ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – AVOIDING AN ILLEGAL REPETITIVE AUDIT
By Robert S. Schriebman
Repetitive audits are illegal. Once the IRS or FTB conducts an audit and closes the matter on a specific year, that closed year cannot be reexamined. This article will discuss the Internal Revenue Code provisions that forbid a repetitive audit. The same rules generally apply to the FTB. Do they also apply to the EDD? I will answer this question later in this article. Issues that are resolved in Year # 1 should be binding on future years assuming the facts are basically the same and there have been no intervening legislation or court decision.
On June 24, 2020, the IRS issued a press release that gave an example of a prohibited repetitive audit and discussed the provisions of the Internal Revenue Code governing repetitive audits. Field Attorney Advice 202002501F (2020ARD123-7).
The taxpayer, an S corporation, owned and operated a vineyard. The vineyard ran at a loss and generated net operating loss carryforwards (NOLs). The vineyard operation was audited by the IRS (Year #1 audit). The auditor determined that the vineyard was not being operated in a business-like manner; it was a hobby. Hobby losses generally are not deductible. The taxpayer appealed to the IRS’ Appeals Division where the case was assigned to an Appeals Officer. The Officer disagreed with the auditor and ruled that the vineyard was truly a business and the losses were allowed. This ruling, however, did not stop the IRS from auditing the next year. (Year #2 audit) The auditor asked to examine the books and records from the Year #1 audit as well as the records for Year #2 audit. The auditor, once again, ruled that the NOL for Year #2 would not be allowed because the vineyard was a hobby. That same auditor went back into Year #1 and again concluded that the vineyard was a hobby in both years. The auditor essentially overruled the prior Appeal decision that found the vineyard was indeed a business, not a hobby.
The Re-Audit in Year #1 Was an Illegal Repetitive Audit
The rules concerning a repetitive audit are set forth in IRC § 7605(b):
No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that and additional inspection is necessary.
The Code imposes restrictions on two activities: (1) unnecessary examinations or investigations, and (2) more than one inspection of a taxpayer’s books of account for a tax year. IRC § 7605(b) does not prevent an IRS agent from “diligently exercising his statutory duty of collecting the revenues.” Benjamin v. Commissioner, 66 T.C. 1084, 1098 (1976) and DeMasters v. Arend, 313 F.2d 79, 87 (9th Cir. 1963). In the vineyard case, the IRS cannot re-audit the hobby loss issue previously decided by a ruling from the IRS Appeals Division. The issue was resolved and settled.
Having said the above, you should know about the Digby case, Digby v. Commissioner, 103 T.C. 441 (1994). In the Digby case two different auditors conducted examinations in consecutive years. In Year #1, the auditor allowed losses based on estimations. In Year #2, a different auditor disallowed losses and went back to disallow them in Year #1. There was no Appeal decision and no Court ruling. The US Tax Court ruled that there was no second examination even though the same records were used in both audits. The issue involved was ongoing. It was not resolved by the IRS for the previous year. Where the issue is resolved by an Appeals ruling or a Tax Court decision, then that issue is resolved and cannot be reopened in a subsequent audit.
In the case of the vineyard, the hobby loss issue, an ongoing issue, was resolved in the taxpayer’s favor. It would be improper for an auditor to go back and try to reverse the holding on his/her own initiative
Repetitive Audits and the EDD
The California Unemployment Insurance Code (CUIC) has no provisions that prohibit a repetitive EDD audit for the same year. I have personally handled EDD audits where the EDD agreed that certain classes of workers were independent contractors in the first year under examination but a different auditor, in a following year, reversed a prior position and found the exact same class of worker to be common law employees. The earlier position had been approved by that auditor’s group manager. When I spoke to that same group manager, and, complained about the inconsistent position taken by the EDD, that manager waffled and stated that each year under audit stands on its own and the new auditor is free to see things differently. Do not count on consistency with the EDD. This situation, however, can be viewed as a two-edged sword. That is to say, an employer is allowed to reopen a closed audit under assessment if new evidence is provided in an attempt to reduce or eliminate an earlier Notice of Assessment.
Repetitive audits are rare, and the cases are few and far between. There are guidelines when it comes to IRS and FTB audits, but there are no specific cases or statutes prohibiting the EDD from taking inconsistent positions in subsequent audits. If this happens to you, contact the auditor’s immediate supervisor and if you get no satisfaction speak with the office manager.
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. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
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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