ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – WHAT YOU PUT ON AN IRS INOME TAX RETURN MAY COME BACK TO BITE YOU IN A CALIFORNIA AUDIT
By Robert S. Schriebman
A tax auditor with the State of California routinely requests copies of IRS filed corporate income tax returns. This is common with both the EDD and the CDTFA (sales tax people). EDD auditors are looking for information relating to compensation for outside workers and S corporation distributions. They also focus on corporate net income, vis a vis compensation to officers. CDTFA auditors have a different agenda. An item of primary importance may be depreciation schedules to determine whether depreciated personal property may be subject to unpaid sales or use tax. The recent case of The Appeal of R. Hernandez, OTA Case No. 20035970, March 29, 2021, illustrates hidden traps in tax returns.
This article will discuss the Hernandez case and how depreciation schedules were used by the Office of Tax Appeals (OTA) to frustrate the taxpayer’s attempt to lie his way out of a potential assessment. The case is also important because it shows how a relatively small corporate-level deficiency will still give rise to a personal level assessment. Finally, the case gives us the latest guidelines on factors used by the CDTFA to assess personal level liability.
The Case of R. Hernandez
Hernandez owned and operated Infinity, a paper product folding and finishing business in Santa Ana, CA. Infinity’s 2007 corporate federal income tax return contained depreciation schedules for 10 customized gluers with a cost basis of $629,000. The then SBE audited Infinity for the period beginning January 1, 2005 through December 31, 2007. During the audit, the auditors noticed these gluing machines and asked Mr. Hernandez if he had paid sales or use taxes on them. The auditors also looked at the depreciation schedules to arrive at a value for tax assessment purposes.
Hernandez Tries to Explain His Way Out of an Assessment
First, Hernandez told the auditors that the company paid use taxes but he could not produce an invoice. He then told the auditors that the machines were not being used in California and were in the process of being sold to a business in Costa Rica. Later, he changed the story again and told the SBE that the machines were not for resale, but were being used in Costa Rica as an R&D project to develop more sophisticated machinery. Therefore, Infinity should not be subjected to a sales or use tax assessment. Hernandez also told the SBE that the depreciation schedules on the 2007 return were a mistake and that Infinity would be filing an amended IRS corporate return. No amended return was ever filed.
After waiting and not receiving any documentary proof to the above stories, the SBE issued an assessment against Infinity in the amount $32,500 in tax plus interest, and a penalty of about $3,100. Infinity paid down the assessment leaving a balance of about $18,000 before it ceased doing business.
The SBE issued a personal level assessment against Hernandez for the $18,000 plus the $3,100 penalty. Hernandez filed a petition with the OTA. During the judge hearing Hernandez made the same arguments and told the same stories to the judge as he the SBE. The judge did not buy any of it.
Hernandez Held Personally Liable
Hernandez was held personally liable for the $18,000 of unpaid taxes and the $3,100 penalty. In my practice I’m used to seeing the State go after responsible individuals for substantially more money. The rule of thumb has been personal exposure for an average of $100,000 or more in unpaid corporate level deficiencies. The message is loud and clear – never assume that the EDD or the CDTFA will forget about relatively small unpaid corporate assessments.
The Elements for Assessing Personal Liability
The Hernandez case set forth the four factors used by the CDTFA for personal level assessments:
- Cessation of business operations: Infinity went out of business still owing unpaid sales and use taxes. That was clearly established by the facts.
- Consumption of Taxable Personal Property Without Paying Tax: Auditors spotted ten pieces of machinery while conducting the audit. In addition, the value of the machinery was stated on IRS depreciation schedules at $629,000.
- Responsible Person: Hernandez, as the owner and CEO, has no place to hide – he’s the man!
- Willfulness: Hernandez controlled the day-to-day fiscal affairs of Infinity, including the filing of income tax and payroll tax returns as well as signing checks. Willfulness does not mean one has to have an evil state of mind. He knew that the company owed taxes but went about operating the business, taking in income, and paying bills.
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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