Bloomberg Tax
May 16, 2023, 8:45 AM

California Audit Rule Will Cause Headaches for Small Businesses

Allison Soares
Allison Soares
Vanst Law
Lauren Suarez
Lauren Suarez

Taxpayers, business owners, and tax practitioners in California have become intimate with three taxing agencies: the Franchise Tax Board, California Department of Tax and Fee, and Employment Development Department. The most active auditing agency that we see right now on the practitioner side is the EDD, which (at a high level) deals with payroll, disability, and unemployment.

Most business owners, professionals, and tax practitioners who have gone through a California EDD audit over the last 10 years have seen a huge shift in the protection of the employee and the loss rights for an employer. California is one of the strictest states in the nation when it comes to the protection of employees, making it a hard environment for the gig workers and small business owners to survive.

The nation views California as the Golden State but doesn’t feel the restrictions of the sunshine tax that is cast on business owners. There’s been the passage and enactment of AB-5, the lobbying that arose from the passing of AB-5, and the state’s struggle to keep a gig economy thriving and surviving after Covid-19 and because of AB-5.

California once again is throwing business owners for a loop—and in true California fashion, that loop is never ending.

Previously, the standard audit period for businesses was a three-year look back period under the California Unemployment Insurance Code Section 1132. But the audit can be extended up to eight years if the auditor finds “bad conduct.” The EDD defines bad conduct as a failure to file quarterly payroll tax returns without good cause.

Based on that logic, every EDD Notice of Assessment can be made within “eight years after the last day of the month following the close of the calendar quarter during which the contribution liability included in the assessment accrued.”

The eight-year audit rule has popped up in a handful of clearly fraudulent and malicious circumstances. But the state could be overreaching by making the rule a daily staple in the lives of California taxpayers—all due to the EDD’s assertion that it has good cause, which has no true definition within the code.

The rule has been enacted more during the past six months under the guise that the state has reasonable cause to believe the taxpayer should have known that all of its workers were employees. Under the California codes that define reasonable and good cause, there’s no black-and-white definition outlining when a taxpayer has gone beyond those practices of a reasonably prudent business owner. This becomes a slippery slope for business owners and practitioners looking to avoid conflict.

We’ve been told that in the eyes of the EDD, it’s reasonable to extend the audit beyond the three-year period because if the employer has employees now, it had employees eight years ago—regardless of whether the business model or the company’s size was different. Many practitioners have tried fight the eight-year lookback period without success. Most taxpayers don’t want to litigate this issue, so practitioners can only go up so high on the chain of command.

Business owners often only have detailed records going back three to six years, which makes the longer auditing period more difficult. If an auditor wants to expand the lookback period, the taxpayer’s desire to battle the issue, funds available, type of business, record keeping, and flexibility of the location and office will dictate how long the fight will last. Whereas some members of the business world may have success in limiting their audits, others will be in for a loss from the start.

Having all workers on payroll is the easiest way to limit liability in any EDD audit regardless of their seasonality, type of work, or duration. Even if after reading AB-5, a business owner realizes an employee is an independent contractor, the EDD will force employers to jump through hoops to prove that they are in fact independent.

Now that the audits are becoming extended past the three-year look back period, the possibilities are endless for what the EDD can assess on employers. And of course, there’s no definition among the code limiting the EDD to expand its search.

California is becoming the eight-year wild west of taxes and audits. Another way to limit liability is, of course, to move to a state with no sunshine tax and that is more employer friendly—so we’d recommend eager employers start looking to see what the average snowfall is in those states ASAP.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Allison Soares is a tax attorney at Vanst Law LLP who focuses on audits, collections, appeals, international disclosures, and all other tax problems.

Lauren Suarez is an attorney at RJS Law who has been practicing tax law for almost 10 years. She has a wide array of knowledge in federal and state tax controversy matters.

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