An Introduction to Payroll Tax Fraud: EDD Investigations

Payroll tax fraud can occur either through deliberate criminal activity or simply because an employer or employee has provided inaccurate or incomplete information.  The Employment Development Department (EDD) takes payroll tax fraud extremely seriously, so it is imperative that you understand the ways in which fraud can occur and take the necessary steps to avoid committing fraud.

What is payroll tax fraud?

Although misreporting or failing to report the correct amount of wages is sometimes distinguished as tax evasion as opposed to tax fraud, there is really no distinction - tax evasion is tax fraud.   If you are found to have committed tax fraud, the agency will take into consideration whether the fraud was intentional or unintentional when recommending whether to prosecute or treat the case as a civil matter.

A common form of tax fraud, commonly referred to as the ‘underground economy’, occurs where employers hire workers ‘under the table’ or ‘off the books’, paying them in cash so as to avoid liability for payroll taxes.  The workers who are so employed may also fail to report their wages and therefore pay less income tax or continue to receive benefits that their income dis-entitles them to. Other instances of tax fraud occur where employers falsely classify workers as independent contractors rather than employees, under report wages or fail to file their payroll taxes in full or on time.

Who is the EDD, and how do they investigate payroll tax fraud?

The Employment Development Department (EDD) is the state’s largest tax collection agency.  Amongst its roles is the collection and administration of payroll-related taxes, including unemployment insurance, disability insurance and personal withholding tax.  In conjunction with several other agencies, the EDD makes up part of the Employment Enforcement Task Force which investigates employers suspected of violating payroll tax, labor and licensing laws.

The EDD cross-matches several sources of data, from official records to information received from former employers or whistleblowers, to identify instances of fraud.  This could include people claiming benefits to which they are not entitled, or employers who are paying workers ‘off the books’ in whole or in part.   Some investigations are triggered by innocent mistakes, such as a business which has fallen behind on its quarterly reporting or which has misreported its financial affairs due to inadequate quality controls or training.

Another area of interest for the EDD is the classification of workers.  If an employee is classified as an independent contractor but applies for unemployment insurance, it may trigger an investigation into whether that worker has been properly classified.  Commonly, the result of these investigations is that workers are reclassified as employees rather than independent contractors, which has follow-on implications for your liability as an employer.

The EDD also pays close attention to entities who have dissolved with outstanding payroll tax liability and then reestablished as a different entity with the same directors.  If these are held to be ‘substantially the same business’ the new entity can be held liable for the previous entity’s outstanding tax obligations.

What happens during an EDD investigation?

Investigations can be very lengthy and are cumbersome to businesses.  They require the business to produce comprehensive financial documents and in many cases, to make their premises available for inspection by EDD agents.  If the investigation is determined to be a criminal matter, agents may use surveillance, search warrants and seizure of evidence in the process.

At this point, you should seriously consider retaining the services of a qualified tax attorney.  Using specialized tax counsel may take some of the burden off you if you are the subject of an investigation, as your attorney will work to ensure that the scope of the investigation is not extended any further than is necessary.  Your lawyer is also a helpful buffer between you, your business, and the EDD, which is invaluable during such a stressful time. Instructing counsel also gives you an intermediary through which interviews can be conducted on neutral ground, to minimize the disruption to the business of having EDD agents come onto your premises during business hours.

What are the potential consequences of payroll tax fraud?

If you are found to have committed payroll tax fraud, there are a number of serious penalties that can be applied.  These will depend on whether the fraud was unintended or amounts to criminal behavior, and whether you are an employer or an employee.

Employees who commit fraud by not reporting their income in order to continue receiving unemployment or disability benefits may face a range of charges including but not limited to:

• 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 have unintentionally or negligently underreported their tax liability will 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 liability.  Nor does the limited liability structure of a company protect its directors if any of them are found to be responsible for the fraud.  Personal assets can be seized, including your house or other personal possessions, in repayment of the liability.  Tax counsel can advise you on how to present your case so as to mitigate any penalties and carry on business without interruption.

Penalties for payroll tax fraud can be severe, so employers and employees both are well advised to ensure that they meet their 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 that you can alter your practices before an audit.   With quality control procedures in place so that your financial reporting is accurate, you should be able to avoid unintentionally minimizing your tax liability.  The effort now will help you avoid costly penalties down the track.