So your CPA maybe the best CPA in the world and this conversation is not to suggest it anything negative about CPAs whom we work with all the time, who are a huge asset to our practice and I don’t think any of the CPAs that we work with would have any problem with me saying this. The CPAs generally are not good in audits and they’re not good because they don’t do a lot of audits. From a CPA perspective, a CPA is compliance based. CPAs are focused most of the time on preparing returns and preparing them accurately. They have a whole living based on being a CPA which is a certified public accountant. A certified public accountant is an individual who is certified to prepare financial statements so the reality of the situation is when a CPA is charged with compliance, and if there is any doubt as to that compliance meaning, there are errors on the tax return the CPA prepared, then there’s a natural conflict of interest because either
Key Takeaways
The CPAs generally are not good in audits and they’re not good because they don’t do a lot of audits.
From a CPA perspective, a CPA is compliance based.
CPAs are focused most of the time on preparing returns and preparing them accurately.
So a dual determination happens when you have a situation with a business that either accrues payroll tax liability or sales tax liability.
What happens in that case is when you have a payroll tax or sales tax liability with the business, the state or the IRS can hold the officers of the company responsible personally if they did not p…
So there’s certain taxes that we refer to as trust fund taxes and those are monies that are held in trust for the benefit of somebody else so a common example of this has to do with payroll taxes.
So a dual determination happens when you have a situation with a business that either accrues payroll tax liability or sales tax liability. What happens in that case is when you have a payroll tax or sales tax liability with the business, the state or the IRS can hold the officers of the company responsible personally if they did not pay those taxes. So there’s certain taxes that we refer to as trust fund taxes and those are monies that are held in trust for the benefit of somebody else so a common example of this has to do with payroll taxes. When you don’t pay payroll taxes there’s a portion of those payroll taxes that are the employer’s responsibility but there’s also a portion which are the employees responsibility. So for the employees portion of those taxes, the government can hold you responsible for that. What a dual determination really hinges on is who is responsible for the non-payment of taxes, whether they had knowledge or whether they were aware of the fact that taxes weren’t getting paid, and whether they could have done something to pay those taxes. So generally speaking if you are aware of a liability and you chose to pay other creditors that warrant, the government is going to hold you liable. So the dual determination process is a very strategic one because when you have a situation where you have multiple officers
They’re running a test on payroll that was paid, taxable wages tax that was paid, payroll tax expenses that are on the general ledger and then independent contractors that basically payroll tax in …
Because at the beginning of the payroll tax audit, you have the best opportunity to limit the scope of the documents requested.
So the best opportunity you have with respect to documents is really to limit the scope.
What usually happens is that the auditor will send you a laundry list of documents that they’re looking for and of the different types of audits, payroll tax audits are usually the ones that have the most flexibility because in a payroll tax audit they’re basically reading through tests. They’re running a test on payroll that was paid, taxable wages tax that was paid, payroll tax expenses that are on the general ledger and then independent contractors that basically payroll tax in a box. So if you’re running an audit, what they’re going to ask for is they’re going to ask for three years of records and they’ll ask for tax returns and they’re going to ask for payroll tax returns and they’re going to ask for internal accounting and this and that mail, so before you go and tackle that big laundry list of documents, the best thing to do is to talk to the auditor. Because at the beginning of the payroll tax audit, you have the best opportunity to limit the scope of the documents requested. For some people providing payroll records for three years isn’t that big a deal but for other companies, particularly companies that utilize a large workforce or large amount of independent contractors, it can be a huge deal to have to come up with all the 1099s and w-2s and everything that gets filed. So the best opportunity you have with respect to documents is really to limit the scope. Most EDD auditors will limit the scope of the records of their request, at least for the first audit meeting, to the last three years of tax returns. They may ask for three years’ bank statements but to limit the other documents to a year, which is the best thing to do because if you can go through a limited testing period, establish that there’s no error and the auditor has a chance to complete their process and check the box, problem solved. So when going through a payroll tax audit don’t just accept the initial document request. Work with the auditors – it’s actually needed so that you’re not having to produce records and digging yourself into a big challenge that is going to take you a lot of time to get out.
So if you can’t reach a resolution in a payroll tax audit you have essentially three options. The first option is to deal with the auditor and their manager. Oftentimes this can be problematic. Obviously this depends on the two people that are involved and people are people. Like any other organization, you get good people and you get bad people so depending on the relationship with the auditor that’s been developed during the course of the audit and depending on the relationship of the manager, it’s going to change the dynamic on how things are resolved at that level. Going to the manager is always an option. Generally speaking, the audit manager is going to back their auditor’s determination. It’s not like the manager is going to sit there and throw the auditor under the bus. The purpose of bringing in the manager is you get somebody more senior. You get somebody who usually is a former auditor but who has exposure to dealing with these issues and can often resolve tensions if they popped up in the audit process by being kind of a third party representative for the government to come in and resolve the situation. The managers don’t really like dealing with these issues. They would rather their auditor deal with these issues and not go to the manager but there is a possibility. Above the manager of the EDD level, you also have the head of the audit division.
Key Takeaways
So if you can’t reach a resolution in a payroll tax audit you have essentially three options. The first option is to deal with the auditor and their manager. Oftentimes this can be problematic.
So the way the EDD appeals process works is like this. Essentially what you’re doing is you’re going in for a mini trial.
So let’s say you have an audit and the audit doesn’t go well and you file an appeal.
Often the EDD settlement officer is allowed to consider the risk of litigation, so they’re trying to get cases out of the appeals process.
Usually if there’s a favorable resolution, they’re willing to settle.
So let’s say you have an audit and the audit doesn’t go well and you file an appeal. Before you get into the appeals process, you have the option of going to EDD settlement and so what that takes is your attorney is going to draft a written settlement request and they’re going to state their case and why they believe that the EDD should settle this issue. So you want to basically do the best job that you can and put together the biggest package you can to get to the EDD because the EDD settlement officer is going to take the audit report and they’re going to take your settlement offer and they’re going to look at it and they’re going to compare the two and then they’ll probably come back to you with questions. Often the EDD settlement officer is allowed to consider the risk of litigation, so they’re trying to get cases out of the appeals process. Usually if there’s a favorable resolution, they’re willing to settle. In most cases with the EDD on payroll tax liabilities, particularly with independent worker classification, there will be an omission and a requirement that any errors that were uncovered during the audit can be corrected for the future so just know in advance that might be a condition to the settlement. Settlement is not going to eliminate your liability entitlement entirely. Particularly in the context of illegal settlement, both sides don’t get exactly what they want so if you understand that and keep that framework in mind during the process, settlement can be a very good tool at the EDD level in order to dismiss cases.
So by segregating this into buckets, you’re going to look at what your exposure is in different categories.
But the long and the short of it is, that’s how you beat the EDD at their own game.
How do I beat the EDD at their own game? So, beating the EDD at their own game is very tough because California, with the passage of AB5, has essentially regulated independent contractors outside of California. In order to be in a true independent contractor relationships, you need to either fall under the definition of AB5 or be engaged in a true business-to-business relationship where the person isn’t involved in being integral to the generation of your revenue.
So for example, I’m a law firm in California and I contract with a bookkeeper or a video production company. That is a bona fide independent contractor relationship. But the reality of the situation is if you come under a payroll tax audit and you have independent contractors in California, which is the subject matter for most payroll tax audits, it’s going to be difficult to beat the EDD because the EDD is locked on this issue and they know exactly what they’re looking for.
With that said, there are some tactics that you can use during the course of the audit to help you out. The first thing that I would recommend is of your independent contractors, separating people out by job category and by what these people do. So this may be a situation where you just have one class of workers, and if so, the strategy will not work for you. But to the extent that you employ multiple independent contractors, and they do multiple things, you want to try and bifurcate them into different buckets. Then within each bucket, you want to relate your level of risk. Certain buckets, you know you’re probably not going to be able to get past the owner. These are people that look like employees. They maybe students. They may be lower skilled workers, whatever they are. But there’s certain buckets that are probably going to be on the fence. And then there may be other buckets that are completely and totally an independent contractor relationship.
So by segregating this into buckets, you’re going to look at what your exposure is in different categories. And the key with beating the EDD at their own game is not necessarily to get out of the audit unscathed, but to get out with as little liability as possible. So there’s no harm in conceding to the independent contractors you know are going to get reclassified ahead of time.
So if you offer that up to the auditor, it’ll make things a lot easier. Then when it comes to the independent contractors that are on the feds, anything that you can do to establish those people as true independent contractors, you want to do that. Do you look at their LinkedIn? Can you see their LinkedIn profiles? Do they have insurance? Do they have a business card? Do they maintain their own websites? Do they advertise themselves? What do these independent contractors do to maintain their own business? All of that is very, very important. So that’s really how you beat the EDD in these situations.
The other way you beat the EDD is through the application of penalties. So the EDD is very severe when it comes to the penalty structure for misclassifying workers or for not filing the appropriate payroll tax returns. Even informational returns. You know, we’ve seen situations in our firm where we’ll have an amount of taxes due and the penalties will be five times or more in excess of the amount of tax.
So it’s really important that when you go into these audits, that you focus on beating the penalties as much as you do, beating the tax. So by developing a narrative at the beginning of the law, by defeating willfulness, by removing yourself from some of these harsher penalties, you’ll do a lot better for yourself. The actual tax itself, when you look at it from a payroll tax perspective in California, isn’t that much. So even workers with a pretty high payroll aren’t paying that much in actual tax, particularly if you have workers that are filing their own returns and paying their personal income taxes, because then you can get a debate it.
But the long and the short of it is, that’s how you beat the EDD at their own game. You go on it to strategically, you go in trying to mitigate your risk, and you go in trying to mitigate any penalties that are associated with that. And that’s how you can be successful in an EDD audit.
So in January of 2020, California Legislature passed AB5 which governed the relationship between companies and their workers. Basically what AB5 states is that unless a hiring entity can prove that a worker is truly independent according to three specific factors, that worker will be deemed to be an employee of the company itself. The factors are number one, the company must not have in any condition of control over the work. Number two the worker services must be outside the core business or the hiring entity and number three the worker must maintain their own separate and independent business. So this was all raised with much fanfare and rightly so was called the death of independent contractors in California because unless you qualify for one of the exemptions that’s under the statute, pretty much all workers fall within an AB5 framework and they can be deemed employees. It’s only those that are providing true outside services like they have bookkeeper or CPA or law firm or videographer that really qualify outside the scope of AB5. The statute really is meant to pull as many people as possible into the employee relationship however from a tax perspective despite all the fanfare on the labor side, it doesn’t really have any impact. The reality of the situation is that the EDD has been using an AB5 framework for quite some time. So what I mean by that, well the reality is that when you go through an employment tax audit, EDD is already looking at control. Control was a previous factor under the old past and now really
Key Takeaways
So in January of 2020, California Legislature passed AB5 which governed the relationship between companies and their workers.
what the EDD is focused on is is the worker integral to the revenue generation function of the particular business.
So the EDD in California operates under a lead system and what I mean by that is the EDD has a computer system that generates leads for its district offices in order to follow up on from an audit p…
So there’s lots of things that can trigger a lead.
So the EDD system works a lot like that in that there’s lots of things that can trigger a leak.
So the EDD in California operates under a lead system and what I mean by that is the EDD has a computer system that generates leads for its district offices in order to follow up on from an audit perspective. So there’s lots of things that can trigger a lead. The way I equated is if you look at the movie Minority Report, you have these three Precog people that would basically be able to predict crime and so every time they predict a crime you’d have a little ball that would roll out of the machine with somebody’s name on it. So the EDD system works a lot like that in that there’s lots of things that can trigger a leak. For example unemployment claims trigger EDD leads all the time and subject the hiring entities to payroll tax consequences or at least payroll tax bonds. You can have a lead issue for issuing too many 1099s over W-2s and what is too many is anybody’s guess. You can have a lead issue for being in a certain type of industry. You can have a lead issue for somebody calling and saying that you’re employing employees as independent contractors. There’s a variety of things that make up the this lead system but here’s the issue from a statutory perspective. The EDD is required to follow up on any leads it gets so even if the lead is bogus they’ll follow up on somebody. Usually they follow up on these by sending a pre-audit questionnaire and making the decision whether or not to pause so you need to be very careful if you receive a pre-audit questionnaire because what it likely means is that a lead was generated in the EDD assistant and they’re following up for you in order to assess your viability for a payroll tax audit.
So the first steps usually taken on an EDD audit are understanding what your risk is.
In gathering documents, first gather your payroll records.
Is there anything about your payroll records that is out of the ordinary?
So the first steps usually taken on an EDD audit are understanding what your risk is. In gathering documents, first gather your payroll records. Is there anything about your payroll records that is out of the ordinary? For most people the actual filing and reporting of their payroll and paying out tax for w2 employees is not really a huge issue. It often relates to wage, hourly or overtime considerations or so on and so forth, but for most people, if you use a payroll company, it’s just pretty straightforward. So a lot of times with EDD audits, those first two tests get passed pretty easily. What most risk in an EDD audit is the second couple of tests. It is looking for taxable wages that weren’t reported but should have been reported. Payments that are on a general ledger that perhaps should have been picked up as wages, compensation of officers that should have been picked up as wages and wasn’t, and the most famous thing in payroll tax audits is the independent contractor and misclassifications issues that happen frequently. That by far is probably the most common red flag and an EDD audit is California going after misclassification issues. But the first thing that you need to do is gather all your documents, assess your risk and then speak with a professional to at least gauge what the reaction is. Whether your understanding of what the risk is matches that of a professional’s. Normally the problem that I encounter as a tax attorney is most businesses adamantly believe that their independent contractors are truly independent contractors and the problem is my understanding of what an independent contractor is based on the law in California and how the EDD looks at EDD independent contractors is different a lot of times from our client’s understanding of what constitutes an independent contractor. The same thing goes for payments towards officers, the same thing goes for other payments that perhaps should be reclassified as taxable wages. So it’s important, like going to a doctor or going to an auto mechanic, to get a second opinion on the risk that you are going to face. That’s not necessarily saying that you need to hire a tax attorney although in most situations it’s a good idea when there’s an element of risk but at least seek the advice of a professional so that you know what you’re walking into and do all this way before you contact the statement. The best thing to do is to get your facts in advance, put your strategy in place and then go forth and deal with the offer.
So the payroll tax audit process is pretty straightforward.
The first thing that happens is that you’re contacted and notified that you’ve been selected for audit and the EDD will ask you to fill out a questionnaire.
Once you fill out that questionnaire then you’re usually assigned to an auditor.
So the payroll tax audit process is pretty straightforward. The first thing that happens is that you’re contacted and notified that you’ve been selected for audit and the EDD will ask you to fill out a questionnaire. Once you fill out that questionnaire then you’re usually assigned to an auditor. After that questionnaire is filled out and upon the assignment to the auditor, the auditor will call you or call your representative and schedule a date for the audit meeting. At that point that’s also a very good time to go through the auditor’s document request, which is a pretty standard document request and see if you can limit the testing period to one year. That will reduce the amount of documents that you have to provide and it will also make the audit process go a lot smoother. At the first meeting with the auditor, what you’re going to be doing is you’re going to be doing four things. Number one you’re going to be reviewing the taxable wages that were paid. Number two you’re going to review the tax that was paid. Number three you’re going to be looking for payments on the general ledger or other payments that were made that potentially should have been subject to payroll tax and number four you’re going to be looking at the classification of any outside workers or any independent contractors. So that’s what you’re going to be running through. When we take on a client we always like to pre-audit them so that we know exactly or in a reasonable degree of certainty exactly how things are going to fall. Then we go into the audit and we’re very well prepared and we can walk through that sequence. Assuming the sequence goes correctly, the auditor will review the information, come to a determination usually within a few weeks or a couple months time and then send the results. If not, then the auditor will will issue a supplemental document request. They’ll ask for more information and they’ll continue to work the case file while the EDD is going through and formulating their results and they’re also reaching out to third parties. They’re reaching out to any independent contractors and they’re reaching out to any outside vendors and so this gets to the point where the auditor is issuing an audit report.
