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California Payroll Tax Audit Process

Employment Development Department's Employment Tax Audit Process

The California Unemployment Insurance Code (CUIC) and the Government Code authorize the Employment Development Department (EDD) to conduct payroll tax audits of businesses operating in California. The payroll tax audit provides education outreach to employers regarding their state employment tax obligations and ensures that benefit coverage is provided for workers who are entitled to such coverage under the law.

Generally, EDD employment tax audits cover a three-year period, comprising the 12 most recently completed calendar quarters. However, in some situations, such as when no returns were filed, the audit period may be longer.

First, the auditor will conduct an entrance interview with employer or with his or her designated representative to explain the purpose of the audit and its process, gather general information about the operation and organization of business and accounting records, and will answer any questions. Only then auditor will review records. Payroll systems to be checked by EDD can be as basic as a manual system with only a check register and individual earnings records or as complex as a computerized double entry system on an accrual basis. Provisions of the CUIC require employers to keep payroll records providing a true and accurate account of all workers (employed, laid off, on a leave of absence, or an independent contractor) and all payments made. Consequently, the type of system taxpayer should use should meet the needs of your business and EDD requirements. Requirements are explained in EDD's California Employer's Guide.

The auditor will review employer's books and records to:

• Verify the business ownership and type of entity (sole proprietorship, partnership, corporation, other).

• Verify that all individuals paid for services have been properly classified as either employees or independent contractors in accordance with the provisions of the CUIC and the common law test as applied by the California Supreme Court.

• Discuss any unreported payments made for personal services and the nature of the working relationship(s) with employer and the worker(s). Based on the facts obtained from the records, input from employer, and discussion(s) with the worker(s), the auditor will determine whether the worker(s) are employees or independent contractors.

In addition, if employer's account has been selected for a complete audit, the following tests will be performed:

• Verification that employer's acknowledged gross wages and taxable wages have been properly reported.

• Verification that employer has correctly withheld and reported personal income tax for wages paid to employees.

Please note that the EDD's employment tax audit information will be made available to the IRS under an exchange agreement, and the IRS may use the information in the administration of its own tax program.

An audit begins with the examination of records for a test year. The test year is generally the most recent completed calendar year. If differences are found in the test year, then the examination may be expanded to include the records for the entire period covered by the audit. To expedite the audit process employer must ensure that all records are available to the auditor.

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