Payroll tax fraud can happen through deliberate criminal activity, or simply because an employer or employee provided inaccurate or incomplete information to the state. The Employment Development Department (EDD) takes payroll tax fraud extremely seriously, so it’s important to understand how fraud occurs, how EDD investigations work, and the steps you can take to protect your business. For a closer look at how EDD criminal cases are investigated and prosecuted, see our guide to EDD criminal investigations.
Key Takeaways
- What is payroll tax fraud?
- Who is the EDD, and how do they investigate payroll tax fraud?
- What happens during an EDD investigation?
- What are the potential consequences of payroll tax fraud?
What Is Payroll Tax Fraud?
Although failing to report the correct amount of wages is sometimes called tax evasion rather than tax fraud, there is really no legal distinction — tax evasion is tax fraud. When the EDD identifies underreporting, it considers whether the conduct was intentional or unintentional in deciding whether to treat it as a civil matter or refer it for criminal prosecution.
Common examples of payroll tax fraud include: failing to register as an employer with the state; paying workers exclusively in cash to avoid payroll tax liability (the so-called ‘underground economy’); intentionally misclassifying employees as independent contractors; failing to report wages paid or pay payroll taxes in full or on time; and using rate manipulation or other schemes to reduce payroll tax obligations.
Workers involved in unreported or under-the-table pay arrangements can also face consequences — they may underpay their own income tax or keep collecting unemployment or disability benefits they are no longer entitled to.
Who Is the EDD, and How Do They Investigate Payroll Tax Fraud?
The EDD is California’s largest tax collection agency, responsible for administering payroll-related taxes including unemployment insurance, disability insurance, and personal income tax withholding. Along with other state agencies, the EDD participates in California’s Employment Enforcement Task Force, which targets employers suspected of violating payroll tax, labor and licensing laws.
To identify potential fraud, the EDD cross-matches data from multiple sources — its own official records, information from former employees, and whistleblower tips. This can uncover people claiming benefits they are not entitled to, or employers paying workers off the books in whole or in part. Not every investigation points to intentional wrongdoing; some start because a business fell behind on quarterly filings or made errors due to weak internal record keeping.
Worker classification is another common trigger: if someone classified as an independent contractor applies for unemployment benefits, it can prompt the EDD to review whether they were properly classified. These reviews often end with workers being reclassified as employees, creating retroactive tax liability for the business.
The EDD also watches for businesses that dissolve while owing payroll taxes and then re-emerge under a new name with the same ownership. If the new entity is found to be substantially the same business, it can be held responsible for the old entity’s unpaid tax debt.
What Happens During an EDD Investigation?
EDD investigations can be lengthy and disruptive to a business. They typically require employers to produce detailed financial records and, in some cases, allow agents onto the premises for inspection. If the case is treated as a criminal matter, investigators may use surveillance, search warrants and seizure of evidence.
If you’re notified of an investigation, it’s worth speaking with a qualified tax attorney early in the process. Experienced counsel can help keep the investigation’s scope from expanding further than necessary, act as a buffer between you and the EDD during a stressful process, and arrange for interviews on neutral ground rather than having agents come to your workplace during business hours.
An EDD audit of an operating business runs as a monthly flat-fee engagement here: one number, agreed up front, that covers the auditor contact, the records responses, the worker classification argument and the petition if the assessment is wrong. Our EDD audit attorney page explains how the engagement works.
What Are the Potential Consequences of Payroll Tax Fraud?
Penalties vary depending on whether the conduct was intentional, and whether the person involved is an employer or an employee.
Employees who commit fraud – for example, by failing to report income while continuing to collect unemployment or disability benefits – can face:
- Repayment of the benefits
- Foregoing of any future income tax refund
- Losing the eligibility to collect benefits in the future
- A possible jail term if the fraud was found to be criminal
Employers who unintentionally or negligently underreport their tax liability will generally be required to repay the outstanding amount with interest and penalties. Employers who are found to have acted criminally in evading payroll taxes may be convicted and given a jail term as well as being required to pay restitution to the state.
Filing for bankruptcy does not protect you from this liability. Nor does the limited liability structure of a company protect its directors if any of them are found to be personally responsible for the fraud – personal assets, including a home or other property, can be seized in repayment of the liability.
Because penalties for payroll tax fraud can be severe, employers and employees alike are well advised to make sure they meet their reporting obligations. If you are worried that you might have committed, or be committing, tax fraud, it is worth talking to an experienced tax attorney now so you can correct your practices before an audit begins. With quality control procedures in place so your financial reporting is accurate, you can avoid unintentionally underreporting your tax liability – the effort now will help you avoid costly penalties later.
Frequently Asked Questions
Is tax evasion the same as tax fraud in California?
Yes — the EDD treats unintentional underreporting the same as intentional fraud when deciding how to proceed, though intent affects whether the case is handled civilly or criminally.
Can I go to jail for payroll tax fraud?
Yes. If the conduct is found to be criminal rather than the result of negligence or error, jail time is possible in addition to repayment and penalties.
What triggers an EDD payroll tax investigation?
Common triggers include worker misclassification, tips from former employees or whistleblowers, cross-matched government data, and businesses that dissolve and re-form while owing back taxes.
Should I hire an attorney if the EDD contacts me about an investigation?
Yes — an experienced tax attorney can help manage the scope of the investigation, communicate with the EDD on your behalf, and reduce your exposure.
Payroll Tax Problem?
Whether you’re dealing with an EDD audit, trust fund recovery penalties, or unfiled 941s, payroll tax issues compound quickly. A brief review can clarify what you’re facing and what resolution options apply.
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