California and Federal Employment Tax Audit

Businesses in California and throughout the United States are fortunate to do business in the largest and most prosperous national economy in the world.

Companies and corporations located in California are particularly well-situated because they also can directly engage in the burgeoning Chinese and Asian economies. The California economy is larger than the total combined economic output of nations like Italy and Russia. When one also accounts for the national economy and accessible foreign markets, businesses in California have significant markets in which to engage.

Businesses in the United States and in California are lucky to have access to ample infrastructure in both mature and emerging markets, but there are costs to maintain the transportation and trade networks, as well as societal needs.

As such, businesses in California and throughout the United States are obligated to collect and pay taxes. While some taxes, such as income taxes, are direct in nature, other taxes are levied indirectly. For instance, employment and payroll taxes are accounted for, held, and turned over by an employer. Whether it is a federal or state employment tax obligation, the employer has a duty to hold that money in trust for the government and to turn it over when it becomes due.

Why Does A Taxpayer Face an Employment Tax Audit?

Businesses and corporations may face an audit due to random chance or because of perceived deficiencies or errors in their employment tax filings. Additionally, certain improprieties or issues in the accounting or handling of payroll and employment taxes can increase the likelihood of a business facing an employment tax or payroll tax audit by either the IRS or by the California Employment Development Department.

Issues that can increase the odds for facing an employment tax audit or exacerbate the consequences of such an audit include:

  • Misclassification of workers – Some companies want to save on employee costs by misclassifying employees as independent contractors. This represents a significant risk. If the matter is not corrected before the company is selected for audit, the consequences can be severe enough to drive a business into bankruptcy where a large labor force or several years of noncompliance are concerned.
  • Excessive use of cash in the business accompanied with paying employees or subcontractors in cash – Some industries rely on cash transactions more than others. However, the IRS and EDD recognize that working primarily in cash creates situations that are more prone to abuse, concealment, and other wrongdoing. Thus, businesses that rely heavily on cash – even legitimately – face higher odds of an employment tax audit. The combination of paying employees or subcontractors in cash and then failing to issue W2’s or 1099’s can result in criminal charges for aiding and abetting income tax evasion.
  • Structured transactions – Transactions that are arranged solely for the purposes of circumventing cash reporting laws or to conceal the true character or nature of the transaction can lead to an investigation and audit. Structured transactions are transactions that could be completed in a single transaction but are broken into multiple transactions. Structuring bank transactions so as to avoid cash reporting on greater than $10,000 is a felony.
  • Use of business funds to cover personal expenses – CEOs, managers, and company presidents who lose sight of the line that divides personal assets and expenses from business assets and expenses could be subject to an audit. For instance, individuals who embezzle funds from their company (even if they intend to repay the funds later) or who characterize personal trips as business retreats can face serious charges.
  • Failure to keep sufficient business records – Employment and tax records must be kept by businesses for a certain number of years. If your company is audited, you will need to rely on these records to show your compliance with all employment tax obligations. The failure to keep records is a violation.
  • Pyramiding payroll tax obligations can also result in a payroll tax audit.
  • Repeatedly running up payroll tax liabilities and then walking away from the corporate structure only to repeat the activity in a new corporation can result in a criminal payroll tax investigation.

Business owners who use these and other practices to under report income or to understate payroll tax quickly become targets for the IRS and/or EDD, facing a risk of criminal prosecution.

When the IRS selects a business for a tax audit, the initial communication will occur by postal mail. In fact, some IRS employment audits will be performed completely by mail. However, the IRS will make all of the determinations about how the audit will occur, when it will start, and how long it will take, as the business owner does not have any choice in this matter.

The employer does have the right to select anyone to represent it during this daudit and having a trusted tax professional available to help with this process is highly recommended.

Employment Development Division (EDD) Handles Employment Tax and Payroll Tax Audits in California

While the IRS handles the administration of the federal employment tax obligations, the Employment Development Division handles the state-based employment tax obligation in California. When dealing with the EDD or the IRS for in-person meetings, you can expect to be asked to provide a tour of the business facilities to the tax authorities.

Oftentimes, the IRS or EDD agent will conduct an informal interview with the individual giving the tour, including the individual’s role in the company, the business the company is engaged in, and the markets and places where the company’s goods and services are sold. The audit process truly begins at this stage, as the auditor is detailed oriented and will take note of the scope and scale of your operations.

Unfortunately, the audit process in recent years seems to be taking longer than in the past, perhaps as long as one year or more. Even more troubling is that, if a deficiency is ultimately discovered, interest and penalties will apply.

It is essential that taxpayers remain aware of their rights, including the amount of time the government agency has to perform the audit. As tax professionals, we work to protect your rights during any employment tax audit or other tax enforcement action.

What Records Are Required for a California or Federal Employment Tax Audit?

Soon after the initial meeting, the auditor will likely request the business owner to produce certain records.

Typically, the audit initially will focus on a test year, often the most recently completed calendar year. If problems or discrepancies are detected, the audit will begin considering records for an additional two years, resulting in a three-year audit period. And when records are incomplete or missing, the audit period can extend beyond three years.

While the EDD and IRS realize that the sophistication of record-keeping systems can vary, California does provide a list of minimum required business records as set forth by Sections 1085 and 1092 of the CUIC. These records include:

  • Annual financial statements
  • Ledgers
  • Check registers
  • Check stubs
  • Bank statements
  • Federal and state income tax returns

However, EDD may also request additional records for payroll purposes, including state and federal tax forms (like W-2s, W-4s, DE-9s, DE-7s, and DE-4s) and other documents. Business owners who fail to keep required documents will extend their audit and cause the auditor to dig deeper into the company finances.

Who to Contact When Facing an Employment Tax Audit

If your business is facing an employment tax audit or another tax enforcement action by the IRS or EDD, the Tax Law Offices of David W. Klasing can work to guide your company through the audit process. We are experienced in working with both state and federal auditors and can successfully navigate the challenges presented by an audit. To schedule a reduced-rate consultation with one of our experienced tax professionals, call 800-681-1295 or contact us online today.

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