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ASK THE EDD LAWYER – HOW TO AVOID EDD’S CONTRACTOR WHIPSAW, Part 1

By Robert S. Schriebman

May 12, 2015

Introduction

The term "Whipsaw" can be defined as getting the best of an opponent in spite of every effort he makes. In other words it is a literal form of "Heads I Win - Tails You Lose."

Contractors, whether licensed or unlicensed, generally do not fare well when it comes to an EDD audit. Contractors are targets. If an EDD auditor has a stack of audit files on his or her desk, and one of those files is a contractor audit, that is the file the auditor will pull out of the stack because the auditor knows that there is a high probability that the end result will be an assessment.

This is Part1 of a 2-part series. In Part 1, we will look at a typical EDD audit and examine the strategy used by the auditor in issuing an assessment. In Part 2 we will discuss how a contractor can use strategies to counter those of the EDD.

Through the Looking Glass - A Typical EDD Audit Report


When an EDD auditor completes his or her examination, concurrently with issuing the Notice of Assessment, the auditor will prepare an Audit Report (AR). The AR, along with all supporting documentation, is available to the taxpayer upon written request to the assigned EDD auditor. Unfortunately taxpayers, along with their inexperienced representatives, never get around to requesting copies of their audit files. Recently a person came in for a consultation. After 5 long years of waiting his matter was set for hearing before an administrative law judge (ALJ). He was represented by an attorney, but in all the years pending the attorney never asked the EDD to produce the AR or any audit documentation!

The typical AR is only about 15 to 20 pages in length. Only about half of the pages are devoted to the actual audit.

The first part of the AR is entitled "Entity Examination." This part consists of primarily housekeeping questions. The second part of the AR is entitled "Employer's Accounting System Examined." This section reviews the type of accounting system and whether or not the taxpayer kept adequate books and records.

The third and primary part of the AR is entitled "Misclassified Workers and Questionable Payments." You can tell by this title that the EDD auditor is starting to turn the audit findings against the taxpayer. This section is the "meat" of the AR. Here is where the auditor examines 1099 recipients and sets forth his or her attempt to obtain facts from recipient interviews to be used against the contractor. You will rarely if ever find information favorable to the contractor so as to allow the 1099 recipient to be treated as an independent contractor.

This section must be reviewed very carefully for any auditor bias against the contractor - and in my experience I have found much anti-contractor bias.

Part of this third section will also examine compensation paid to corporate officers. Corporate officers are by law statutory employees. They are not to be issued 1099s. It is here that the auditor will determine issues such as adequate compensation and whether or not any corporate loans to officers should be reclassified as additional compensation and payroll taxes assessed accordingly.

The last important AR heading is entitled "Applicable Penalties." There are at least 12 different penalties available to the EDD auditor. In this section the auditor will identify each penalty assessed and will explain why it was assessed. For example, one of the most popular penalties is set forth in CUIC § 1127 - The negligent penalty. This is a 10% penalty and is very popular with the EDD auditor.

The EDD Contractor Whipsaw

Contractors rarely get a break from the EDD. A licensed general contractor may only treat a licensed subcontractor as an independent contractor. Therefore, if the subcontractor does not have a license, that subcontractor is automatically deemed to be an employee of the general licensed contractor. There is virtually nothing the general contractor can say or do that will change the mindset of the EDD auditor (for more information see CUIC § 621.5).
These are difficult cases to win and there is great risk to the contractor in taking the matter before a judge. But what about an unlicensed contractor?

Not all contractors need to be licensed in California. What if an unlicensed contractor hires an unlicensed subcontractor? CUIC § 621.5 does not apply to a licensed subcontractor. There is no automatic presumption that the sub is an employee. Therefore, may the contractor treat his unlicensed sub as an independent contractor? NO! This does not seem to matter to the EDD auditor. The EDD will conclude that the unlicensed sub is still an employee pursuant to CUIC § 621(b) and 13004. These are the so called "Common Law" tests.

The contractor, licensed or unlicensed, just can't win. Like I said at the beginning of this article, "Heads I Win - Tails You Lose".

In Part 2, we will examine ways in which a contractor can do "Damage Control" when audited by the EDD.

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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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