ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – UNDOCUMENTED CASH – A NIGHTMARE FOR YOU – A JOY TO AN IRS OR EDD AUDITOR
By Robert S. Schriebman
When an IRS or EDD tax auditor finds undocumented cash during a routine examination, a lightbulb of suspicion goes on. Is the taxpayer-employer hiding something? Are filed employment tax or income tax returns false? The typical EDD auditor starts to think of additional unreported payroll taxes including penalties such as Worker Information Return penalties; possibly fraud penalties as well. IRS auditors will start to think of accuracy-related penalties, civil fraud penalties, and even potential criminal prosecution if a pattern of non-reporting is present for several years.
Creating Reasonable Doubt
Undocumented cash or bank deposits that do not tie into the income stated on tax returns may not be subject to taxation. Basically, there are five (5) reasons for undocumented or unreported cash:
- After tax dollars;
- Return of capital;
- Loan proceeds;
- Gifts, and
- Tax exempt proceeds.
I am reminded of an IRS audit I handled as a new attorney. A family owned and operated a Mexican food product factory. They were very successful. The IRS audited the eldest son and found quite a large amount of unreported deposits. The auditor was confident that he had a major fraud to report to his superiors. When talking to the parents, I learned that the father gave each of his children cash as gifts over several years. I had the father sign a Declaration under penalty of perjury setting forth the approximate dates and amounts given to each child. Gifts are not considered taxable income. The auditor had no choice but to take his axe and find a different tree to cut down.
EDD’s Point of View
When EDD auditors find undocumented income in employers’ bank accounts, they usually adopt the position that these funds are subject to payroll taxes. This is especially true for small corporations and LLCs. Because the undocumented receipts exceed the amounts on W2s, the auditor usually concludes that this represents more wages than was reported. Because the W2s do not reconcile with the bank accounts, auditors conclude that the corporation or LLC must pay more in payroll taxes. In addition, the auditor goes to his/her arsenal of penalties and assesses the Negligence Penalty of 15% and Worker Information Return Penalties that average close to 13%. When the employer attempts to explain that the additional proceeds represent loans or the return of capital, the argument is usually shot down due to the absence of appropriate documentation.
On June 1, 2020, the US Tax Court issued a decision in the Estate of Mary P. Bolles T.C. Memo, 2020-71 (June 1, 2020). The case is important because it sets forth the basic checklist for establishing a valid loan.
The Estate of Mary P. Bolles
The facts in the Bolles case have nothing to do with corporations, LLCs, or payroll taxes. The matter involves determining the proper federal estate tax. What came out of the case are guidelines and minimum requirements that courts look for to establish sufficient proof that a valid loan has been made and a valid debtor-creditor relationship exists as a matter of law. What is good enough for the courts should be good enough for the EDD.
The following factors are considered traditional factors used to decide whether undocumented cash or deposits constitute a loan or a gift:
- There was a promissory note or other evidence of indebtedness.
- Interest was charged.
- There was security or collateral.
- There was a fixed maturity date.
- A demand for repayment was made.
- Actual repayment was made.
- The borrower had the ability to repay.
- Records maintained by the lender, and/or the borrower reflect the transaction as a loan.
- The manner in which the transaction was reported for tax purposes is consistent with a loan.
For corporations and LLCs either borrowing money from owners, or lending money to them, it is vital to have minutes in your corporate minute book that authorize the making of the loan and the terms and conditions of repayment. The first thing EDD auditors look for are these corporate minutes. It is tough to try to sell the loan to the auditor if these minutes are absent. It is inappropriate and even dangerous to attempt to prepare and back date these minutes once the audit has begun.
Internal Revenue Code § 61, and the FTB equivalent, set forth the definition of taxable income. Traditionally, gifts and loans are not considered taxable income. Having said this, it is vital for you to take the steps now to protect yourself from a suspicious tax auditor tomorrow. Even in this electronic age, I still find that documentation by paper is more important today than it has ever been; and by paper I do not mean emails. Auditors want to see Declaration of Gift, Promissory Note and appropriate 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 40 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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