appreciated.

Answers

Topic Expert
Lee Andrews
Title: P/T CFO, Business Consultant
Company: Pacific Bag, Inc./Other Clients
(P/T CFO, Business Consultant, Pacific Bag, Inc./Other Clients) |

EDD? Are you referring to the Employment Development Department in California? Or is this something else (Federal?) -- needs defining. I'll assume this is CA or some other state employment department. In which case, to answer your request, I went through a state employment audit last year. Not too painful -- more an annoyance. They seemed to focus on accuracy of payroll records, timekeeping records and "independent contractors". They wanted to know if we had hired people, like temps, on an hourly pay basis without setting them up as official P/T employees on payroll. We had previously hired some young summer interns at various times and paid them by the hour by gross check to do some minor tasks like labeling, on an as-needed basis. Because they did not fit the state legal definition of "independent contractors", the implication was that we were deliberately avoiding state unemployment taxes, etc. (like that made our net income target for the year!). The dollars were very minor, and we did issue 1099MISC forms. Our "transgression" was to not put them on the official payroll, for which we got a small fine (<$100) and a letter asking us to make sure not to do that again. In other words, if you hire an exec's 17-year old relative to sweep the warehouse floor or break down some old boxes for, say, $12 an hour, for 10 hours a week for just one month one summer -- be prepared to suffer the wrath of the state! So what lessons did I learn? It just reconfirmed my opinion about politicians and bureaucrats that rule the world with impunity (although they can shut down an entire government and cost us all a fortune). Oh yes, and the cost of that taxpayer financed state audit was hugely more than our fine or possibly missed unemployment tax calculations.

Bryan Frey
Title: VP Finance/Corp Controller
Company:
(VP Finance/Corp Controller, ) |

That was precisely what I was looking for! Thank you, Lee, great answer.

Anonymous
(CFO) |

My early career was spent providing accounting and tax services to small businesses and dealing with issues such as this.

Unless your company is a "fly by night operation" that didn't really care about employment, tax or other business regulatory issues, you have little to be concerned about. EDD auditors are only interested in assuring that your company properly reported, withheld, and timely remitted all required employment taxes and earnings reports of all employees.

The examples that Mr. Andrews cited are spot on. It's usually little different than a worker's comp payroll audit.

But, I'll provide you with a caveat based on years of experience: Many EDD (and IRS) auditors are incompetent. But don't let that make you complacent or feel like you can challenge them. You need to treat them respectfully and pretend they are smarter than you are or risk the consequences of them focusing their energies on making your life miserable. They do have pretty impressive powers.

Be nice. Play along. Stroke their egos. It can take you far in avoiding penalties and interest on back due amounts.

To further the case: We frequently hear in the news of companies being shut down by government tax authorities for "not paying their taxes". Most people assume that "taxes" is referring to income taxes that the entity owed. But, it almost never is. It's referring to payroll taxes that were not paid.

Not paying payroll taxes is one of the surest signs of a fly by night or mom and pop operator I know of. It's also a good way to assure that a business will not survive the long run. It's the denizen of self employed business people. It is usually the start of a downward spiral.

I'm a bit surprised by the cavalier attitude expressed by the first responder to your inquiry. I'm no fan of government overregulation or the burden that places on businesses. But purposely ignoring or being unaware of the employment laws and tax consequences of independent contractor vs employee is something I might expect from the accountant at Fred's Discount Painting Service and not from a CFO at a serious firm. Laughing off the small fine imposed in that particular case might lead to something much more serious later on. There are liabilities beyond payroll taxes for not getting the employment relationship right.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

I went through what is probably the equivalent type of Audit once, about 8 years ago. They were looking for 1099 contractors that were Employees.

They left empty handed, because at the time everything was legal (since that time the state changed some laws and its questionable as to the status of those contractors).

Topic Expert
Keith Perry
Title: Director of Global Accounting
Company: Agrinos, Inc.
(Director of Global Accounting, Agrinos, Inc.) |

Good catch; maybe post an article on the impact of NY's Wage Theft laws? They may be leading the way for other states.

Topic Expert
Keith Perry
Title: Director of Global Accounting
Company: Agrinos, Inc.
(Director of Global Accounting, Agrinos, Inc.) |

Echoing Anon's comment and adding on some detail;
1) Mis-classifying a w-2 employee as a 1099 employee might be considered a gentle term for fraud, even if the mistake is inadvertent, and there can be serious consequences. For example, if they should have been w-2 then you should have withheld, paid into social security, medicare etc. Maybe they should get 401K, stock options, profit sharing? If they were injured then *you* could have to pay for their lost wages and rehab out of pocket. This is a long list, and yes, it can shut companies down if it is more than a minor thing. And, do not be cavalier if the initial scope is minor; you may have to open the kimono, looking into overtime, withholding rates, etc.
2) Very often EDD comes in because there is cause: a contractor is dismissed and files for unemployement; there is a worker's comp claim; you simply have lots of low-paid employees on 1099s. You should find this out.

So, in response to an audit:
1) Investigate the source. What triggered it? Is it random, or is there a red flag that you need to be aware of?
2) Investigate internally. The easy part is confirming that your payroll provider and worker's comp provider are doing their jobs, and that you haven't mis-classed anyone. Check your overtime rules, vacation/PTO policy for all of your salaried employees. Then check your contractors. There is no set rule, so this can be quite fraught if you have many independent contractors on your payroll. The rules are here: http://www.dir.ca.gov/dlse/faq_independentcontractor.htm but please remember that they are *very* open to interpretation. Try looking at them with the most critical eye possible.
3) Build your case of documentation as to what you've paid to whom and why; what are and aren't employees, etc. If you are defending IC status, make sure that you can provide a preponderance of evidence that they are in fact ICs.
4) Have a nice, productive and open meeting with the Auditor, with nicely sorted documentation. They will (in my experience) be grateful that you are open and informative. They are generally nice people trying to keep the playing field level for us; the less of their time we waste, the more time they can devote to hunting down people who are actually on the wrong side of the rules.

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