California and Federal Employment Tax Audit

California 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 can also 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 Brazil. 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 and both mature and emerging markets. However, 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 and owing or is otherwise appropriate to do so.

Why Does A Taxpayer Face an Employment Tax Audit?

Businesses and corporations may face an audit due to random chance or because their time for an audit has come. However, certain improprieties or issues in the business’s accounting or handling of payroll land 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 a tax audit or exacerbate the consequences of an audit include:

  • Misclassification of workers – Some companies want to save on employee costs by misclassifying employees as independent contractors. While businesses in some states may manage to avoid detection, it is a high risk to take.  If the matter is not corrected before the company is selected for audit, the consequences are severe.
  • Excessive use of cash in the business– Some industries rely more so on cash transactions than others. However the IRS and EDD recognize that cash is 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.
  • 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.
  • 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. For instance, individuals who embezzle funds from their company 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 in itself.

These are a few of the issues the IRS and/or EDD will attempt to detect during an audit. Business owners who use these and other practices to under report income or understate their payroll tax quickly become targets for EDD. Business owners who attempt to churn through corporate entities to avoid payroll tax face a risk of criminal prosecution.

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. The EDD typically requires an in-person meeting where they will take a tour of the business facilities. 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.

Unfortunately, the audit process seems to be taking longer in recent years. An audit by EDD or the IRS can take one year or longer. Even more troubling is that, if a deficiency is eventually and 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 audit. We work to protect your rights during any employment tax audit or other tax enforcement action.

california employment tax auditWhat Records are required for a California or Federal Employment Tax Audit?

A California or IRS employment tax audit will typically begin with an in-person tour and interview of the facility by the auditing agent. 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. He or she will use anything he or she noticed that doesn’t square with your records to justify further inquiry. However, the auditor will soon likely request the business owner to produce certain records.

Typically, the audit will first focus on a test year that is often the most recently completed calendar year. If problems or discrepancies are detected, the audit can extend for an additional two year for a three-year audit period. However, audits can extend for longer periods of time when records are incomplete or missing. While the EDD and IRS realizes that the sophistication of record-keeping systems can vary, California does provide for 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 such as W-2s, W-4s, DE-9s, DE-7s, DE-4 and other documents. Business owners who fail to keep required and other documents, at minimum, 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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