Ask The California Employment Tax And Payroll Tax Attorney – EDD Contractor Audits, Part 4 – Improper Projections Of Corporate Officer Compensation

 By Robert S. Schriebman
2021

Introduction

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. This article will discuss improper EDD projections of compensation for small corporation and LLC officers and shareholders. This is Part 4 of the series that will discuss what my contractor clients have experienced in 2021.

Freddie’s Audit

Background

 Freddie is a licensed general contractor operating as an S Corporation. He has been in business since 2012. Freddie is the president and CEO of his corporation. The EDD audit began in 2020 and was completed in mid-2021. From 2012 until 2017, Freddie took periodic draws from the corporation and reported this income on his state and federal tax returns. The corporation did not file quarterly or annual EDD and IRS payroll tax returns.

In early 2017, the corporation was audited by the IRS. During the IRS audit, the agent reviewed Freddie’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.

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 requested the usual corporate documentation including corporate tax returns going back to 2014 (the 2013 return was destroyed in the ordinary course of business). Each return showed a net profit and net taxable income for each year averaging $120,000 per year. The auditor did not review in detail the corporate returns other than the corporate annual net income.

The EDD auditor did not ask Freddie for personal documentation such as the following:

• Personal bank statements
• Personal bank deposit slips
• Personal state or federal income tax returns
• Personal loans between Freddie and his corporation.

The EDD auditor resorted to an internal EDD study to show the average compensation for a corporate supervisor – not a corporate officer or majority shareholder.

Based on this internal EDD study the auditor assessed the corporation additional compensation for Freddie for each year going back to 2014. The internal study showed compensation of $55,000 per year. The auditor also assessed a harsh negligence penalty of 15% and stiff worker information return penalties of almost 13% of projected compensation because the corporation did not issue Freddie a W2 in each year in issue. There was no evidence whatsoever that the corporation paid Freddie $55,000 per year. His draws were sporadic. In some years there were no draws.

Violation of the Employers’ Bill of Rights

EDD Publication DE 195 explains the Employers’ Freddie 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. Freddie’s audit did not meet these standards.

While an auditor is allowed to make estimations, there must be a reasonable basis for doing so. There must be proof that actual dollars were paid out to a person in Freddie’s position. If there is no evidence of payment, any estimated projection is improper. Auditors are allowed to shift and allocate corporate disbursements, but they are not allowed to create them out of whole cloth. The auditor never bothered to request copies of personal records such as personal bank statements, deposit slips or personal income tax returns. The auditor also failed to properly analyze S corporation tax returns for K1 distributions and Schedule M information. The auditor also did not review the financial statement portions of the corporate returns to determine retained earnings or basis. An auditor cannot blindly attribute unrealistic amounts of wages without analyzing all this vital information.

There is a long list of US Tax Court decisions relating to the proper way to establish reasonable projections. These cases all have one thing in common – there must be actual payments made to corporate officers. IRS Fact Sheet FS-2008-25 clearly states that there must be actual payments made to an employee/shareholder. All of this information is binding on the EDD!

The auditor failed to recognize and incorporate long-standing IRS factors determining reasonable compensation in the projected estimations

The EDD auditor relied solely on an EDD mechanical application from an internal EDD source to determine the reasonable amount of compensation for a “General and Operation Manager in the Los Angeles Area.” There was no analysis presented of the factors the auditor should have used to arrive at an artificial pay rate. A proper analysis dictates that the auditor should have consulted IRS guidelines that have been used for years by the US Tax Court and by IRS auditors as set forth in Fact Sheet FS-2008-25.  These factors are as follows:

a.  Training and experience.
b.  Duties and responsibilities.
c.  Time and effort devoted to the business.
d.  Dividend history.
e.  Payments to non-shareholder employees.
f.  Timing and manner of paying bonuses to key people.
g.  What comparable business pay for similar services?
h.  Reliable objective outside studies.

Conclusion

No auditor is allowed to manufacture what is not there. There must be evidence of actual corporation payments made to officers and shareholders. Just because a company has an annual net profit, does not mean that there is cash on hand for additional compensation. An auditor is allowed to shift and allocate that which is present and real but cannot create additional compensation out of whole cloth.

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 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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