Ask The EDD Attorney – The Danger In Presenting False Documents In EDD And IRS Audits

By Robert S. Schriebman
February 3, 2015

Introduction

On February 3, 2015, the IRS published a news release discussing the dangers of filing fake documents to hide income or overstated expenses. On the same day, the U.S. Tax Court imposed strict civil fraud penalties on a tax return preparer who submitted a number of false 1099 forms none of which was prepared by the banks named on those forms. The Tax Court found “badges of fraud” committed by the tax return preparer including under reporting of income, overstating deductions, and the filing of false documents, including false tax returns. The Court imposed stiff civil fraud penalties to be discussed below. See Y.K. Young, TC Memo, 2015-18, Dec. 60,223(M).

The concurrent release of the IRS Bulletin and the Tax Court’s Young decision held a message to anyone contemplating the risk of submitting false documents or the backdating of various documents in both IRS and EDD audits. Therefore, this article will discuss the fraud penalties assessed by both the IRS and EDD and will discuss my recent experiences with clients candidly asking me what the risks are in doing so. I will also discuss how it is perfectly proper to prepare “reconstructions” of past events that may be acceptable to both IRS and EDD auditors.

IRS and EDD Civil Fraud Penalties

Both the IRS and EDD have very stiff civil fraud penalties. As bad as the IRS penalty is the EDD version is worse. Internal Revenue Code § 6663(a) imposes the civil fraud penalty. The statute is short and to the point: If any part of any underpayment of tax . . . is due to fraud, there shall be add to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud. Section 6663(b) states that if the IRS finds any portion attributable to fraud the entire underpayment will be subjected to the fraud penalty unless the taxpayer can prove those portions of the underpayment not fraudulent. See IRC § 6663(c).

The EDD has two fraud penalties that are set forth in CUIC § 1128. Section 1128(a) imposes an initial 50 percent penalty and § 1128(b) imposes and second 50 percent penalty. In most EDD fraud cases that have crossed my desk the EDD has assessed both fraud penalties.

Remember, the EDD shares information with the IRS. This can result in a devastating penalty nightmare of almost 200 percent of deficiencies subject to fraud penalties. Of course, this does not include the cost of representation to fight these penalties. Once these penalties have been assessed and not removed, a taxpayer can have a negative history with the EDD and IRS.

Whenever a client asks me what the odds are of getting caught in a fraud penalty situation I tell my client that if he or she gets caught the odds are 100 percent!

Common Fraudulent Documents in an EDD Audit

Officers or shareholders of small business corporations often do not keep adequate records when it comes to taking money out of the business. Sometimes these people are ill advised. A few years ago, I had a case where a client took out close to $1 million from her small corporation. She was the sole shareholder. She was advised by her then accountant that she could take money out as ‘draws’ and treat them as loans from the company. Usually loan proceeds are not taxable income; they are not taxable wages. My client never took a salary. She did not report any of these “loans” as salary and wages. Recently, another client gave money to her boyfriend through the company. He was not an employee. The boyfriend did not report any of these funds as income. No W-2 or 1099 was issued to the boyfriend.

If monies are borrowed from a small corporation there must be adequate documentation to prove that a bonafide loan was being made. There must be corporate minutes authorizing the loan and a legally drawn promissory note. There should also be a record of the repayment of these loans through cancelled checks issued to the company by the borrower.

In both of the above examples each client, now in the process of being audited, asked me if they could back date the required documentation. They planned to go online, find the forms, and backdate them to the years 2012 and 2013, when the money was taken out of each company. I explained the risks of the civil fraud penalties as well as the risk of criminal prosecution.

Clients wishing to prove that the worker was an independent contractor want to backdate a written contract between the worker and the company. This practice must be discouraged. It gets two parties in trouble – the employer and the worker. Both are now engaged in fraud. The existence of a written independent contractor agreement has little impact on most EDD auditors even when that agreement was accurately dated.

Legally “Backdating” Documents

During an audit it is permissible to prepare reconstructions of past events such as a mileage log for deductible travel and entertainment expenses. It is also permissible to prepare reconstruction of entertainment expenses reflecting the date of the expense and the business purpose of the expenditure. However, the reconstruction must be clearly labeled as such, i.e. RECONSTRUCTION FOR AUDIT PURPOSES. This tells the auditor that you are not trying to pull the wool over the auditor’s eyes by trying to pass off a back-dated document as one having been prepared concurrently with the event.

Conclusion

Both the IRS news release and the Tax Court’s Young decision make it very clear that you can get into serious trouble by preparing phony 1099s, W-2s, or loan documents. This is distinguished from a legal and appropriate reconstruction as long as the compellation clearly states that it is a reconstruction for audit purposes.

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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 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.

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 Scriebman 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.