ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – CHALLENGING AN EDD EIGHT-YEAR AUDIT ASSESSMENT – PART 2
By Robert S. Schriebman
This is Part 2 of a 2-Part series that will discuss how to challenge an 8-year EDD audit assessment as opposed to the standard 3-year or 12 payroll-tax-quarter assessment. Of late I have seen more 8-year audit assessments being issued by the EDD. I find these assessments to be particularly harsh and disturbing.
EDD Audit Statute of Limitations and Why the EDD Conducts an 8-Year Audit?
There is only one statute of limitations section in the entire California Unemployment Insurance Code (CUIC § 1132). This section states that the basic audit process shall be 3 years. If the examining auditor finds “bad conduct” on the part of the employer, the auditor can extend the audit up to 8 years. Bad conduct means failure to file quarterly payroll tax returns without “good cause.” Good cause is not defined. Most auditors, however, do not delve into why returns were not filed. If the computer shows that returns were not filed, that is enough bad conduct to warrant an extended audit. Most auditors do not take the time to inquire as to why the returns were not filed.
Favorite Target for an 8-Year Audit Assessment
For as long as I can remember, the typical 8-year audit involves the construction industry and the audit of general contractors. Because of the frequency of 8-year audits involving general contractors, this article will focus on a hypothetical scenario involving a general contractor.
General Contractor Scenario
Frum-N-Hammer, Inc. (Frum) is a general contractor. Frum has been in business since January 2000. Nine years ago, Frum was audited by the IRS. This audit focused on income and business-related deductions. The IRS agent did not concern himself with any worker status issues. Frum only engaged licensed subcontractors and issued annual 1099s. Frum also hired day laborers and helpers but did not issue these workers W2s or 1099s.
Frum has received an audit notice from the EDD. The assigned auditor has initially requested the following records going back 8 years. This is the auditor’s first communication with Frum. The auditor has never personally contacted anyone in the company. The following is a list of the documentation requested:
- 8 years of corporate bank statements with check images attached
- 8 years of balance sheets and profit & loss statements
- 8 years of W3s, W2s, 1096s and 1099s
- 8 years of corporate tax returns
- 8 years of general ledgers
Harvey Frum, the corporate president, feels there is something wrong with the auditor’s initial request for 8 years of records. He is right to be concerned and has come to me for advice and help. What follows is my response to Harvey’s concerns.
The Auditor Has Violated Both the Letter and Spirit of the Employers’ Bill of Rights
EDD Publication DE 195 clearly states, “You have the right to an impartial audit and a full explanation of the audit findings.” This very same quote is also found on page 78 of the 2022 California Employer’s Guide, DE 44.
The auditor apparently specializes in auditing contractors. The auditor also appears to have a bias against contractors by making an initial demand for 8 years of records without having any documentation or information to justify expanding the audit beyond the usual 3-year or 12-quarter examination. I have several cases in my office involving the same auditor who repeatedly issues assessments based on an 8-year audit.
It is clear that this auditor made up his/her mind in advance to conduct an 8-year audit without any evidence of bad faith on the part of the employer. This conduct violates the Employers’ Bill of Rights.
Frum Has Good Cause for Not Filing Quarterly Returns – IRS “Safe Harbor” Protection
This matter involves Section 530 of the Revenue Act of 1978. This Act created the IRS “Safe Harbor” rules. When the safe harbor provisions apply, the employer is protected from any retroactive liability for withheld income taxes and payroll taxes. Under these provisions, workers can be treated by the employer as independent contractors without fear of reclassification by the IRS. H.R. Rep. No. 95-1748, 95th Cong. 2nd Sess. 5 (1978); 1978-3 C.B. 629.
The employer is protected if it has “reasonable basis” under Section 530 for not treating a worker as an employee. What constitutes reasonable basis? There are three criteria for establishing reasonable basis:
- Judicial precedent or a published ruling
- Long-standing recognized practice in the industry
- A past IRS examination not necessarily for employment tax purposes. If the examination entailed no assessment attributable to the taxpayer’s employment tax treatment of workers.
Nine years ago, Frum was audited by the IRS. There was no assessment involving worker status. Under federal law, the IRS can conduct an examination and not consider worker status, but this fact counts to grant safe harbor status and protection.
Having said the above, the EDD does not have safe harbor provisions. This can cause some confusion and inconsistency between IRS rules and EDD rules. Nevertheless, Frum’s worker status was blessed and affirmed by the earlier IRS audit. This constitutes sufficient good faith on the part of the employer for not filing quarterly payroll tax returns with the EDD.
Therefore, Frum acted in good faith and its conduct does not warrant the bad faith necessary for an 8-year examination.
Is the Auditor Biased Against Contractors?
There is every indication that the assigned auditor is biased against contractors. The auditor may have checked EDD’s computers and discovered that Frum had not filed any quarterly payroll tax returns. Without interviewing Frum’s officers, or contacting Frum’s counsel, the auditor issued a demand for 8 years of records when the usual practice is to request only the past 3 years or 12 quarters. Issuing an 8-year initial demand is strong evidence of auditor anti-employer bias.
Frum acted in good faith, and its conduct does not warrant the absence of “good cause” required under CUIC § 1132 for expanding an audit beyond 3 years. It is clear from the auditor’s conduct that he/she has a bias against this employer. Frum is entitled to an objective and professional level examination provided by the Employers’ Bill of Rights. Frum is entitled to a fair playing field. A new auditor is required in the interest of objectivity and fairness.
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 50 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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