How to Prepare for an Employment Tax Audit in California
The lead-up to an employment tax audit can be one of the most stressful times for a business owner. To avoid legal missteps, it is important to gain a thorough understanding of what such an audit entails.
In this feature, experienced employment lawyer Elnaz Masoom provides an outline of the process involved in an employment tax audit by California’s EDD, what business owners should expect, and what steps should be taken in the aftermath.
This article covers the general process and important issues that we see come up in the course of California’s Employment Development Department tax audits, with a focus on the employment misclassification audits of businesses that utilise the services of independent contractors. Substantive legal analysis of California’s independent contractor laws is not part of this content.
A General Overview of an Audit by the EDD in California
The EDD audit process will always begin with a notice from the EDD. Oftentimes, this notice will come along with a list of documents or information being requested, a questionnaire, and a general description of the audit process. Following this initial communication, the EDD will set up a visit or a phone call to discuss the documents produced and ask follow-up questions. Once the auditor reviews the available records, the auditor will provide you with a Proposed Notice of Assessment either verbally or in writing, followed by the Notice of Assessment setting forth the findings and your liability assessment. If you are assessed back taxes or penalties, you will also be notified of your right to appeal the EDD’s determinations and assessments.
The Joint Enforcement Strike Force (JESF) is the Major Source of Audits
Random audits are rare. Occasionally, audits are triggered when a former 1099 contractor applies for unemployment benefits with the Employment Development Department (EDD) or by the late payment of payroll taxes. Notably, the most significant source of audits is the Joint Enforcement Strike Force (JESF). Led by the EDD, the JESF is a coalition of California state government enforcement agencies, including the Franchise Tax Board (FTB) and the Division of Labor Standards Enforcement (DLSE), that work together and share information to combat what is known as the “underground economy.” The JESF has procedures for reporting underground operations to the EDD for investigation, often resulting in EDD audits.
Random audits are rare.
The EDD’s Inspection Powers Are Limited by “Relevance”
The law allowing for the inspection of an employer’s books and records gives the EDD the right to inspect “ordinary and necessary” records relating to workers, whether these workers are employees or outside contractors. [i]
Intrusive audits can easily get out of hand — this can occur if you deal with an inexperienced auditor who goes into a phishing expedition not necessarily with a clear purpose but to see what might be discovered. Other times, the auditor insists on inspecting each and every document listed on the EDD’s Minimum Required Records list, even when they are not relevant to the audit, or are duplicative of other requests[ii]. As interpreted by the US Supreme Court and the California Supreme Court, the information sought must be “reasonably relevant to the intended investigation.”[iii]
Notably, the usual statute of limitations for EDD audits is three years, but on certain occasions may be extended up to eight years if the auditor finds “bad conduct” on behalf of the business. This bad conduct is identified as failing to pay payroll taxes on time without good cause. In the case of fraud or investigation for evading taxes, there is no statute of limitations.
Employers Are Entitled to an Objective Audit
For years, improper audit techniques on the part of EDD have resulted in misclassification findings while creating chaos for businesses. It is the responsibility of the auditor to take a proper representative sample of workers and their functions before considering reclassifying an entire group of workers as employees rather than independent contractors. When an inadequate sampling is conducted, reclassification is improper and lacks support.
If the auditor did not go far enough in taking a representative sample or there is no sampling at all, more interviews and diligence is warranted by the auditor under the employer’s Bill of Rights. [iv]
What to Expect During the 30 Days Post Audit
Depending on the outcome of your EDD audit, the aftermath will vary. The auditor may find violations, underpayments, or an overpayment of taxes. A determination of underpayment of taxes will warrant your business to pay overdue taxes with interest and penalties. Payment will be due 30 days from when the assessment is finalised; otherwise, a penalty will be added. The taxpayer’s appeal rights are limited and time-sensitive, so the 30 days post-audit are crucial. Within 30 days from the Notice of Assessment, you must either pay the amount fined or file an appeal. Any negative findings of the EDD can have serious repercussions for the future of your business.
Even if you can “afford” the penalties, you may have to change how your business operates. Aside from the penalties that will accompany the EDD’s determination, the way your business operates will need some serious revisions. Changing the way your business operates comes in conjunction with abiding by a whole new set of laws and regulations that you did not have to previously follow.
We have seen over the years that these changes are not easy to implement as they include an analysis of various wage and hour laws and management practices. Plus, most legitimate contractors maintain significant control over how and when they perform their tasks, negotiate mutually agreeable contract terms, are free to complete work without control by another, and would not agree to any other type of business arrangement.
Why Do You Need Legal Counsel by Your Side?
During an EDD audit, consulting with legal counsel will provide you with a better idea of your company’s rights and facilitate communication with the EDD. Legal counsel will also help you build a solid case defending your business practices, as audits can be fast-paced and have serious consequences. Competent legal counsel can spot inadequate audit methods and fight the auditor’s unreasonable expectations. This is probably the most crucial reason to have proper legal advice and representation to protect your business model, which you may be forced to change as a result of an audit. Finally, legal advice is key during the transition from the contractor to an employee model.
Elnaz Masoom, Managing Attorney
1625 The Alameda, Suite 700, San Jose, CA 95126
Tel: +1 408-599-3191
About Elnaz Masoom
Elnaz Masoom is the founder and managing attorney of Masoom Law PC, an employment and litigation law firm based in San Jose, California. Elnaz has practiced employment and business law exclusively since 2010 and has assisted organisations across a multitude of different fields and with widely varied business strategies, cultures and product offerings. With an interdisciplinary understanding of business organisation, management practices and labour laws, Elnaz has successfully represented businesses and employers during employment tax audits up to and including administrative hearings and appeals.
[i] See CUIC §§ 1085, 1092.
[ii] See EDD Publication DE 231 TA.
[iii] See 1980 Younger v. Jensen, 26 Cal 3rd 397; see also US. V Powell (1964) 379 US 48.