You probably know better than to pay your employees in cash and to avoid classifying them as independent contractors.
As attractive as just filling out a 1099 might be, it often leads to problems down the road if a payroll tax audit occurs and the paper trail isn’t kept up to date.
What many business owners fail to fully understand when they pay employees under-the-table in cash, is that it can quickly become a criminal offense. Failing to account for those payments equates to tax evasion, and that can get you some years behind bars.
But, before we throw the baby out with the bathwater, let’s talk about the EDD’s payroll tax system and establish some groundwork.
Giving the Government Its Due
According to Unemployment Insurance Code (“UIC”) Section 1735, an officer, owner or any person in charge of the affairs of any corporation, LLC or LLP, is personally liable for the amount of the contributions, withholdings, penalties and interest unpaid by business entity if the business entity willfully fails to pay the amount.
Assessments become delinquent if not paid before they become final, and subject to a penalty of 10 percent. UIC Section 1135, Sections 1222 and 1224 provide that assessments become final (and delinquent) after 30 days from an assessment date, or if the taxpayer petitions or appeals assessment, within 30 days of an Administrative Law Judge or Appeals Board decision date.
Therefore, filing an appeal generally extends time to pay tax. Employment tax assessment imposed by the EDD under UIC is appealed before an Administrative Law Judge. The employer-taxpayer needs to file a petition for review or reassessment within 30 days of service of a notice of assessment or denial of a claim for refund.
This period can be extended for another 30 days by an administrative law judge if good cause is shown by the taxpayer-employer. UIC Section 1222 states that assessment or denial of claim for refund will be final if the taxpayer fails to file an appeal within the allowed period.
The appeal must be in writing and can be mailed, shipped, Fedexed, electronically transmitted by email or brought in person to the applicable office of the appeals board or even to the EDD branch office.
Notices are served by EDD in person or by mail. The time for filing a petition (30 days) is extended five days if the petitioner is within the state (35 days), 10 days if outside the state but within the country (40 days), and 20 days if outside the country (60 days). The UIC Section 1206 Notice is effective at the time of mailing by EDD or at the time of delivery to the employer-taxpayer.
In an appeal petition, the employer who appeals must put the name of the petitioner (person or business entity), employer EDD account number, and the mailing address of the employer. Although it is not required, the petition may also include the telephone number and email of the employer, EDD case number, statement of reasons for appeal, any request for language assistance (Spanish, for example), and the signature of the employer who appeals assessment of denial of tax refund.
Prior to hearing before an administrative law judge, the taxpayer can and probably should request a copy of all documents in the audit file. The EDD will charge a small amount for copying files. Then the taxpayer can review the EDD’s answer to their petition.
After that, the taxpayer may find it helpful to figure under which category they fall under (corporate officer, agent, salesman, homeworker,unlicensed worker, artist or author).
The taxpayer may find it helpful to review the EDD publications pertaining to the taxpayer's particular industry or talk to an attorney about that. The attorney would review relevant precedential cases applicable to this case.
It is important to determine the taxpayer’s status to figure out what laws and regulations apply to a person or business entity, which, in its turn, will help to figure out proper arguments to present on appeal.
After that, penalty issues can be addressed as well as statute of limitations (time period within which appeal is allowed).
For an appeal, the taxpayer should prepare and file a pre-trial brief or memorandum of points and authorities, in which they must describe relevant law and apply it to their case in support of appeal. The taxpayer may want to locate and interview helpful witnesses, including workers previously interviewed by EDD, principals of the business and management employees.
Please note that an administrative law judge may order taking of interrogatories (a set of written questions to the opposing party, answers to which later can be used as evidence) and depositions (formal detailed oral questioning by a opposing party to their attorney, recorded and transcribed, which later also can be used as evidence).
Witnesses should be subpoenaed (called) by so called subpoena duces tecum issued by an administrative law upon request by either party to appeal. The subpoena comes with a mandatory declaration under penalty of perjury on pre-printed form or your own.
The taxpayer can request one from the Office of Appeals of the EDD. The subpoena must be delivered to the witness in person with enough time before hearing for the witness to attend, and any adult individual can deliver a subpoena.
Generally, witnesses cannot refuse a properly prepared and served subpoena, unless the witness legally objects to it. Please note that the law requires a certain small amount to reimburse a witness for their expenses and time.
Then parties to appeal (Taxpayer and EDD) can stipulate as to facts – to agree on certain facts that will not be disputed by either party. After that the judge will conduct a hearing.
At the hearing, either party can testify, review the case files, introduce exhibits, question opposing witnesses or parties on any relevant questions, to answer opposing evidence and to impeach any witness. For those lacking English skills sufficient to understand or present their case, the EDD will provide interpreters free of charge.
Evidence rules are more relaxed than in regular court proceedings. Basically, any relevant evidence can be presented. The hearing can be attended by any member of the public. The judge can also allow filing a written argument after trial, 22 CCR Section 5064. The administrative judge issues a decision and the EDD must quickly serve it on the taxpayer. In the decision, the judge will explain the reasons for their decision.
The California Unemployment Insurance Appeals Board (the “Board”)
The decision by the administrative law judge can be appealed to the Board within 30 days of the decision. The appeal must be filed in a timely manner or the taxpayer will lose the appeal option. The Board will review matters, can allow hearing on request and sometimes may allow new evidence upon request (but generally new evidence is not allowed). Parties may file legal briefs.
If the Appeals Board fails to serve notice of decision on the taxpayer within 90 days after the taxpayer filed the appeal, then the taxpayer can consider the appeal petition as automatically denied.
The Superior Court
The employer-taxpayer can file a lawsuit in California Superior Court if certain prerequisites are met. First, the employer must have already paid tax, interest and penalties. Then the employer must file a claim for refund in writing with the EDD.
The claim for refund must state grounds on which the claim is founded, period covered, amount claimed and the date of payment of the amount. The EDD must deny the claim, then the taxpayer must have a hearing by an administrative law judge, and then the Unemployment Insurance Appeal Board must deny the claim for refund.
Only after that, the taxpayer can go to Superior Court. The Taxpayer must file a complaint within 90 days of the service of a notice of decision by the Appeals Board.
The EDD may, in writing, extend for a period of not exceeding two years the time within which court action may be instituted if a written request for such extension is filed with the director within the 90-day period, UIC Section 1241(a).
California Payroll Tax Settlements
The California EDD offers taxpayers a tax settlement program, where the EDD and taxpayer can settle a claim for less than the amount owed. The EDD can settle if it evaluates costs and risks associated with the litigation of the case and determines that it is better and less expensive for the EDD to settle for a lower amount than to litigate in court.
The settlements program allows an employer the opportunity to enter into a settlement agreement to also avoid the cost of prolonged litigation associated with resolving a disputed employment tax matter.
The California EDD will consider a settlement offer only when the assessment or denial of claim for refund is already under petition with the California Unemployment Insurance Appeals Board (CUIAB), meaning when the taxpayer appeals assessment or denial of claim for refund.
If the case is still in progress or involves fraud, intent to evade, and/or a criminal violation(s), the case is generally not eligible for settlement.
When reviewing an offer, the EDD will consider the risk of loss for the state and the cost of litigation balanced against the benefits of reaching a settlement agreement. Issues of fairness, financial hardship and the survival of the business may be considered by the EDD to establish a settlement amount, but such issues cannot be used by the taxpayer as the sole reason for entering into a settlement agreement.
Upon approval of the settlement offer, the employer and the EDD will enter into a settlement agreement. All settlement agreements are subject to approval by an administrative law judge, and some require approval by the CUIAB and/or the attorney general.
How to Apply
To apply for settlement, a taxpayer must send a settlement offer in writing to the EDD. In the letter, a taxpayer must include their EDD employer account number, the specific assessment against them or claim for refund for which the taxpayer offers a settlement, date of assessment or denial of claim for refund, amount of liability involved, and the time period covered.
A taxpayer must also describe the basis for offer, including the amount and terms of the offer. The EDD also requires the taxpayer to include an analysis of the risk of loss to the state or a reasonable estimate of the cost of litigation which appears excessive and the reason why the taxpayer's offer should be considered.
If a taxpayer has anyone who will negotiate on the taxpayer's behalf, the offer must include the name, address, and telephone number of the individual authorized to negotiate a settlement agreement.
If the taxpayer’s offer meets the criteria for a settlement, the EDD will contact them for final negotiation and execution. If the offer does not meet the criteria for a settlement agreement, the taxpayer will receive a denial letter from the Settlements Office.
Once negotiation begins, all information during negotiation is considered confidential and cannot be used by the EDD against the employer. If a worker’s status is at subject, then the employer may be required to start reporting the worker as an employee.
If the disputed employment tax matter is final or the sole issue is the inability to pay, it will not meet the criteria for a settlement. However, there may be other options available to you.
Section 1236 of the CUIC requires a public record for any settlement agreement that forgives more than $500 in taxes and penalties. The public records are on file with EDD’s Director in Sacramento, California.
When The Playing Field Is A Familiar One
California payroll tax audits present some major challenges for businesses. However, should you need some assistance, you have come to the right place if you are being audited by the EDD.
The staff at Brotman Law sees the real playing field with respect to the issues that arise in a payroll tax audit and we have wide experience dealing with district offices all over California.
If you want us to play ball on your team, we can devise a playbook for getting you through the examination and avoiding the very serious penalties associated with a California payroll tax audit.