How to Handle EDD Tax Audit

California EDD Tax Audit Process: Legal Framework, Procedures, and Appeals
The California Employment Development Department (EDD) is a state agency tasked with overseeing payroll tax compliance, unemployment insurance, disability insurance, and workforce development programs. For businesses operating in California, an EDD tax audit can be triggered by suspected payroll tax violations or worker misclassification. This tax lawyers guide provides a comprehensive review on how to handle EDD tax audit, its legal framework, procedural steps, and the appeals process, equipping business owners with knowledge to navigate EDD tax audit.

Legal Framework Governing EDD Audits
The EDD operates under the California Unemployment Insurance Code (CUIC), which establishes the legal basis for payroll tax collection, worker classification, and audits. The CUIC mandates that employers properly classify workers as employees or independent contractors, report wages accurately, and remit payroll taxes, including:
Unemployment Insurance (UI): Funded by employer contributions to support unemployed workers.
Employment Training Tax (ETT): A small tax to fund workforce training programs.
State Disability Insurance (SDI): Funded by employee withholdings to cover disability benefits.
Personal Income Tax (PIT): Withheld from employee wages for state income tax obligations.

Key EDD Tax Rules: AB 5 and the ABC Test
A cornerstone of handling EDD tax audits is the classification of workers, governed by Assembly Bill 5 (AB 5), effective January 1, 2020, and its successor, AB 2257. AB 5 codified the ABC Test from the Dynamex Operations West, Inc. v. Superior Court (2018) case, which presumes workers are employees unless the employer can prove all three prongs:
A: The worker is free from the control and direction of the hiring entity in performing the work, both under the contract and in practice.
B: The work performed is outside the usual course of the hiring entity’s business.
C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
Certain professions, such as physicians, lawyers, and specific gig economy roles, are exempt from the ABC Test under AB 2257 and are evaluated using the older Borello Test, which focuses on the degree of control and other factors. Misclassification under these tests can lead to significant liabilities, including back taxes, penalties, and interest.
Other Relevant Laws and Regulations
California Labor Code: Governs wage and hour laws, which may intersect with EDD audits when investigating unreported wages or off-the-clock work.
California Code of Regulations, Title 22: Details EDD’s audit procedures, reporting requirements, and appeal processes.
Joint Enforcement Strike Force (JESF): Established under California Government Code §15900, the JESF facilitates inter-agency cooperation (e.g., with the Franchise Tax Board and Division of Labor Standards Enforcement) to combat the underground economy, often triggering EDD audits.

EDD Tax Audit Process
The EDD audit process is methodical and formulaic, designed to verify compliance with payroll tax obligations and worker classification. Below is a detailed breakdown of the steps, followed by a flowchart for clarity.
Step 1: Audit Notification
The process begins with an audit notice sent via mail, outlining:
The audit’s scope (e.g., payroll records, worker classification).
A list of requested documents (e.g., payroll journals, W-2s, 1099s, bank statements, contracts).
A questionnaire about business practices and worker relationships.
The audit period, typically covering the prior three years.
Triggers for EDD Tax Audit:
Worker misclassification (e.g., an independent contractor filing for unemployment benefits).
Discrepancies in tax filings or late payments.
Employee complaints or tips.
Random selection (rare, but possible).
JESF investigations targeting the underground economy.

Step 2: Entrance Interview
The EDD auditor conducts an entrance interview, either in-person, by phone, or virtually, to:
Discuss the EDD tax audit’s purpose and scope. EDD Auditors review the business’s operations, including worker roles and classification practices. California companies should have a tax lawyer present during this stage to avoid providing information that could expand the EDD tax audit periods or scope of engagement.

Step 3: Document Review and Fieldwork
The auditor examines submitted records, cross-referencing payroll journals, tax returns, and worker agreements against CUIC requirements. Key focus areas include:
Worker Classification: Applying the ABC Test or Borello Test to determine if workers are properly classified.
Payroll Compliance: Verifying accurate reporting of wages, withholdings, and tax payments.
Recordkeeping: Ensuring compliance with CUIC recordkeeping mandates.
Auditors may visit the business premises or interview workers to assess control and direction in work relationships.

Step 4: Proposed Notice of Assessment (PNA)
After completing the review, the auditor issues a Proposed Notice of Assessment (PNA), detailing:
Findings (e.g., misclassified workers, underpaid taxes).
Proposed liabilities, including back taxes, interest, and penalties.
The opportunity to provide additional evidence to contest the findings.
Businesses have a limited window (typically 30 days) to respond with supporting documentation or negotiate adjustments.

Step 5: Notice of Assessment (NA)
If the business does not contest the PNA or the auditor upholds the findings, a Notice of Assessment (NA) is issued, finalizing the tax liability. Payment is due within 30 days, or a 10% penalty is added to the amount owed. Failure to pay may lead to collection actions, including liens or personal liability for business owners.

EDD Tax Appeals Process
If a business disagrees with the NA, it can appeal through the California Unemployment Insurance Appeals Board (CUIAB). The appeals process is time-sensitive and formal, requiring careful preparation and legal expertise.
Step 1: Filing the Appeal
Deadline: File a Petition for Reassessment within 30 days of the NA’s mailing date.
Process: Submit the petition to the local CUIAB office, including a detailed explanation of why the NA is incorrect and supporting evidence (e.g., contracts, worker testimonials).
Outcome: Filing an appeal stays collection actions until the appeal is resolved, unless the EDD determines the appeal is frivolous.

Step 2: Administrative Hearing
An Administrative Law Judge (ALJ) conducts a hearing, which may be in-person, by phone, or via video conference. The hearing focuses on:
Evidence Review: The ALJ evaluates documents and testimony to assess worker classification (using the ABC or Borello Test) and tax compliance.
Burden of Proof: The employer must demonstrate that the EDD’s findings are incorrect.
EDD Participation: The EDD rarely attends hearings, which can benefit appellants if they present compelling evidence. The ALJ issues a decision to uphold, reverse, modify, or set aside the NA. Decisions are mailed within weeks of the hearing.

Step 3: Second-Level Appeal to CUIAB
If dissatisfied with the ALJ’s decision, the employer can file a second-level appeal to the CUIAB within 30 days. This is a paper review, not a new hearing, where the CUIAB evaluates the ALJ’s decision for legal errors. The decision is final unless appealed further.

Step 4: Superior Court Appeal
As a last resort, employers can file a petition in California Superior Court within 30 days of the CUIAB’s decision. This is a complex legal proceeding definitely requiring a tax attorney, as the court reviews the administrative record for errors of law or abuse of discretion.

Settlement Option
The EDD offers a settlement program for pending appeals, allowing employers to negotiate reduced assessments. However, settlements often require agreeing to reclassify workers as employees, which may impact business operations. Legal counsel is critical to evaluate settlement viability.

Joint Enforcement Strike Force (JESF): Combating the Underground Economy
JESF Activity: The JESF continues to drive audits, particularly targeting industries with high independent contractor use, such as construction, gig economy platforms, and hospitality.

EDD Tax Appeals Strategy:
Gather detailed evidence, such as signed contractor agreements, proof of independent business operations, and worker testimonials.
Prepare thoroughly for the ALJ hearing, as it’s the primary opportunity to present your case.
Consider settlement if the evidence is unfavorable, but weigh long-term operational impacts.

Contact Us
For businesses facing an EDD tax audit, Tax Lawyers Group APC offers specialized EDD representation to guide you through every stage of EDD tax audit notification to tax appeals. Contact us today for a consultation to safeguard your business and achieve the best tax audit outcome.