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Employee VS. Independent Contractor Audits Part 1

By Robert S. Schriebman

Without question, the Employment Development Department (EDD) and the IRS attacks on small businesspersons are on the rise. One of the hottest areas of activity is the employee-independent contractor audit. California and the IRS realize that there are billions of dollars in lost revenues every year when employers treat true employees as independent contractors.

For troubled businesses treating real employees as independent contractors, the audit process is justified, but there is a lot of governmental abuse, too.

Disgruntled Employee Syndrome

Here is what can happen: The state comes in, usually on the tip of a disgruntled "employee," seeking unemployment benefits. The "employee" usually gets unemployment relief. The EDD proceeds to audit the employer covering a period of three or four years. Some of these audits can actually go back to the beginning of the business operation! After the state completes its audit, it may turn its report over to the IRS, and visa versa. The IRS can either conduct its own audit or make use of the extensive state working papers and assess a federal deficiency accordingly. To both deficiencies can be added: delinquency penalties, additions, and daily compounded interest. Thus, the targeted employer can be whipsawed between the state and federal governments. However, this is not the end of the story.

Whipsaw Between EDD and IRS Employment Tax Examinations - Individual Level

California and the IRS have provisions assessing various portions of the employer's tax liability to so-called "responsible individuals." With the IRS, it is Trust Fund Recovery Penalty under IRC Sec. 6672. California has a transferee liability assessment. The individuals are faced with the same exposure that their corporation had, plus an additional penalty if the individual assessment is not paid within a short period of time (California Unemployment Insurance Code (CUIC) 1735).

Know this: Both the entity-employer and certain vulnerable individuals can be doubly whipsawed between state and federal tax assessments. Interest compounds daily and there are additional delinquency penalties.

Know this: The whipsaw used by the EDD and the IRS can actually result in four separate assessments! Think about it - there is the EDD corporate level assessment, the IRS corporate level assessment, the EDD individual level assessment, and last but by no means least, the IRS individual level assessment. That's four potential assessments that can arise out of one audit - and that's enough to financially ruin many people! Should you have legal representation to try to deflect this disaster? You bet!

What is a target-employer to do? How is the deficiency assessed by both the state and federal government to be paid? Bankruptcy proceedings do not help very much because most employment and withholding taxes cannot be discharged in conventional bankruptcy proceedings.

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.