Our last article, we discussed the purpose of the EDD audit initial interview questions. Those initial questions just kind of go through some of the background information on the business and help to explain that. After the initial interview, the EDD will conduct what they call a payroll test. The purpose of this article is to explain the payroll test and its function within the EDD audit.
A payroll test is a verification of the business's payroll posting system. The EDD auditor is making sure that payroll is being reported by the business accurately and properly. What that essentially means is the EDD is going to compare their records to the records of the business in order to make sure the payroll journal matches what the EDD has on file.
What the EDD auditor will do in an independent contractor audit is request payroll records as a part of the initial document request you receive from the state of California. They will ask you for a copy of the business’s payroll journal during the audit period. The auditor will pick an employee at random and then the EDD auditor will check that employee's W2 for the tax year and verify that with what the state of California has on file.
The EDD auditor will match the payroll tax returns and then go a step further. They will make sure that the information that was listed on the payroll tax returns, in California those are DE 9s and DE 9Cs, match the information that was reported on the W2 to the IRS. Then the auditor will match that against the information that is in the payroll journal. What the EDD auditor is doing here is essentially a multi-step check of the payroll records and the reporting to different agencies to see if there is any discrepancy. When the EDD looks at the taxable wages for the employee, it is okay if there is a minor difference, which is usually attributable to an accounting error. If you have hourly employees, there might be some discrepancy over the hours and that difference can be perfectly explainable, but a difference of more than 5% is really going to create a problem during the EDD payroll test.
During an EDD audit, the way we handle the payroll test internally at Brotman Law is that we go through and cross-reference the payroll journal against the W2s and against the payroll tax returns that were filed both with the IRS and with the Employment Development Department. However, it is critically important that this be done in advance of the EDD audit, so you can have confidence in the information that you are about to present and can similarly screen out any issues. As long as you complete this and pass your own test internally, you will pass the payroll test in your EDD audit.
Other things to note about payroll, make sure you look issues that may be present when you have two different entities or a change in ownership during the audit period. In our experience, we see a lot of errors related to this. Make sure to reconcile both entities against total filings for the business, explain changes in the employee situation (particularly applicable for businesses that use a lot of part time or seasonal workers, and generally just be organized by consolidating records to the extent possible. Doing this will help you navigate through the EDD audit much more smoothly.