Individuals are not the only taxpayers who should fear being audited. The Internal Revenue Service (IRS) also audits business entities, including corporations and limited liability companies (LLCs). Further, the IRS communicates information with state tax authorities, such as the California Employment Development Department (EDD), which may lead to a secondary audit. In many cases, tax audits of business entities stem from issues with payroll taxes, alternately known as “FICA taxes” – a reference to the Federal Insurance Contributions Act – or simply “employment taxes.” Therefore, if you own a small business in California, you must take precautions to avoid making errors that could trigger a payroll tax audit. As our California employment tax audit attorneys explain, an audit can result in debilitating penalties – and potentially, the financial death of your business.
How to Determine Payroll Audit Risk in California
Payroll audits often begin with something that looks civil, not criminal. The IRS and California agencies frequently focus on worker classification, cash wages, wage base errors, fringe benefits, and mismatches between payroll tax filings and underlying payroll systems. In California, the Employment Development Department (EDD) audits employers to verify that they correctly reported wages and payroll taxes and properly classified workers. The EDD typically starts with a test year and expands the audit period when it finds discrepancies in that year, or when records appear incomplete.
You should treat specific patterns as higher-risk because they often lead auditors to dig for criminal employment tax intent. Heavy cash use, paying workers in cash without proper wage reporting, and classification practices that do not align with the facts commonly intensify scrutiny. The same holds true when auditors see payroll systems that do not reconcile to bank activity, or when the employer cannot produce clean source records and tries to backfill documentation late in the process. When auditors shift from verifying numbers to probing control, knowledge, and decision-making authority, they often lay the groundwork for individual liability and, in the wrong fact pattern, criminal tax referral.
Why Was My Small Business Chosen for a Payroll Tax Audit?
Payroll tax audits rarely stay confined to arithmetic. Employment tax examinations can cover a full calendar year, which places all four quarterly payroll tax returns in scope, and the scope can expand further if the examiner identifies systemic issues. Because Form 941 reporting ties directly to withheld federal income tax and Social Security and Medicare taxes, payroll records give the government a high-resolution map of what the business paid, withheld, and should have deposited. When the IRS concludes that the business failed to remit trust fund taxes, it can pursue the Trust Fund Recovery Penalty (TFRP) against individuals, not just the entity. That structure makes payroll audits uniquely personal for owners, officers, controllers, and anyone who exercises authority over disbursements.
As our tax audit lawyers mentioned a moment ago, many business audits are rooted in payroll tax errors: for example, the failure to file Form 941 (Employer’s Quarterly Federal Tax Return), which is used to report, among other information:
- The amount your employees received in wages, tips, and other compensation
- The amount of federal income tax withheld from employee wages, tips, and other compensation
- Adjustments for sick pay, tips, fractions of cents, and group-term life insurance (and total taxes thereafter)
- The total balance due to the IRS
While missing documents or financial discrepancies are virtually guaranteed to attract government attention, it is not always the IRS which initiates an audit. It is not uncommon for payroll tax audits to be triggered by the company’s own workers, who may file complaints should they encounter difficulties with self-employment taxes. For instance, such a worker might file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding).
Why might this occur? Usually, because the business has misclassified the worker as an “independent contractor,” when in fact, he or she should have been classified as an “employee.” Depending on how the business owner responds when questioned about Form SS-8, the matter can escalate from a need for clarification into a full-scale audit of the entity. The most common manner in which a payroll tax audit gets started in California is when an independent contractor files an unemployment claim arguing that they were improperly classified as an independent contractor and in reality, they were an employee.
When Are Workers Classified as Employees vs. Independent Contractors in CA?
If you regularly visit our tax law blog, you may recall an article we published back in May, shortly after the California Supreme Court delivered a ruling which crystallized previously vague guidelines for worker classification. In case you don’t have time to reread the entire article, we will provide a brief overview to refresh your memory.
Before the ruling, Dynamex Operations v. Superior Court (2018), the IRS looked at three basic questions to confirm whether workers had been classified appropriately:
- Was the worker under “behavioral control,” e.g. restricted to wearing uniforms?
- Was the worker under “financial control,” e.g. reimbursed for work-related purchases?
- Did the worker and employer have a relationship that suggested long-term, ongoing employment?
Finding these criteria insufficiently precise, the California Supreme Court held that employers would have to meet stricter, clearer standards when attempting to justify their worker classification determinations. These standards are that:
- The worker is not under “control [or] direction of the hirer.”
- The work performed is “outside the usual [scope] of the hiring entity’s business.”
- The worker consistently performs the type of work (e.g. cleaning, plumbing) that he or she performed for the business in question.
If your workers meet these criteria, they should be classified as independent contractors. Otherwise, they should receive “employee” designations. Failure to classify employees as such – a common tactic for avoiding payroll taxes, such as Social Security and Medicare taxes – can lead to complaints against your business. In turn, these complaints can trigger dangerous employment tax audits.
IRS Payroll (FICA) Tax Penalties
Unfortunately for the entities chosen to undergo a payroll tax audit, the IRS can impose numerous penalties – not to mention calculate costly interest – if noncompliance is uncovered. These penalties include, but are not limited to, the following:
- 26 U.S. Code § 6651 (failure to file tax return or to pay tax) – Penalties can be as great as 25%, depending on how long such failure persists and whether the taxpayer can prove that he or she had “reasonable cause” (as opposed to engaging in “willful neglect”).
- 26 U.S. Code § 6656 (failure to make deposit of taxes) – Penalties range anywhere from 2% to 15%, depending on the duration of such failure and the dates on which the entity received various IRS notices.
- 26 U.S. Code § 6662 (imposition of accuracy-related penalty on underpayments) – In accordance with 26 U.S. Code § 6662(a), “[T]here shall be added to the tax an amount equal to 20% of the portion of the underpayment” in question. This includes underpayments related to negligence, substantial understatements of income tax, and undisclosed foreign assets, such as unreported foreign bank accounts that required the taxpayer to file an FBAR (Foreign Bank Account Reporting).
How Payroll Issues Become Personal, and How Civil Exposure Can Turn Criminal
The civil enforcement engine in payroll matters often starts with the Trust Fund Recovery Penalty. The IRS can assess the TFRP against any responsible person who willfully fails to collect, account for, and pay over trust fund taxes. The IRS can treat a wide range of individuals as responsible persons if they have the duty and power to direct the collection, accounting for, or payment of trust fund taxes. The IRS also defines willfulness in a way that captures more than a deliberate plan to cheat. It treats willfulness as awareness (or constructive awareness) of unpaid taxes coupled with intentional disregard or plain indifference, and it flags explicitly paying other creditors with available funds while leaving trust fund taxes unpaid as an indicator of willfulness. The IRS calculates the TFRP as the unpaid trust fund tax, meaning the withheld income taxes plus the employee portion of FICA.
Criminal tax exposure arises when the government frames the conduct as willful failure to collect, account for, or pay over tax. Section 7202 makes that conduct a felony, and the statute provides for up to 5 years’ imprisonment and a fine of up to $10,000, plus prosecution costs. In addition, 18 U.S.C. § 3571 (the general federal fine statute) can authorize higher maximum penalties, including up to $250,000 for individuals and $500,000 for organizations, for felony offenses such as 26 U.S.C. § 7202. In practical terms, the government often develops civil payroll cases first, including responsibility and willfulness analysis, and then evaluates criminal statutes if facts show deliberate noncompliance, concealment, or diversion of trust fund money.
You should also treat payroll tax issues as potential criminal tax issues earlier than you would in an income tax audit. The government can view unpaid trust fund taxes as more than a delinquency because employees never control those withholdings, and the law treats them as trust fund taxes held for the government. When facts suggest willfulness or affirmative deception, the government can easily move beyond civil tools like assessments and liens and consider criminal statutes that target employment tax misconduct. A payroll audit, therefore, creates a dual-track risk profile, civil exposure that can reach personal assets through the TFRP, and criminal exposure if the government frames the conduct as willful nonpayment, concealment, or false records.
Why Dual-Licensed Attorney-CPAs Materially Reduce Payroll Audit Risk
Payroll tax audits live at the intersection of accounting mechanics and criminal tax intent. You need a team that can reconstruct payroll facts with precision while managing the legal risk that auditors can attach to statements, records, and “explanations.” Attorney-client privilege and attorney work-product protections can materially change how you gather facts, frame responses, and limit unnecessary self-inflicted damage. A CPA-only relationship does not give you attorney-client privilege, and Congress only granted a limited confidentiality privilege for certain tax-advice communications with federally authorized tax practitioners in noncriminal IRS matters and noncriminal federal tax proceedings. Once criminal exposure enters the picture, you should assume that privilege gaps can hurt you if you treat technical payroll work as purely accounting support.
Dual-licensed Tax Attorney-CPAs can run the matter as legal defense first and technical reconstruction second, without forcing you to choose between a legal strategy and accurate payroll analytics. That approach matters most when the government starts assessing personal responsibility, willfulness, and credibility. The defense must control who speaks, what gets produced, and how the record explains discrepancies, while maintaining strict integrity. You must never alter, destroy, or “clean up” records. You should also avoid informal interviews and casual narratives that auditors later treat as admissions. A properly structured defense can often narrow the audit scope, correct errors without creating intent evidence, and position the case for administrative resolution rather than referral.
This coordinated approach also matters in California, because the EDD can verify UI, SDI, ETT, and state withholding reporting through its payroll verification methods, and audit findings can trigger cascading exposure across agencies. If you operate in California, you should align federal and state positions closely and early, as inconsistencies can damage credibility and increase risk.
Contact the Tax Law Offices of David W. Klasing if You Require Dual-Licensed Attorney-CPAs for Payroll Audits
Contact the Tax Law Offices of David W. Klasing if an IRS or California EDD payroll audit places your business, and you personally, at risk. Payroll audits can quickly shift from payroll mechanics into intent-focused scrutiny, including who controlled disbursements, why deposits fell short, and whether the government can frame the facts as willful. Our firm guides businesses through employment tax audits and other tax enforcement actions by the IRS and EDD, and we are experienced in working with both state and federal auditors to navigate the demands and pressure points that these audits create.
You should also call us when you want a unified defense that integrates legal strategy with payroll and accounting analysis from day one. David W. Klasing holds dual California licenses as an Attorney and a CPA and has the added advantage of having earned a master’s in taxation. That dual-licensed capability matters in payroll audits because you must get the numbers right while you also protect against avoidable admissions, unmanaged document production, and a record that the government can later characterize as deceptive.
If you want an objective starting point, you can verify the firm’s credibility markers and then act quickly before the audit record hardens. The Better Business Bureau gives the Tax Law Offices of David W. Klasing an A+ rating, and Avvo lists David W. Klasing with a 10.0 rating. Schedule a confidential, reduced-rate initial phone consultation by calling (800) 681-1295 or by using our online scheduling and contact options HERE.
