California employers face aggressive scrutiny from the Employment Development Department (EDD) during payroll tax audits. A key component of these audits is the Payroll Tax Verification Test. In this systematic process, EDD auditors verify that businesses have accurately reported all wages and payroll taxes and properly classified their workers. In practice, this means the auditor will cross-check payroll records, tax returns, and forms (e.g., W-2s, DE-9/DE-9C wage reports) to ensure that gross wages and taxable wages were correctly reported and that the appropriate California personal income tax (PIT) was withheld and remitted for each employee. Any discrepancies uncovered can trigger deeper investigation, reclassification of workers, and hefty employment tax and federal withholding assessments.
What is the EDD Payroll Tax Verification Test?
During a California EDD employment tax audit, the Payroll Tax Verification Test is the auditor’s process of verifying that an employer’s payroll tax reporting is complete and accurate. In essence, the auditor will test the employer’s reported payroll figures against the underlying records to confirm several critical points:
All Wages Paid Were Reported
The auditor examines the employer’s books (payroll journals, general ledger, bank records, etc.) to identify the total compensation paid to workers. Those amounts are then matched to the wage totals the employer reported on payroll tax forms (such as the Quarterly Contribution Return and Report of Wages, DE-9/DE-9C). The EDD explicitly performs a “verification that your acknowledged gross wages and taxable wages have been properly reported” as part of a full California employment tax audit. Any unreported cash payments or “off-the-books” wages are likely to be discovered and counted as taxable payroll at best and referred for California criminal employment tax prosecution at worst.
Withholding and Taxes Were Paid Correctly
The auditor will also verify that the employer withheld the correct amount of California personal income tax (PIT) from employee wages and reported/remitted those withholdings to the EDD. This involves cross-checking payroll tax returns and employee W-2s to ensure, for example, that the total state income tax withheld on all W-2s matches the amounts the employer deposited with EDD. If the auditor finds, for instance, that an employer’s W-2 forms show more wages or withholding than was reported on the EDD returns (or vice versa), it will raise immediate civil and potential criminal employment tax red flags.
Worker Classifications Were Correct
As part of the verification process, the EDD auditor reviews all payments for services to determine if everyone who should be treated as an employee was properly classified and reported on payroll. The audit will “verify that all individuals paid for services have been properly classified as either employees or independent contractors” in accordance with California state law. Misclassified workers (treated as independent contractors when they should be employees) represent unreported wages and unpaid payroll taxes in the EDD’s eyes – a primary focus of the verification test.
The Payroll Tax Verification Test is typically applied first to a “test year” – usually the most recently completed calendar year – in a standard EDD audit. If that initial year checks out with no significant discrepancies, the audit may be limited to that year. However, if problems or discrepancies are detected in the test year, the EDD will expand the California employment tax audit to cover additional years (often a total of three years, and sometimes beyond if records are missing or issues appear pervasive).
In an entrance interview at the audit’s start, the EDD auditor will explain the process and gather information about the business’s operations and recordkeeping system. The auditor will then request a broad range of records to conduct the verification tests, including payroll registers, bank statements, check documents, general ledgers, financial statements, tax returns, and payroll tax filings (such as Forms DE-9/DE-9C, W-2s, and 1099s). California state law (Unemployment Insurance Code §§1085 and 1092) requires employers to maintain “true and accurate” payroll records and make them available to EDD auditors. If an employer’s records are inadequate or incomplete, the auditor may use other methods (like interviews or industry estimates) to reconstruct payroll, and the audit can take a broader civil and criminal employment tax scope.
Legal Authority and Mechanics of the EDD Payroll-Tax Verification Test
California’s Unemployment Insurance Code (CUIC) gives the EDD broad power to audit employers and verify that UI, SDI, ETT, and state income-tax withholding have been adequately reported and paid. A standard employment tax audit covers the most recent three years (12 quarters), beginning with a single test year; if that year shows errors—or if records are missing—the examiner can expand the review and even reach back further.
The process starts with an entrance interview and a detailed Information Document Request (IDR). By law (CUIC §§ 1085, 1092), employers must produce payroll registers, earnings records, bank statements, ledgers, tax returns, DE-9/DE-9C wage reports, W-2s, 1099s, and any independent contractor agreements. The auditor then applies the Payroll Tax Verification Test, matching books to filed returns. Discrepancies—unreported wages, under-withheld PIT, or misclassified contractors—trigger assessments under CUIC § 1127 plus interest and penalties (e.g., late-filing penalties, a $1,000 DE-7 late-recon penalty, and up to 50 % fraud penalties or criminal tax charges under § 2117.5 for willful tax evasion).
EDD findings rarely stay in-house: by agreement, the Department shares audit results with the IRS, exposing employers to parallel federal employment-tax assessments and potential Trust Fund Recovery Penalties. In short, California’s statutory framework empowers EDD auditors to demand comprehensive records, reconstruct payroll when data are thin, levy severe civil (and criminal) sanctions, and pass their conclusions to federal counterparts—making early, strategic defense vital.
Common Triggers and Red Flags for EDD Payroll Tax Audits
Misclassified Workers
Treating core personnel as independent contractors is the No. 1 trigger. A single 1099 worker who files for California unemployment compensation and shows no wage record will most often spark a full worker classification audit. Anonymous tips via the EDD “Help Us Fight Fraud” portal have the same effect.
Heavy Cash or Off-Book Pay
Industries that run large cash payrolls—restaurants, bars, construction, home services—invite scrutiny. Low or zero PIT withholding on quarterly DE-9/DE-9C returns while revenue stays strong signals possible under-the-table wages.
Return Mismatches
Big gaps between federal filings (income-tax returns, 1099-NECs) and California payroll reports, or oversized “consulting” or “labor subcontractor” expenses, suggest disguised wages and draw EDD data-match inquiries.
Non-Filer or Chronic Late Filer
Missing or habitually late DE-9/DE-9Cs generate automatic delinquency notices and estimated assessments. Repeated pyramiding of payroll taxes—withholding but never remitting, then shifting to a new entity—is a prime enforcement target.
Abrupt Payroll Changes
A company that suddenly reports zero payroll while operations continue, or profitable corporations whose officers draw no wages, prompts the EDD to ask why. Large downward amendments paired with 1099 filings raise the same question.
Business Funds for Personal Use
Extensive personal expenditures booked through the company look like unreported compensation and scream poor record-keeping—both audit magnets.
High-Risk Sectors
Construction, hospitality, trucking, healthcare, and many gig-economy or professional-services shops rely heavily on contractors and transient labor. Following the passage of AB 5, the EDD has aggressively audited these industries for ABC-test compliance.
Special Issues for High-Risk Industries
Construction & Contracting
- Heavy use of day labor and “1099 subs” puts every worker under the ABC microscope; entire crews are often reclassified, resulting in six-figure liabilities. Under California labor law, day laborers are classified as employees especially where they have no legal right to work in this country.
- Cash day-pay and job-cost ledgers give auditors the paper trail they need; licensed contractors also risk license suspension for willful tax evasion.
- Federal contract holders risk loss of the entire federal contract if found to have committed payroll tax infractions.
Defense Focus: show subs hold valid CSLB licenses, insurance, multiple clients, and meet ABC carve-outs; keep iron-clad 1099s and payment logs.
Hospitality (Restaurants, Bars, Hotels)
- High turnover, tip income, and dual-wage schemes (minimum wage on payroll, cash “top-ups” off the books) draw tip verification and misclassification exams.
- Missing DE 34 new-hire reports, inaccurate tip pooling, or time-card gaps trigger penalties.
Employment Tax Audit Defense Focus: meticulous tip logs, daily sales/tip-share reconciliation, every worker—even one-day temps—on the payroll.
Medical & Dental Practices
- Doctors, hygienists, or therapists mislabeled as contractors fail the Borello and ABC tests unless they truly operate as independent professional corporations.
- EDD probes management-service arrangements and staffing-agency claims; the inclusion of “contractors” (such as health insurance and set schedules) is a red flag.
Employment Tax Audit Defense Focus: separate professional entities, written service agreements, proof of outside clientele, and clear division of control.
Transportation & Trucking
- The owner-operator driver model conflicts with AB 5’s “B prong”; unless the driver hauls for multiple brokers under a bona fide business, the EDD treats them as employees.
- Interstate operations don’t shield California work; fuel-tax or income-tax exams often hand off leads to EDD.
Employment Tax Audit Defense Focus: incorporated driver entities, trip logs showing multi-client hauls, written leases, permits, and robust business-to-business contracts.
Professional Services & Tech Firms
- Freelance writers, coders, and designers who work mainly for one firm flunk ABC; S-corp owners drawing tiny salaries face “reasonable-compensation” adjustments.
- Startups paying equity or 1099s in lieu of wages invite reclassification and payroll-tax assessments.
Employment Tax Audit Defense Focus: document multiple clients for freelancers, execute referral-agency or professional-services exemptions where viable, and pay owners market-rate W-2 wages.
Across these sectors, the EDD hones in on worker classification and unreported wages. Cash pay, tip shortfalls, per-diem abuses, and inadequate documentation are all factors that fuel assessments. Proactive reviews with an Attorney-CPA—contracts, licenses, timesheets, and payroll reconciliations—are vastly cheaper than fighting reclassifications after the audit clock starts ticking.
How The Tax Law Offices of David W. Klasing Navigates EDD Audit Disputes, Appeals, and Tax Court
Note: 95% of the time, what a California Employment Tax auditor ultimately assesses gets rubber-stamped all the way up the appeals ladder and into California Tax Court. For the best results, by all means, hire us for the California Employment Tax Audit!!!!
Immediate Post-Audit Action
When the EDD issues a Notice of Assessment or Withholdings Due, we request a supervisor conference before the assessment becomes final, armed with fresh evidence and legal authority. Many assessments die here: our tax attorneys have persuaded EDD supervisors to drop misclassification findings or recalculate alleged wage gaps before a formal appeal is even necessary.
Filing the Petition for Reassessment
If the EDD doesn’t budge, we draft and file the DE 1000M appeal—on time, with every contested dollar and legal ground spelled out. That single filing transfers the case to the independent CUIAB and automatically freezes collection while interest accrues. We monitor the 30-day clock so you never lose appeal rights or face premature liens.
Winning at the ALJ Level
- In the de novo hearing, we act as lead trial counsel:
- Prepare witnesses (or rebut EDD’s),
- Cross-examine the auditor,
- Lodge evidentiary objections, and
- Present dual-track arguments—tax law and forensic accounting—to show why the audit computations or ABC/Borello determinations fail.
Our litigation experience often exposes the auditor’s unfamiliarity with courtroom rules; we have overturned six-figure assessments by demonstrating the misapplication of AB 5 standards or mathematical errors in the Payroll Verification Test.
CUIAB Board & Settlement Leverage
If the ALJ’s ruling is unsatisfactory, we escalate with appellate briefs to the five-member Board—frequently prompting EDD counsel to settle on favorable terms rather than risk an adverse published decision. Where broader legal precedent is at stake, we press for reversal; otherwise, we negotiate reduced liability, penalty abatement, or extended payment terms.
Judicial Options and Cost-Benefit Analysis
Should administrative remedies fail, we evaluate Superior Court strategies—mandamus, refund suits, or coordinated settlements with EDD counsel. Because litigation is costly, we present a line-item cost-benefit memo, so you decide whether to fight on or close the matter. Our courtroom pedigree means the EDD knows we will litigate if necessary.
Collections Defense Throughout
From the moment an appeal is filed, we handle every call from EDD collectors, file stay notices, and ensure no levy slips through. We also negotiate installment agreements or Offers-in-Compromise if cash flow demands a parallel payment solution.
Bottom line: you are never at the EDD’s mercy. The Tax Law Offices of David W. Klasing combines deep employment tax-law expertise with courtroom-ready advocacy and CPA-level number-crunching to eliminate or slash payroll-tax assessments—or, at minimum, buy the leverage and time needed to settle on terms your business can live with.
An EDD payroll-tax audit—and the unforgiving Payroll Tax Verification Test at its center—can expose any California business to crushing federal and state employment tax assessments, ABC-test reclassifications, and penalties steep enough to threaten your business’s very survival. The EDD currently presumes most workers are employees, cross-shares its findings with the IRS, and wields CUIC penalty and fraud statutes that multiply the cost of every reporting misstep.
Our dual-licensed Attorney-CPA team at the Tax Law Offices of David W. Klasing meets that firepower with equal parts legal strategy and forensic accounting: we brief you on the rules before the first document request, contain the audit’s scope, rebut wage and withholding discrepancies line-by-line, and—when necessary—drive the fight through CUIAB appeals or Superior Court to secure a just result. If an EDD examiner is knocking, do not go it alone. Call (800) 681-1295 or schedule a reduced-rate, attorney-client-privileged initial consultation today. We will analyze your exposure, explain your rights in plain terms, and craft a defense that protects both your company and everything you have built.
