CA Employment Development Department (EDD) normally commences audits by a letter briefly explaining audit procedure and requesting documents. They do not actually need all those documents. These audits focus on independent contractors (ICs) and re-characterization to employees. Once re-characterized, EDD assesses a tax retroactively for three years which includes personal income withholding tax, employer contribution taxes of unemployment, disability, training, interest and possibly penalties.
When you receive an audit letter take a deep breath, after all your auditor is a real and probably nice person. But, the auditor has a job: assess employment taxes. EDD has an ever growing larger bias for employment. The IC test is subjective and common words “prove” employment. So the auditor uses those words. It is important that you use other common words to prove IC status. But, you must understand the subtle subjective legal meaning of these common words used to distinguish between employment or IC. So, when you communicate with an auditor only use words that weigh on the IC side of the IC test. (See “What Is an Independent Contractor?” post.) For example, if you say you “hire” an IC, the auditor will know you are thinking in employment terms and you start losing your support for IC status.
Having represented many businesses in EDD Employment Tax Audits, I start by calling the auditor to narrow the amount of documents required and set a meeting date. The first meeting will center on the nature of the business and how that relates to IC’s services. The information provided the auditor establishes the initial audit direction.
After the initial meeting and data review, the auditor will send out questionnaires to a sample of the ICs who were paid during the audit period. After reviewing returned questionnaires, the auditor will usually call selected ICs. Frankly, the selection seems to center on the ICs whose answers do not distinguish between IC and employee. Those answers shape the auditor’s finding of fact and determines EDD’s conclusion of IC or employee.
Finally, the auditor will notify the business of its determination whether the ICs are to them ICs or employees. If employees, the EDD will send you a proposed assessment covering three years and assess the four taxes and retroactive interest. It will likely include a ten percent penalty for negligently mischaracterizing the (now) employees, unless you have good cause for that characterization. Good cause is normally following an attorney’s advice. The EDD commonly and mistakenly includes workers in the audit that should not be there, such as attorneys, CPAs, or other consultants doing business under their own name. I usually call the auditor to explain and prove why those should be eliminated. Prior to the final assessment, you will be offered an interview with the auditor and his/her supervisor. My experience is the EDD will not change their determination, so I usually avoid the exit interview.
Then, the EDD mails you its final assessment. The business has 30 days to appeal or pay. If you do not appeal and do not pay, there will be another ten percent penalty.
The IC test is very subjective and Employment Tax Audit results are semantic driven. Use wrong words and an IC becomes an employee in the eyes of the EDD. So, in reality the first thing you should do when you receive an EDD notice of employment tax audit, is to call Chris Schaefer – (415) 454-2421 – and take advantage of a free limited consultation regarding your EDD Employment Tax Audit before contacting the EDD.