If you’re a business owner in California, you are required to file and submit payroll taxes. This implies an encounter with the California Employment Development Department (EDD) and the IRS —which leaves you and your business up to scrutiny.

The EDD relishes enforcing penalties against employers who fail to pay the appropriate sum of payroll tax, particularly for 1099 employees or independent contractors. It has the authority to audit your business if it suspects misclassified employees to avoid submitting payroll taxes.

Nevertheless, an audit does not have to be a grueling experience. You can take several steps to prepare. Also, it’s best if you consult with a tax preparer in Carmel, California, about your specific circumstances for more peace of mind.

Read below to learn about payroll tax audits for your business.

What Initiates Payroll Tax Audits in California?

Payroll tax audits are frequently prompted by former employees asking for unemployment insurance, which is interpreted as claims that the individuals were employees of your organization and so they’re entitled to unemployment benefits.

Instead of thoroughly investigating each claim, the EDD will investigate the status of all independent contractors employed by your organization.

The key to passing an EDD audit is to provide relevant documentation, only records about employment-related issues.

Furthermore, do not disclose any information other than what the auditor requests. Any admission you make could be used against you. A tax accountant in Carmel, California, can help you organize the appropriate documents for auditing.

The Different Types of Payroll Tax Audits Tests in California

The Payroll Verification Test

A payroll test verifies companies’ paycheck posting systems. On the other hand, the EDD auditor verifies the business’s payroll reporting accuracy. That implies the EDD will compare their records to your company’s records to ensure the payroll log matches the EDD’s records.

A California EDD auditor will ask for payroll data as part of an independent contractor audit. A random employee will be chosen for the audit, and the EDD auditor will compare that employee’s W2 for the tax year to what the State has on file.

The EDD auditor will verify the payroll tax returns. They will check the payroll tax returns (DE 9s and DE 9Cs in California) against the W2 information supplied to the IRS. The auditor will then compare that to the payroll log.

When the EDD examines the employee’s taxable pay, a modest discrepancy usually due to an accounting error is acceptable.

In an EDD audit, we at Savage Accountancy, APC cross-reference the payroll journal with the W2s and the payroll tax forms filed with the IRS and the Employment Development Department. As trusted business appraisers and tax accountants in Carmel, we advise doing this before the EDD audit to be confident in the facts you are about to give, and identify any concerns.

If you finish this and pass your internal payroll test, you’ll definitely pass your EDD audit payroll test.

Apart from this test, the EDD may also look at your business’ personal income tax withholding to ensure that the amounts listed correspond to what the State of California has on file.

California’s Independent Contractor Test

Payroll tax audits are the most troublesome area for many firms, which underscores why you should outsource accounting and tax services. To clarify, workers are classified as either employees or independent contractors.

An employee receives regular pay and has several state and federal employment protections. Employers are responsible for paying half of the FICA taxes and the Medicare levy on behalf of employees. Moreover, they must pay federal and unemployment taxes.

On the other hand, an independent contractor is an independent person hired by a corporation. These individuals are responsible for their taxes, including Medicare and social security. Independent contractors are not eligible for unemployment benefits; hence no unemployment tax is due.

When determining proper classification, a formal contract declaring that an individual is an employee is an independent contractor is not enough to prove that status. Whether a worker is legitimately an employee or a contractor requires a factual determination based on the facts of the case at hand.

The California legislature approved AB5, which governed the interaction between businesses and their employees, in January of 2020. AB5 provides that unless an employing organization can demonstrate that a person is truly autonomous based on three particular conditions, that worker will be considered the company’s employee.

The factors are as follows:

  1. The firm must not have comparable influence over the worker.
  2. The worker’s services must be unrelated to the hiring entity’s principal business, and 3) the worker must be self-employed.

Payroll Tax Penalties

If a violation is discovered following the payroll tax audits, the IRS can impose hefty penalties based on the following codes:

  • 26 U.S. Code § 6651 (failure to pay tax or file tax returns – Penalties range from 5% to 25% depending on the length of the failure and whether the taxpayer can demonstrate “reasonable cause” (rather than “willful neglect”).
  • 26 U.S Code § 6656 (failure to deposit taxes) – Penalties range from 2% to 15% based on the period of failure and the dates the organization got several IRS letters.
  • 26 USC 6662 (imposition of accuracy-related penalty on underpayments)

Hire Accounting and Tax Services Carmel CA

Indeed, your failure to deposit, withhold or match your employment taxes can cost your business a great fortune. Although the issue may seem trivial, it can bankrupt your business—especially if you’re a small business owner and starting. So, be sure to seek professional services.

Our business tax accountant and personal tax preparer company in Carmel, CA, will assist you with bookkeeping, payroll, and payroll tax services, ensuring that you’re on the right side of the Californian employment tax law.

Ready to start? Call us today at 831-298-5175 to get started.