Chapter 9

Using the EDD Lead System in a California Payroll Tax Audit

Depending on the strength of the lead, the auditor may or may not know information about your case ahead of time. 

The first call on the audit is to figure out exactly what the auditor knows about the case. How much third-party information have they gathered and what access to that information do they have. 

A lot of times what you are going to find is-- or especially early in the process, the auditor has not done the due diligence necessary to really investigate the client's circumstances. They are following up on a lead, there is usually a triggering issue, they've been assigned to the case and they have to go through the process of documenting a report and going from there.

Here is how you can deal with an issue that you suspect is the lead issue in the context of the payroll tax audit:

Step one, figure out what the auditor knows about the client.

Step two, repeat back what you know about the client to set the framework and the auditors mind for how they run their audit:

Step one, figure out what the auditor knows about the client.

Step two, repeat back what you know about the client to set the framework and the auditors mind for how they run their audit

For example, take a client we had who issued a high amount of 1099s for a business. They have six employees, they happened issue 30 1099s in the year in question. The auditor says, we asked the auditor, "Hey auditor, do you have any idea why the client is being audited?" 

They say, "Well, it appears that the client is issuing a large amount of 1099 based on the number of employees they have."

"Okay. Let me just explain to you. We thought this was going to be an issue ahead of time. I just want you to know that the business in question uses a lot of independent things to help them do their job. 

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They've also 1099'd their landlord, they've 1099-ing their SEO company, they're 1099-ing in their bookkeeper. I'll probably get 1099 at the end of the year. but anyway, that's why it has nothing to do with their employees or employees of employees.

They've got the same six people working in the business that have been working in the business for the last three years. One or two come and go but everything's pretty fine. But just so you know, we've got this 1099 issue addressed. We don't think there's going to be any real problems in the audit."

You see what we just did there? I've just set an expectation to the auditor. The auditor now has a fact in their mind. It's an unverified fact but I've already stated a position. I've already started crafting a narrative to the auditor.

Assuming that I can present evidence that will back up that narrative, the auditor is going to start to believe that story, the more the auditor believes your story, the deeper they go down the rabbit hole then they are going to basically mitigate any issues in their own mind without you having to do it for them. 

This will speed up the pace of your audit, this will get you through your general ledger test a lot quicker.

This will get you through 1099 tests quicker because if the auditor believes your story, just like when you believe things, you have confirmed a belief that you think is true and you go from there. 

After you've explained the position, after you've set the auditor mind, then you're going to want to go through the author's initial document request. 

Hopefully, you want to try and limit the scope of the document request to one year for the client’s sake and your own.

Two Common Problems for Taxpayers in California Payroll Tax Audits

The first and biggest problem is the misunderstanding that the taxpayer has by thinking that just because they did not do anything wrong, there is no risk associated with the audit. That is a fallacy because a lot of times the EDD is auditing somebody because they have a reasonable suspicion that something they are doing is not correct. 

It is very important for the taxpayer to understand what their risk is in the beginning of the audit and then take step 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.

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 are not.

Those 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, as there are a lot of other factors that go into the payroll tax audit analysis and things that tend to be problems for taxpayers.

Most importantly, pre-audit yourself and if you have a good presentation, you can usually screen out most of the issues before they could pop up and then before they create financial liability to you or your company.

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The Biggest Risk in a California Payroll Audit

Other than in cases where there is some sort of fraud involved, the biggest risk by far in a payroll tax audit is the penalties because the EDD has some really nasty penalties. In our tax law firm, we have seen situations with clients where the penalties would be four or five times the amount of tax. Those penalties really amplify the amount of the liability.

When we are 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 if it turns into a fishing expedition. The auditor, if left unchecked, will ask for all sorts of things and will go through them with a fine-tooth comb. This naturally, as you can imagine, leads to more penalties

This creates a lot of back and forth and back and forth. However, much of this can be really mitigated if you pre-audit the situation and know what you are walking into. If you come into the audit with a very well-defined plan and a very well-defined presentation, you can lead the auditor through the audit — you are controlling the flow of information.

Controlling the flow of information in a payroll tax audit is the best thing that you can do. In a California payroll tax audit, remember that an ounce of prevention is really worth a pound of cure.

The California Payroll Tax Audit Process

Generally, EDD employment tax audits cover a three-year period, comprising the 12 most recently completed calendar quarters. However, in some situations, such as when no returns were filed, the audit period may be longer.

An audit begins with a formal notification of audit through postal mail. The auditor will send a list of requested documentation and a pre-audit questionnaire.

A minimum documentation request includes:

  • Verification of business ownership
  • Check registers and stubs
  • Bank statements and canceled checks
  • General ledger and journal
  • Annual financial statements
  • Vouchers and pay-out slips
  • Forms 1099

The pre-audit questionnaire is designed to elicit admissions and give the auditor enough information to develop an audit plan. You must carefully plan your responses to avoid problems later.

If you have not yet consulted a skilled tax attorney, this would be a good time to do so. A tax attorney can help you minimize admissions that could cause problems down the road.

An audit typically covers a three-year period unless circumstances arise that cause the auditor to go back further.

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How to Prepare for a California Payroll Tax Audit

To review, EDD auditors are looking for four things in the context of a payroll tax audit. They seem simple but there are a lot of nuances to them. We are about to get into some of those nuances.

Number one, EDD tax auditors are looking for taxable wages that were reported. They are verifying that the information that was given to the EDD was, in fact, the amount of taxable wages that were paid, and that is consistent with reporting to the IRS.

Number two, tax auditors are looking for the amount of tax paid. It is the same thing; they are looking for consistency in the tax that was paid as was reported to EDD.

Number three, EDD auditors are looking for payments that could be potentially reclassified as taxable wages. 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 is what the EDD is doing when they are going through the general ledger analysis.

The last thing that the auditors are looking for are any misclassification issues. They are reviewing all the outside workers that the company has an any vendors and they are making sure that they are not taxable employees.

There is a fairly detailed analysis involved in that process. There is a lot of digging, particularly with the general ledger and misclassification issues.

In a nutshell, that is what the auditor looks for as they go through the payroll tax audit process.

Now that you know what the EDD auditors are looking for, how do you get ready for the actual audit?

What to Expect at the EDD Audit Meeting

First, the auditor will conduct an entrance interview with the employer or with their designated representative to explain the purpose of the audit and its process, gather general information about the operation and organization of business and accounting records, and will answer any questions.

Only then, will the auditor review records. Payroll systems to be checked by EDD can be as basic as a manual system with only a check register and individual earnings records or as complex as a computerized double entry system on an accrual basis.

Provisions of the CUIC require employers to keep payroll records providing a true and accurate account of all workers (employed, laid-off, on a leave of absence, or an independent contractor) and all payments made. Consequently, the type of system taxpayer should use should meet the needs of your business and EDD requirements.

Requirements are explained in EDD’s California Employer’s Guide.

The auditor will review employer’s books and records to:

  • Verify the business ownership and type of entity (sole proprietorship, partnership, corporation, other)
  • Verify that all individuals paid for services have been properly classified as either employees or independent contractors in accordance with the provisions of the CUIC and the common law test as applied by the California Supreme Court
  • Discuss any unreported payments made for personal services and the nature of the working relationship(s) with employer and the worker(s). Based on the facts obtained from the records, input from the employer, and discussion(s) with the worker(s), the auditor will determine whether the worker(s) are employees or independent contractors.

In addition, if employer’s account has been selected for a complete audit, the following tests will be performed:

  • Verification that the employer’s acknowledged gross wages and taxable wages have been properly reported.
  • Verification that the employer has correctly withheld and reported personal income tax for wages paid to employees.

Please note that the EDD’s employment tax audit information will be made available to the IRS under an exchange agreement and the IRS may use the information in the administration of its own tax program.

An audit begins with the examination of records for a test year. The test year is generally the most recent completed calendar year. If differences are found in the test year, then the examination may be expanded to include the records for the entire period covered by the audit.

To expedite the audit process, the employer must ensure that all records are available to the auditor.

When it comes to employment classification, the tax auditor has the discretion to define and apply a list of factors to determine whether a worker is an employee or an independent contractor, which brings us around to the relationship between employment classification and payroll tax audits.

The EDD auditors always assess the factors used to determine employment classification (which are highly subjective) in their favor; therefore, it is more difficult to convince them that a contractor is not an employee. One more thing, a worker can be an independent contractor according to the IRS and yet be an employee in the eyes of the EDD.

As a tax attorney, the problem that I encounter is that most businesses adamantly believe that their independent contractors are truly independent contractors. My understanding of what an independent contractor is based on the law in California and a lot of times, how the EDD looks at independent contractors is much different from our client’s understanding of what constitutes an independent contractor.

The same thing goes for payments towards officers and other payments that perhaps should be reclassified as taxable wages. It is important to get a second opinion on the risk that you are going to face.

I am not necessarily saying that you need to hire a tax attorney, although in most situations it is a good idea when there is an element of risk. At least seek the advice of a professional so that you know what you are walking into and do this before you contact the California payroll tax auditor. 

How Long Does the Audit Take?

If everything is done correctly, the payroll tax audit process should not take any longer than six months. It is a lot of time, I know. You think, "They are going to go through my payroll records for six months."

The reality is, from the time that you get the initial notice, to the time the case gets assigned to an auditor, to the time you have the meeting, to the time the auditor works on the report, to the time it gets finalized, that is about a six-month process.

The best thing that you can do to try and get this process over with quickly , is to come in with a very well-organized plan and a very well-developed presentation to lead the auditor through the process.

The more boxes you can check for the auditor initially, the more that you can help them write their report. The more that you can address the issues in that report, the faster your payroll tax audit is going to move and the more quickly you can get yourself out of trouble.

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