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ASK THE EDD LAWYER – HOW DOES THE EDD ATTACK A SHAM CORPORATION?

By Robert S. Schriebman

June 25, 2015

Introduction

Johnny Doe is a business man. He is the sole shareholder of Ajax Corporation, a California corporation. He hates paying taxes of any kind. He hires Sam Sharpie, a know-it-all accountant, who, on the side, is also a financial planner and a self-proclaimed expert in asset protection strategies. Sam advises Johnny that he can save EDD taxes by creating a Nevada corporation and having that corporation create a fat tax deductible retirement plan. In that way Johnny can get out of paying California FTB income taxes as well as creating big deductions for contributions to the retirement plan which will also result in not paying any IRS taxes. Sam also advises Johnny to create a new corporation every couple of years and pay his workers out of the new corporation to avoid increases in California's UI rates. Following Sam's advice Johnny forms a new California corporation named Alpha, Inc.

The FTB conducts an audit and determines that the whole setup is nothing more than a scam to cheat the people of the State of California. They turn Johnny over to the EDD. The EDD concludes that Johnny is trying get out of paying his share of California employment and withholding taxes because the payroll checks are coming out of the newly created Alpha, Inc..

How do the FTB and EDD see through this maze of corporations to get at the heart of what Johnny and Sam are trying to do?

SUTA Dumping

When a new company starts business, and applies for an EDD account number, the EDD sets the Unemployment Insurance (UI) rate at 3.4% for the first $7000 of wages for each worker. After a couple of years at this low rate, the EDD increases the rate. The rate increase can get expensive for companies with many employees.

One of the biggest issues facing the Unemployment Insurance (UI) program is a tax evasion scheme called SUTA (State Unemployment Tax Act) dumping. This scheme includes acts to manipulate state account numbers and the UI experience rating process. When a low UI rate is obtained, payroll from another entity with a high UI rate is shifted to the company with the lower rate. The company with the old higher rate is then "dumped."

SUTA dumping is a national problem. In 2004 President Bush signed into law the SUTA Dumping Prevention Act. This law requires each state to enact laws to prevent employers from inappropriately lowering their UI contribution rates. The law not only bands SUTA Dumping but also imposes stiff penalties on those who engage in or promote such abusive practices.

It is standard EDD practice, when conducting an audit into workers' status, to check for SUTA dumping by conducting what is known as a "universal examination." This consists of examining subsidiary corporations, of a parent company or multiple "brother-sister" companies, to see if the workforce has been shifted between the companies.

Economic Reality Audit

At the end of May 2015 the California State Board of Equalization (SBE) issued a decision involving the appeal of Myles D. Hubers and Michelle R. Hubers (Case No. 534595). Through the advice of their accountant the Hubers created a series of corporations, one located in Nevada, as well as an elaborate retirement plan system that generated so many deductions that the Hubers paid no California taxes on millions of dollars of income generated in the years 2001 and 2002. The FTB challenged the economic reality of the Hubers elaborate tax avoidance scheme and unraveled it. They gave the Hubers a big tax bill and the SBE backed them up 100%

Since there were no California court decisions on point the SBE relied upon the decisions of the Federal Courts including the U.S. Tax Court. The IRS had previously established a two-pronged test to determine whether or not the formation of a corporation, engaging in business, had true economic reality, or was it simply a sham. The test, as set forth in Casebeer v. Comm'r (9th Cir. 1990) 909 F.2d 1360 is as follows:

(1) Whether the taxpayer has shown a subjective intent evidencing a business purpose for engaging in the transaction other than tax avoidance; and

(2) Whether the taxpayer has shown by objective evidence that the transaction had economic substance beyond the creation of tax benefits.

The FTB does not have to apply both factors to find a sham company. Either factor will do. The FTB and the EDD work closely together and they share information. They may even get the sales tax people, the SBE, involved to see if any California generated sales are buried in an out-of-state company.

Conclusion

We have all heard the old saying, "Oh what tangled web we weave when first we practice to deceive." Unfortunately, Johnny Doe took the advice of his know-it-all accountant, Sam Sharpie, to practice deception. The laws against tax evasion reach everyone engaged in the scheme; not just the business man but his tax advisor too. Let the advisor beware.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See "California Tax Collection Practice and Procedures" and "California Taxation Practice and Procedure", both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, "IRS Tax Collection Procedures - A Manual for Practitioners" published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, "IRS Tax Collection Procedures - A Manual for Practitioners" published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See "California Tax Collection Practice and Procedures" and "California Taxation Practice and Procedure", both published by Commerce Clearing House.

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