ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – WHY DOES THE EDD TARGET GENERAL CONSTRUCTION CONTRACTORS – PART 1?
By Robert S. Schriebman
This is Part 1 of a 2-Part series that will discuss EDD audits of general construction contractors from a representative’s point of view.
Why does the EDD target general construction contractors? The short answer is that audits of general construction contractors yield big bucks for the California State Treasury. Audits of general construction contractors usually yield profits to the EDD per audit-hours worked; a positive return on the investment of time. I cannot remember when an audit of a general construction contractor resulted in a no change. I find that they can be punitive and unfair.
Underground Economy Task Force
The State of California has what is known as an Underground Economy Task Force. The Task Force is composed of representatives from the EDD, California Department of Labor, and Workers Compensation. These people drive around to various construction sites and randomly interview workers, supervisors, and contractors to determine if there are any violations of the law. They usually find something, and when they do, they prepare an Underground Economy Report that is given to the EDD and other state agencies for the purpose of audit and enforcement.
The EDD Enters the Picture
Once the EDD enters the picture, the audit is assigned to a specialist who is highly experienced in conducting audits of general construction contractors. You would think that these specialists would have some type of a checklist that would take into account the realities of how the construction industry operates, such as allowances for materials, supplies, rental equipment, etc. This checklist, if one exists at all, should be in sync with the Employers’ Bill of Rights discussed below. After handling my share of general construction contractor audits, I can tell you, based upon my experience, that I do not believe there is an objective audit checklist, or if there is, it is disregarded. I do not believe that EDD auditors pay much attention to the Employers’ Bill of Rights, especially when it comes to taking into account the realities associated with the construction industry.
This series of articles will discuss the Employers’ Bill of Rights and will give you some real world insights into how the EDD does business with the general construction contractor community. The bottom line to all of this is, in my opinion, that the EDD does not give general construction contractors a fair and an objective audit. I have seen too many instances where the opposite is true – that many audits of general construction contractors result in punitive assessments with little if any analysis and no allowances for out-of-pocket expenses and improper application of laws relating to the treatment of alleged unlicensed subcontractors. Obviously, I cannot go into each and every audit experience I have had, but the audit that I have handled recently, leave much to be desired, as far as professional and objective audits are concerned.
EDD’s Employers’ Bill of Rights
If you are a general construction contractor under audit by the EDD you should ask your assigned auditor for a copy of the Employers’ Bill of Rights (EDD Publication DE 195). There is not a lot of information in the brochure handout relating to audits per se. Most of the topics deal with collection issues, penalty abatement, and appeal rights. However, there is one very important heading entitled, “An Impartial Audit.” The key provision is as follows: “You have a right to an impartial audit and a full explanation of the audit findings.” Sadly, I find the general construction contractors rarely experience an impartial audit. The brochure handout is never given in the basic audit package notifying the employer that he/she is under examination. You have to ask for it.
Another provision of the Bill of Rights informs you of your right to professional representation. You have the right to consult with a professional of your choice and to shop around if necessary, if this postpones the audit, so be it. It’s your right – exercise it!
Sole Proprietors Have the Maximum Exposure
Many small general construction contractors do business as a sole proprietor. They file an individual state and federal income tax return with a Schedule C. Most IRS income tax audits are conducted against sole proprietors because a) Schedule C is easier to audit and 2) and usually results in income tax assessments. On the other hand, a C or S Corporation is not audited as frequently.
When it comes to the EDD, I believe, sole proprietors have the most exposure because there is no statute of limitations for collecting an EDD audit assessment against them. On the other hand, corporations and LLCs provide greater protection against the EDD disregarding the corporate entity and assessing individuals as responsible persons pursuant to CUIC § 1735.
Areas of High Priority for EDD Auditors
EDD auditors assigned to audit a general construction contractor seem to focus, at least initially, on several key areas of potential violations.
- Failure to file payroll tax returns
- Cash payments to workers especially common laborers.
- Hiring unlicensed subcontractors
- Inaccurate books and records
- Failing to issue W2s and 1099s
- Discrepancies on W2s and 1099s when compared to entries in general ledgers and check registers
- S Corporation K-1 distributions, not being treated as compensation
- S Corporation health insurance premiums to owners
When an EDD auditor obtains internal records, such as the general ledgers, check registers, and cancelled checks, the auditor will compare the amounts stated on W2s and 1099s to see if they accurately reflect payments to workers and third-party payees. If the Underground Economy Report reveals that workers were paid in cash, the auditor will ask for a breakdown of cash payments. This analysis usually follows a request from the auditor for three years of bank statements together with copies of cancelled checks. Heavy penalties are then assessed for any perceived violations without giving the contractor an opportunity for a rebuttal.
Construction Audits May Go Back Eight Years
The usual audit period for most EDD industry examinations, is twelve (12) payroll tax quarters. This covers a basic three (3) year audit period. However when it comes to the construction industry, as well as the food service industry, I have seen audits go back as far as eight (8) years. Audits going beyond the basic 3 year period are usually the result of an employer who has not filed quarterly payroll tax returns. For example, I recently completed an audit of a general construction contractor whose business started out as a sole proprietorship and eventually became a corporation. After a 3 year audit of the corporation was conducted, the auditor found “some irregularities” with the sole proprietorship. This caused the auditor to go back to the very beginning of the business – 8 years. This extensive audit resulted in an assessment against the corporation and another assessment against the proprietorship. I have also counseled other practioners whose construction clients were also subject to audits going beyond the basic 3 year period. It seems that audit expansions are more common in the construction industry.
In Part 2, I will discuss specific examples of how EDD auditors conduct examinations of construction industry employers and how these examinations are sloppy and are always tilted against the contractor with punitive penalties to boot. We will see how some auditors fail to take into account payments for non-compensation such as no allowances for materials, supplies, rental expenses, etc. We will also look at how the EDD contacts workers and subcontractors to verify the truth of what general construction contractors tell them. We will also look at how tough the EDD can be when it comes to assessing penalties.
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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