ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – FREQUENTLY ASKED QUESTIONS – ALL ABOUT EDD AUDITS – PART 3
By Robert S. Schriebman
During the COVID-19 pandemic the EDD conducted very few if any audits. Auditors were reassigned primarily to handle the unprecedented number of unemployment benefit claims. The auditors worked from remote locations. In early 2021 the audit program resumed. I have received many calls from employers who find themselves under examination. 2020 was a tough year for them. They have many common questions and concerns. In this series of FAQs, I will attempt to provide answers to their questions and address their concerns. If you find yourself in this situation, you are welcome to call my office and speak with an experienced professional.
The following FAQs are real. They are not academic. They have been asked by callers and clients over the years. I have learned that there is no such thing as a stupid question. I pass these onto you.
What is the EDD looking for when they conduct the audit – what are EDD audit priorities?
The primary focus of the typical EDD audit centers around the following areas:
- Proper worker classification
- The accuracy of W2s and 1099s when compared to the general ledger or the check register
- Unreported compensation usually paid in cash
- S corporation distributions
- C corporation issues involving reasonable compensation
- Credit card abuse
- Unreported health insurance premiums – S corporations
- CUIC § 1735 candidates
Let’s discuss each of these priorities.
Proper Worker Classification
One of the highest priorities in the EDD audit process is the proper classification of workers. W2 wage earners usually do not generate any issues especially if their compensation reconciles to the books of original entry. 1099s on the other hand usually raise red flags. This is especially true if a 1099 form shows the recipient’s name and a social security number instead of an EIN (Employer Identification Number).
The Accuracy of W2s and 1099s Reconciled with the General Ledger or the Check Register
EDD auditors check the amounts stated on the face of both W2s and 1099s with the general ledger and/or check register. If they match the amounts stated on the W2 or 1099, the auditor then focusses on whether the 1099 recipient should have been treated as a common law employee. If the records do not reconcile, and the general ledger or check register shows more money being paid out than reported on the W2 or 1099, some explaining is necessary. These discrepancies could lead to stiff Worker Information Return Penalties as well as additional tax assessments.
Unreported Compensation – Cash Payments
While payment in cash is not illegal, the EDD is always suspicious of cash. This is especially true when the employer fails to issue the worker a W2 or a 1099. Usually those who pay in cash do not have adequate books and records. All of this taken together, especially if the conduct is consistent over the usual three-year audit period, can lead to serious assessments that include the negligence penalty as well as two fraud penalties.
S Corporation Distributions
The EDD has always had a running battle with S corporations. The EDD does not like K-1 distributions that are not reported as wages. Many K-1s show a relatively small amount of wages when compared to a large amount of distributions that are not treated as wages. The EDD has special internal studies that show what the average wage should be for owner compensation in that particular industry. The EDD will use those studies to change the distributions to taxable compensation. This raises the issue of reasonable compensation which is never simple.
C Corporation Issues Involving Reasonable Compensation
C corporations do not make K-1 distributions like S corporations do. With C corporations, the EDD is looking for unreasonably low compensation. The EDD will use its special internal studies that show what the average wage should be for officer compensation in the particular industry. The EDD will use those studies to attribute higher compensation and assess employment taxes on the increase. The EDD pays no attention issues involving retained earnings to generate dividends or the return of capital which is a non-taxable event.
Credit Card Abuse
It is standard practice for an auditor examining the books and records of a corporation or LLC to request records of credit card payments. The auditor will review these statements to determine if the entity is paying for expenditures that should be attributed to officers, directors and key employees. Once these are found the auditor will assess payroll taxes based additional compensation represented by credit card payments that are not clear entity expenses.
Unreported Health Insurance Premiums – S Corporations
The tax treatment of fringe benefits paid to owner-employees of an S corporation is different from the tax treatment for other employees. Fringe benefits paid to S corporation employees who are not shareholders, or who own two percent or less of the outstanding S corporation stock are tax free. On the other hand, owner-employees owning more than two percent of the S corporation stock are not treated as employees for fringe benefit purposes, and their fringe benefits may not be tax free. Additional compensation will be taxed if health insurance premiums are paid to owner-employees owning more than two percent and not included as compensation.
CUIC § 1735 Candidates
Part of every EDD Audit Report is a section requesting the auditor to point out so-called "responsible persons" for the assessment of personal liability for corporate or LLC level unpaid assessed taxes. It is not the auditor’s job to actually make the assessment itself. Rather this is the job of the assigned collector in the event that the entity fails to fully pay the assessment. There are many articles on this website that discuss the 1735 assessment and how to deal with it.
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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