ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – EDD CONTRACTOR AUDITS, PART 2 – WHEN A THREE-YEAR AUDIT BECOMES AN EIGHT-YEAR AUDIT
By Robert S. Schriebman
In 2020 the EDD did not conduct audits during most of the year due to the pandemic. Auditors were assigned to assist people with filing unemployment compensation claims. Audits resumed in early 2021. I have seen disturbing audit techniques on the part of EDD auditors especially when it comes to audits of various facets of the construction industry. The purpose of this series of articles is to alert you to these practices as they seem to violate the essence of the Employers’ Bill of Rights entitling an employer to a professional level objective examination. When it comes to EDD audits of general contractors, it appears to be a common practice for the EDD to expand the normal three-year or twelve-quarter audit period to a maximum eight-year audit. This is Part 2 of a 4-part series that will discuss what my contractor clients have experienced in 2021.
Bill is a licensed general contractor operating as an S Corporation. He has been in business since 2012. Bill is the president and CEO of his corporation. The EDD audit began in 2020 and was completed in mid-2021. From 2012 until 2017, Bill took periodic draws from the corporation and reported this income on his state and federal tax returns. In early 2017, the corporation was audited by the IRS. During the IRS audit, the agent reviewed Bill’s draws and informed him that he should have taken a salary, filed quarterly and annual payroll tax returns, and received a W2. Until this time the corporation had not filed 941 quarterly returns or the annual 940 FUTA return. Starting in mid-2017 and continuing every quarter, the corporation filed both IRS and EDD payroll tax returns in a timely fashion.
Bill was the only employee of his corporation. The corporation had always hired licensed subcontractors and issued them annual 1099s. Periodically helpers and day workers were needed to complete various tasks. Many of these workers earned less than $600 per year. Those earning more received 1099s.
The IRS audit did not review the status of any helper or day worker as an employee. The agent did not address these matters.
Enter the EDD
The audit began in 2020 and finished in mid-2021. Because the corporation did not file payroll tax returns until 2017, the auditor took the position that there was no good cause for failure to file and expanded the audit period from usual three years or 12 quarters back to 2013. This was allowed pursuant to CUIC § 1132. The auditor concluded that all workers should have been licensed by the CSLB and reclassified all helpers and day workers as W2 wage earners. The EDD issued a Notice of Assessment that included a harsh 15% negligence penalty and stiff worker information return penalties amounting to almost 13% of the compensation paid to these workers.
Was the EDD auditor justified in going back to the year 2013 and reclassifying helpers and workers as W2 wage earners?
Violation of the Employers’ Bill of Rights
EDD Publication DE 195 explains the Employers’ Bill of Rights. With regard to the quality of an EDD audit it states, “You have the right to an impartial audit and a full explanation of the audit findings.” An employer is entitled to a professional level, objective audit conducted by an experienced auditor.
The Audit Statute of Limitations
There is only one statute of limitations law in the entire EDD’s Unemployment Insurance Code. It is CUIC § 1132. The normal audit period is three years or twelve quarters. If an employer consistently and timely files quarterly payroll tax returns, that is enough to show good faith and confine the audit to its normal period. In mid-2017 the IRS informed Bill that he needed to go on salary and file quarterly and annual returns because, as president and CEO, he is a statutory employee. By the time the audit started the corporation had a three-year period of compliance. That was enough to show good faith for limiting the audit to the normal period of time. The EDD auditor was wrong in looking beyond this three-year period in order to find bad faith. Therefore, the audit should have been a normal period affair. Any period of assessment beyond the normal audit period should be barred by the statute of limitations.
IRS ‘Safe Harbor’ Rules and Their Impact on the EDD
In early 2017, Bill was audited by the IRS. No adjustments were made by the IRS concerning worker status. The corporation had “safe harbor” status under the Revenue Act of 1978, and is considered under federal law to have had a reasonable basis for treating its outside service providers as independent contractors.
While the EDD does not have “safe harbor” provisions, Bill’s corporation was conducting its business affairs in a reasonably prudent manner and continued to do so from mid-2017 through 2021, the completion of the audit. This factor should constitute good cause and not the requisite bad cause justifying the EDD’s conduct of an 8-year examination that went back to 2013.
The Revenue Act of 1978 § 530 Safe Harbor
When the safe harbor provisions apply, the employer is protected from any retroactive liability for withheld income taxes, FICA taxes and FUTA taxes. Moreover, under these provisions, workers can be treated by the employer as independent contractors without fear of reclassification by the IRS. The safe harbor provisions eliminate an employer’s liability for employment taxes arising from an employment relationship if the employer has a “reasonable basis” for not treating the subject worker as an employee.
The employer must have a reasonable basis for treating workers as independent contractors. A “reasonable basis” under § 530 includes 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 deemed to be independent contractors.
Bill’s audit should have only been a three-year or twelve quarter examination. All other years or quarters in the Notice of Assessment should have been statute barred. Getting a “blessing” from the IRS and consistently treating workers as independent contractors may not be binding on the EDD, but they cannot be the grounds for any penalty, or excessive assessment.
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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