Now that the April filing deadline has passed, small business owners may be asking: what’s next?

As tempting as it may be to put off thinking of taxes until next year, some small business owners may be required to respond to an EDD audit.

Read on how to learn how what triggers an EDD audit and how to respond.

What is a CA EDD Audit?

California’s Employment Development Department (EDD) conducts an audit to determine if the employer has paid the full and correct amount of taxes due under California law.

What Triggers EDD Audits?

EDD audits are most commonly triggered by:

  • An independent contractor filing for unemployment
  • The EDD verification process
  • Late filing of tax returns or late payment of taxes
  • Failing to pay wages on time or collect SDI and PIT

Many verification EDD audits are conducted on a random basis and not based on any assumptions of inaccurate or incomplete information. Additionally, EDD has the power to audit a company if they believe the business has purposefully misclassified workers in an attempt to avoid paying payroll taxes.

However, many legitimate businesses are unintentionally misclassifying employees as a result of new, strict worker classification regulations, related to Assembly Bill 5 (AB-5).

What is AB-5?

AB-5 is a piece of legislation that extends employee classification status to some independent contractors and gig workers depending on the qualifications outlined in the ABC test. AB-5 went into effect on January 1st, 2020, and changed how Small Business Owners (SBOs) who hire independent contractors operate in California.

Learn more about how this law came into effect, and how Dyanmex ruined it for everyone, here. 

How Can AB-5 Lead to the Misclassification of Employees?

AB-5 introduced the ABC test as a stricter guideline to determine how to classify workers as 1099 independent contractors. A worker must meet all three criteria of the ABC test to be classified as a 1099 independent contractor instead of a W-2 employee.

  1. The worker is free from the control and direction of the hiring entity in connection to the performance of the work.
  2. The worker performs work that is outside the usual course of the hiring entity’s business.
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If the contractor misses one of the criteria in the ABC test, they should be classified as a W-2 employee.

Learn more about AB-5 and the ABC test, here.

What Happens If I Misclassify an Employee?

Employee misclassification can lead to several unfortunate outcomes, including fines and penalties.

With the new regulations, employee misclassification is more common for small businesses. As an example, let’s examine the case study of one of our clients, Ryan Brown, who misclassified his workers and was faced with EDD audit.

Check out the video below!

Meet the Client: Ryan Brown

Ryan Brown owns a construction company in Oceanside, California. His business classified a portion of the staff as 1099 independent contractors and the rest as W-2 employees.

How Can the Misclassification of W-2 Employees Happen?

The services of the hired independent contractor must be consistent with all three of the criteria established by the ABC test or they are automatically classified as a W-2 employee.

In Brown’s case, he didn’t realize that the independent contractors were providing the same services as the W-2 employees. Therefore, the employees he classified as independent contractors didn’t meet the second requirement, “[workers] perform work that is outside of the usual course of the hiring entity’s business.” Thus, all staff members should be classified as W-2 employees–any worker the business claimed was an independent contractor was misclassified.

What Triggered Brown’s EDD Audit?

EDD conducted a random site sweep of Brown’s business. This sweep resulted in EDD finding misclassified workers.

What Happened When Brown Contacted Milikowsky Tax Law?

Brown called Milikowsky Tax Law and set an initial meeting. Before signing any kind of retainer, John started making calls to learn more about the audit and what steps they needed to take immediately to protect the business and provide accurate information to EDD and CSLB.

What Were the Results of Brown’s EDD Audit?

After less than a month, EDD sent a final letter indicating that while minor fines were due, the case was closed. For Brown, the results–and knowing his business was going to be fine– provided a sense of relief.

Ryan’s results are both exceptional and the kind of outcome our team strives for with every client. And while we can’t promise any client’s outcome will be the same as another, we can say with utmost assurance that the team at Milikowsky Tax Law is your relentless advocate in the face of EDD, CSLB, and IRS audit.

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