Sam Brotman, JD, LLM, MBA January 4, 2018 4 min read

California Payroll Tax Audits and Payments to Officers

In addition to payments to employees either as casual labor or as reimbursements, the auditor is also going to look at any payments to officers or any personal expenses that are being written out of the business, and in an effort to classify personal expenses as taxable wages. Let's talk about that in a little bit of detail.

Usually with respect to payments to officers, we are usually talking about situations where you have a closely held business with a single owner, or a married couple as an owner, or perhaps two partners that either have a close friendship or have a familial relationship. In going through the business's records, the auditor is going to look for things that are openly flagrant. This is not exactly an income tax audit where the auditor is going to though and verify the ordinary and necessary purpose of every item.

However, the auditor is going to look at things that are flagrant like I said and they're going to go through and try and classify those things as taxable wages. What are things that are flagrant? Meals and entertainment that are considered excessive and or have very low dollar amounts. If your corporate officer has a habit of going to McDonald's or Wendy's, and continually charges single order meals through the business, unless you can characterize that as a travel meal, then you're going to run into some problems.

Entertainment is a big category where we see reclassifications to taxable wages. Any concert tickets, any bars and restaurants, any nightclubs, those types of expenses are all potential red flags. Basically, anything that looks like fun, any RV rentals, things like that. That is what they are going to look at and the auditor is really going to scrutinize these from a business standpoint. Any food expenses or personal expenses that appear on the GL and obviously the more personal these expenses are in nature, the more likely that a reclassification will occur.

A few isolated personal expenses are ok. The auditor will generally ignore isolated instances of smaller categories, but they are going to look for large-scale evidence that there is commingling involved. Travel is also another big expense that they're going to look at. If you have a corporate officer who is doing lots of travel to particularly to places that sound like fun, like Las Vegas, Hawaii, places like that, they're going to look at that. International travel is obviously also very closely scrutinized.

How do you deal with these issues? Well, you cannot really change things that occur on the general ledger, neither can you leave out expenses that occur during the course of the business. What you do have control over though is the document that is ultimately being produced to the auditor. Alot of times, you will see these charges just pop up without any proper categorization and you need to go back and make sure that these expenses get classified for what they are.

If an expense item is a travel meal, for example, you want to put them in the travel meal category. If you have a whole bunch of travel meals in a travel meal category, and can explain that the owner of the business has to travel frequently, or is involved in networking, or is involved in whatever, then that as whole looks a lot less flagrant than having a bunch of meals pop up in advertising. The idea is that the document will lend credibility to the explanation that is being given for these items.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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