Ask The California Employment Tax And Payroll Tax Attorney – EDD Audits – The Importance Of Establishing A True Indebtedness – Part 2
By Robert S. Schriebman
This is Part 2 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.
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.)
The Minimum Requirements for a Valid Indebtedness
There Must Be Paper
Most loans between a shareholder/member and a corporation or an LLC, are informal arrangements which may not comply with all the customary legal formality for a commercial loan. A good reference is US Tax Court Case, Zohoury v Commissioner, T.C. Memo 1983-597. The most important thing to remember is one word – PAPER. There has to be a promissory note and there should also be corporate minutes authorizing the note. There has to be objective evidence establishing that the loan was entered into.
Whether Interest Was Charged
Interest and a fixed prepayment schedule are characteristics of a true debtor-creditor relationship. The amount of interest charged should be competitive with commercial rates currently charged by a recognized lending institution.
Whether There Was Any Security or Collateral
Not all loans require collateral or security such as a Deed of Trust. If the entity does own real estate, giving the lender a secured interest in the real estate objectively establishes a valid debt.
Whether There Was a Fixed Maturity Date
The loan should have a fixed date in time when all or a part of the loan must be repaid.
Whether a Demand for Repayment Was Made
Record keeping is vital in establishing a valid debt. An auditor may ask to see any written demand for whole or partial repayment.
Whether the Lender Maintained Any Records the Loan Was Made and Whether the Borrower Reflected the Transaction as a Loan
This factor reflects the importance of keeping records on both sides of the transaction to prove that a loan was intended. This issue often arises when one claims the money received was a gift. Usually gifts do not occur in commercial settings. What is important is to document the intention of making a loan. When it comes to a corporation or an LLC, this can be accomplished by preparing corporate minutes reflecting the company’s intention to borrow a specific sum, a specific interest rate, and a specific repayment date or installment payments.
Whether the Manner in Which The Transaction Was Reported for Tax Purposes Constituted a Loan.
The lender will not reflect loan repayments as income. If the loan is not repaid, the default may be reflected as a bad debt loss (whether personal or business). The borrower will reflect interest payments as a deduction. The lender will not reflect loan payments as additional taxable compensation.
The EDD is suspicious of most loan transactions to or for a small business. Auditors will want to reclassify loan payments as taxable wages. In order to avoid from this happening, one must have their affairs in order, and this means the correct documentation that truly reflects a borrow-lender relationship. There must be a promissory note and there should minutes reflecting the loan. The internet has many places to go that will provide samples of promissory notes and corporate minutes.
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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