ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – EDD AUDITS – THE IMPORTANCE OF ESTABLISHING A TRUE INDEBTEDNESS – PART 1
By Robert S. Schriebman
This is Part 1 of a 2 Part series.
The issue of indebtedness often plays a major part in an EDD audit. It may mean the difference between taxable compensation and a tax-free return of loan proceeds. This article will discuss the importance of indebtedness in an EDD audit of a corporation or an LLC. The corporation may be an S or a C corporation. Before doing so, however, let’s define what indebtedness is and then get specific on the impact of the existence of a debt in a typical EDD worker status audit.
What is the definition of indebtedness? Black’s Law Dictionary states the following: “The state of being in debt, without regard to the ability or inability of the party to pay the same. The owing of a sum of money upon a certain and express agreement. Obligations yet to become due constitute indebtedness, as well as those already due. And in a broad sense and in common understanding the word may mean anything that is due and owing.”
Importance of Indebtedness in an EDD Audit
The importance of indebtedness in an EDD audit centers around the reasonableness of the compensation received by officers and key employees. The EDD has access to studies that show what the average executive should be compensated in a specific industry. If the auditor takes the position that the corporation’s president or key LLC member is not taking home enough money, according to EDD studies, the auditor will estimate and project additional hypothetical compensation and seek to assess payroll taxes, penalties and interest. Many auditors will do this without regard to whether or not the entity had sufficient cash or income to meet the estimation or projection. This is especially true in LLCs and S corporations where retained earnings are not a factor in distributions. The targeted officer or member may have taken distributions that are not reflected in a W2. The distribution will usually be in excess of what is stated on the W2. When auditors see this, most will conclude that there is taxable unreported compensation. The officer or member will take the position that the excess distribution was a repayment of a loan made to the entity. Unfortunately, most of these arguments fall on deaf ears with the EDD. Why? There is usually no evidence whatsoever that a loan was ever made by the shareholder/member to the entity.
What proof is necessary in order to convince an EDD auditor that a valid loan exists and that its repayment is not taxable compensation? Merely stating that a loan was made way back when and is now being repaid will not fly with most EDD auditors.
The Case of J and T Black
The Black case was decided by the Office of Tax Appeals (OTA). It is a complicated case that centers around whether or not a loan was made and never repaid. The taxpayer sought to argue that the receipt of over $425,000 was not additional compensation subject to California income tax. The case is important because the judge made an extensive commentary on what is necessary in order to establish a valid loan for tax purposes. (In the Matter of the Appeal of J. Black and T. Black, OTA Case No. 19095223, Feb. 2023)
In Part 2, I will discuss the elements constituting a loan that will be recognized by the State of California as legally valid.
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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