rs-california-payroll-tax

What Do EDD Auditors Look for in a Payroll Tax audit? So 88 auditors are looking for for things in the context of a payroll tax audit and there they seem simple but there’s a lot of nuances to them number one they’re looking for taxable wages that were reported so they’re verifying that the information that was given to the EDD was in fact the amount of taxable wages that were paid and it’s consistent with reporting to the IRS number two they’re looking for the amount of tax paid so same thing they’re looking for consistency and the tax that was paid and the text that was reported to EDD number three they’re looking for payments that could be potentially reclassified as taxable wages so this is the point where they look at officer compensation they look at any payments that are on your general ledger that were issued to workers that may be considered taxable wages they look for personal payments that should be reclassified as taxable wages that’s what the EDD is doing when they’re going through the general ledger analysis the last thing that they’re looking for is they’re looking for any Mis classification issues through reviewing all the outside workers that the company has any vendors and they’re making sure that there are not taxable employees so there’s a fairly thick analysis that goes through that process there’s a lot of digging particularly on the last three items with a general ledger and the misc classification issues of the EDD ghoster but that’s what the auditor looks for as they go through the payroll tax audit process.

So the biggest risk by far in a payroll tax audit is the penalties. The EDD has some really nasty penalties. We’ve had situations in the firm sometimes where the amount of tax would be one number and the penalties would be four or five times what the amount of taxes actually is. That’s insane but the biggest risk that we see is that the penalties really amplify the amount of the liability. So when we’re looking at a payroll tax audit our focus is really on penalties and what we can do to eliminate them or at the very least mitigate them. Number two, the risk in an EDD audit is it turns into a fishing expedition audit if left unchecked. We’ll ask for all sorts of things and we’ll go through them with a fine-tooth comb and this creates a lot of back and forth. All of this can be really mitigated if you pre-audit the situation and if you come into the audit with a very well-defined plan and a very well-defined presentation and you’re leading the auditor through the audit kind of with breadcrumbs to make sure that we’re checking the boxes on the avenues that need to be checked and you’re controlling the flow of information. Controlling the flow of information in a payroll tax audit is the best thing that you can do. It’s difficult once you get into the independent contractor part of this and the reason for that is when you’re dealing with situations with independent contractors, the auditor is going to go out and try and interview those people. The problem and the risk to the client is you don’t know exactly what those people are going to say a lot of times. What will be found is that the auditors will lead them through some of the factors that will make them employees. They shouldn’t be doing that but it is a practical purpose that’s sometimes what happens and in other cases they’re disregarding the information in order to help them build their case. Ultimately the auditor is writing a report so the content of that report

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The first and biggest problem is the misunderstanding that the taxpayer has thinking that just because they didn’t do anything wrong, there’s no risk associated with the audit. A lot of taxpayers hang their hat on the fact that “well this is the way that I’ve done things, this is the way I’ve always done things and I’ve been doing everything a hundred percent correct” and that’s a fallacy because a lot of times the EDD is auditing somebody because they have a reasonable suspicion that’s something they’re doing is not correct. So it’s very important for the taxpayer to understand what their risk is in the beginning of the audit and then do things to mitigate that risk during the audit process. The second common problem that we have in audits is with independent contractors. A lot of times the clients will insist that their independent contractors are really independent contractors but the problem is that because of what the independent contractor says or does, or because of the circumstances of the situation, it actually convoluted the analysis and the EDD is very aggressive towards the classification of workers. Whenever possible, it tries to classify workers as employees and the presumption is that they are employees unless the taxpayer can demonstrate evidence to show that they’re not. So those are by far the most common problems with EDD audits and those are the things that you should work to mitigate. That list is not exhaustive. There’s lots of other things that go into the payroll tax audit analysis and things that tend to be problems for taxpayers as they go through it but most importantly if you go in there, if you pre-audit yourself and if you have a good presentation, you can usually screen out most of the issues before they pop up and before they create financial liability to your company or yourself.

So the first thing you need to do is you need to understand your risk. How big is the error? How bad is the error? Was the error willful or was it not willful and how much damage is it going to be caused? By understanding that you’ll know what the best case scenario and the worst case scenario is. The next thing you have to determine is whether or not the auditor’s going to catch it. A lot of things with payroll taxes are black and white so if the auditor is going through their testing, chances are they’re going to catch something but if you can somehow limit the auditor’s focus into a test year or you can steer them away from the issue, then you may be able to avoid liability and you may not have to disclose the issue. If you are forced to disclose the issue, you need to decide whether you’re going to come out of the gate and disclose it or whether you’re going to make the auditor catch you. In our experience it’s far better to get in front of issues that you know are going to be a problem. If you do that the biggest focus that we have is on penalties and by getting out in front of the issues, that’s the best chance that you have to really mitigate the penalties. The penalties oftentimes can be well in excess of the tax – like four or five times the amount of the tax, so mitigating those penalties in the context of the audit is really critically important. I mean I’ve seen clients’ liability be cut in half or more by just mitigating the penalties, so it’s important to go into the audit when you have an error with a strategy for handling that error and then present it to the auditor in the way that’s going to minimize the damage as the result of that error.

Absolutely. So the EDD is like any other tax organization in California. If they want you for payroll taxes and they see evidence of criminal activity, they can refer you to the EDD Criminal Investigative unit and that unit can make a recommendation to the district attorney. We see this all the time in cases where there was a failure to report payroll or where there’s very serious fudging of the numbers with payroll tax returns. So if you think that there’s any criminal liability at the start of the case you want to work to mitigate that issue as quickly as possible and the way that you do that is to throw as much cold water on the idea that your errors were willful as possible. If you can dampen down the willfulness, there’s a good chance that you can avoid criminal liability on the payroll tax side of things because the EDD only has limited resources to send cases criminally. So if you’re open about what the errors are, if you can explain your way out of them, if you can reduce the seriousness of them or at the very least mitigate any sort of willfulness, that’s your best way to avoid criminal liability. Again I think it’s a good idea in general to have a tax attorney retained in an EDD audit, but especially if you’re facing criminal liability. Get somebody on the team, get a criminal tax attorney involved and get somebody who’s going to be able to know what they’re doing and guide you through that process.

Well it depends, so let me give you some of the factors that drive cost. In a payroll tax audit, the actual preparation process isn’t usually that intensive because a lot of the documents are kind of run-of-the-mill and most companies are not usually having problems with either the payroll test or the payroll tax tests that come in an audit. The biggest driver of cost is if you have problems with the other two tests. So it’s either the independent contractor misclassification issue or is the payments that should have been reclassified as taxable wages. If you’re having an issue with those two categories, then a lot of the work that we’re doing on our end as tax attorneys is mitigating that problem and the size of the hole that’s been dug impacts how much digging we’re going to have to do to fill it. So from a cost perspective, it varies based on the size of the problem that we’re crossing and it also varies based on the size of the fight that we’re dealing with the auditor. As you can imagine, like most organizations, some people in the EDD are nice, some people are friendly, some are helpful, others are not. So we don’t really have any control over the auditor and if the auditor turns out to be a not very nice person, that’s obviously going to factor in the cost because there’s a lot of time we’ve just been fighting it. With that said most EDD audits at our firm are anywhere from about $5,000 to $7,500 in cost and keep in mind a lot of that cost is determined by who’s working on the matter. So a lot of times, we have a very good senior paralegal who is able to work with clients and do a lot of the initial prep work and then we have one of the attorneys come in and just knock the thing out of the park. Those are great because we’re able to really mitigate cost. For more serious issues we involve the senior attorneys at the beginning. There’s a much more strategic approach to dealing with it and obviously when you get somebody with a higher level of experience, it just tends to drive cost. So we take the philosophy in our firm to try and be as efficient as possible and the nice thing about us is we do so many EDD audits that our whole team is kind of on board for what we’re going to do but you know we’re not going to send a paralegal to go represent you in an EDD audit. So we’re going to send an attorney but there’s a lot of things that we can kind of do so that gives you a good range for what’s involved. It’s generally 1015 hours of time in the course the audit. Obviously if things go south that’s going to drive cost. Obviously if we have problems with documents that’s going to drive cost but that’ll give you a general sense for what you’re looking at to have a representative retained in a matter.

Is it Possible to Settle with the EDD Auditor? So when we have a lot of clients who ask us is it possible to settle and what they mean is “Can I Just throw a number at them and make this go away? The answer is NO you can’t throw a number out at the EDD auditor and say” Hey i’m going to give you 20 grand will you go Fly a Kite? It just doesn’t work like that but where you can negotiate with the auditor is the auditor is motivated to try and close the case agreed they want you to agree to the results the audit, because the audit goes into appeals they got to do more work so the auditor is writing a report it doesn’t need to get approved by their manager it does need to get approved by sacramento so they’re not going to lie down for you but they will negotiate and give and take particularly on the penalty portions of the liability which as i’ve explained in earlier videos can get really really high so a lot of the back and forth a lot of the negotiation that happens is on the penalty portion of the liabilities or at least from an independent contractor perspective putting people into buckets for classification these people are clearly independent contractors these people are clearly employees and these people are kind of in the middle so with the people that are in the middle you can negotiate with the auditor back and forth particularly if you think you’re going to have an agreed audit. The trick is is you want to be very active in the negotiations with the edd you don’t want to just hand everything over to the auditor and have them write a report you want to go through you want to do their work for them essentially want to turn the audit in and then have them come back to you and say well we don’t agree with this at least it gives you an avenue for presenting information with some level of superiority, so that’s the best way to negotiate or to settle with the edd auditor in that context and that’s where you’re really going to have the most results in getting your liability down and then minimizing your risk.

What types of penalties can I face in an EDD audit? So I won’t get too far down this rabbit hole because the EDD has a lot of penalties that they can assess against taxpayers. Anything ranging from something that’s relatively minor, up to your more severe civil fraud penalties and failure to file proper returns and or any sort of evasion penalty. But the biggest problem with the EDD is that the penalties tend to stack on top of each other.

So you can have an audit, and by the time you get done adding three or four penalties, it really, really adds up. And in a lot of cases, we see penalties that are four and five times the amount of tax, which is just insane. You know, if you owe this much in tax and you owe this much in penalties, that’s not really a fair result. So a lot of our focus on a lot of our care during the course of the audit goes in mitigating those penalties.

Obviously, we want to get the most severe ones off the table first. You get all the willfulness ones, get all the fraud, get all the evasion ones, get them to go away. But then it’s about working down the definition of what’s negligence in the audit, whether proper documentation was filed, whether the taxpayer has reasonable cause.

So those are the things that we really work and finesse on with the auditor try and get stuff down and to limit the liability for our clients.

So the appeals process with EDD operates as kind of a little mini trial. The best way to think about it is if I’m sitting at a conference table, it would be me sitting at the conference table, be you (the client) next to me, you’d have the EDD auditor sitting at the conference table, you’d have the EDD hearing representative (usually an attorney, not always but sometimes) and then you’ll have an administrative law judge sitting at the other end of the table. And what happens is kind of a formal mediation process. The EDD will go first. They’ll present their case, you get to ask questions, you get to cross-examine, you get to go back and forth on this and then you present your case and they will ask you questions. They’ll flesh out your case and then ultimately the judge in the case will make a decision.

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Payroll tax audits are best handled from a measure twice, cut once approach. So the important thing at the beginning of the audit is to have a plan even before diving in with the auditor. You want to have a clear plan for how the audit is going to go and the second thing that you want to do is pre-audit. So basically the goal should be I want to walk into the audit meeting and have the audit done so that you’re handing over a binder, walking the auditor through the audit as if you’ve already done it, like I’m the auditor and I’m presenting the case to their supervisor, you want to have that level of efficiency and organization because what happens is you go to these audit meetings and then you leave these audit meetings and the auditor sits there and spends like three or four months digging up other information on their case and dealing with all their other cases and calling independent contractors. So a lot of times what will happen is there’s a familiarity with the materials that you’re presenting but they’re not going to remember it word-for-word. The auditor is not going to make a decision on the spot and let you walk away so if you have a very good organized presentation then it will greatly assist when the auditor writes their report. Sometimes you’ll get lucky and you’ll see when you go to EDD audit meetings that the auditor will be typing things in and writing their reporters. They do so that they have less work to do later. This is great, because it allows you to speak and feed words into the auditor’s head which then naturally go into their audit report. That’s great but if you do the art for them and you present them with it, then you’ve basically given them a big carrot saying “hey here’s your audit, you don’t have to do any work just agree with our result and we’re done” and that’s the best way to handle it because number one, you get all the issues out in front. You present them in the best light possible and then you work to really mitigate penalties which is the real killer in EDD audits. I’ve mentioned before the penalties in the audits are sometimes four or five times the amount of the tax so you really want to slim those down and if you can control the scope of the audit, you can control the focus and drop breadcrumbs, so you’re generally going to have the most success possible and you’re going to ace your payroll tax audit.