What Small Business Owners Should Know About California and Federal Payroll Tax Audits

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.  

Why Was My Small Business Chosen for a Payroll Tax Audit?  

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:  

  1. Was the worker under “behavioral control,” e.g. restricted to wearing uniforms?  
  1. Was the worker under “financial control,” e.g. reimbursed for work-related purchases? 
  1. 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:  

  1. The worker is not under “control [or] direction of the hirer.”  
  1. The work performed is “outside the usual [scope] of the hiring entity’s business.”  
  1. 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).  

California FTB, EDD and IRS Employment Tax Audit Attorneys Representing Business Owners 

Regardless of whether worker misclassification is a factor, an employer’s failure to withhold, deposit, and/or match employment taxes can result in an FTB, EDD or IRS tax audit – and with it, costly consequences for the entity or business owner. Due to the tremendous risks involved, skilled representation is in you and your company’s best interests.  

Whether you need assistance proving that your workers were properly classified because your business is facing a worker classification audit, require an experienced IRS tax attorney to coach and protect you throughout the audit process, or want to hire aggressive IRS appeals representation to resolve the controversy through tax litigation, the California employment tax lawyers at the Tax Law Office of David W. Klasing provide the full suite of services to meet the most complex tax and legal needs. To arrange a reduced-rate consultation, contact our offices online, or call (800) 681-1295 to get started. 

Also, we’ve expanded our offices! In addition to our offices in Irvine and Los Angeles, the Tax Law Offices of David W. Klasing now have offices San Bernardino, Santa Barbara,Panorama City,Oxnard, San Diego,Bakersfield,San Jose, San Francisco, Oakland  and Sacramento. 

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