Companies Battling High Payroll Taxes Must Still Play by the Book

Payroll taxes are rising in California and other states where debt taken on during the Covid-19 pandemic is affecting businesses that have had an increase in payroll taxes per employee.

Some companies may be tempted to pay employees in cash. And while doing so isn’t illegal, risks arise when a business uses cash payroll to avoid withholding, payroll tax deposits, 1099 reporting, Forms W-2, worker classification rules, or employment tax filings. For California businesses, the takeaway is that cash wages still must be documented, reported, classified correctly, and included in required federal and California payroll tax deposits and wage filings.

A cash wage paid to an employee remains wages for tax purposes. IRS Publication 15-A states that an employer generally must withhold federal income taxes, withhold and pay over Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee.

California adds another layer. The Employment Development Department, or EDD, administers four state payroll taxes. The unemployment insurance and employment training taxes are employer contributions, and the state disability insurance and personal income taxes are withheld from employees’ wages. Wages are generally subject to all four state payroll taxes unless a specific exclusion applies.

This means a restaurant, construction company, salon, retailer, home-service business, or professional office can’t solve payroll costs by keeping workers off the books. Once the government identifies cash payroll, the case can expand quickly.

The IRS may reconstruct wages, assess employment taxes, review income tax deductions, and investigate responsible persons. EDD may assess unpaid withholding for the four payroll taxes, penalties, and interest.

If the facts show concealment, false tax returns, payroll pyramiding, or repeated use of cash wages to evade employment taxes, the matter can move from civil audit exposure to a criminal tax investigation and prosecution.

Off-Book Workers

Cash payroll cases rarely depend on a single criminal employment tax admission. Auditors compare:

• Payroll returns
• Forms W-2 and 1099
• Bank withdrawals
• Cash logs
• Point-of-sale records
• Job schedules
• Timecards
• Text messages
• Subcontractor ledgers
• Insurance records
• Workers’ compensation files
• General ledgers
• Income tax returns

A business that reports low payroll but shows high labor-related revenue, large cash withdrawals, inconsistent gross margins, unexplained “contract labor,” or workers appearing on schedules but not payroll records gives auditors and criminal tax investigators a clear roadmap.

Tax audits by EDD often focus on whether workers were properly treated as employees or independent contractors. If a business calls workers “helpers,” “day labor,” “casual labor,” or “1099 workers,” that label doesn’t control—the actual relationship controls. EDD looks at the facts of the working relationship, including control, independence, and whether the worker is performing work as part of the business.

EDD may reclassify them as employees and assess back payroll taxes. IRS employment tax auditors can examine the same worker facts under federal standards.

The audit risk becomes more serious when cash payroll links to other tax issues. A business may deduct cash wages without issuing Forms W-2 or Forms 1099, fail to report cash sales used to pay workers, or claim labor costs on the income tax return while reporting no corresponding payroll tax filings. It may pay workers from unreported receipts.

Those patterns can arouse suspicion that the business used off-the-books payroll to underreport income and evade employment taxes.

Payroll Tax Assessments

Civil payroll tax assessments can be severe even in the absence of a criminal case. At the federal level, employment tax exposure can include unpaid income tax withholding, employee and employer Social Security and Medicare taxes, Federal Unemployment Tax Act tax, deposit penalties, failure-to-file penalties, failure-to-pay penalties, interest, and corrected wage reporting.

California tax exposure also can be substantial. When off-the-books payroll spans several quarters or years, EDD can assess unpaid contributions, withholding, penalties, and interest across multiple reporting periods.

Most payroll tax cases start as civil matters, but off-the-books workers create facts that criminal tax prosecutors understand well. Red flags include:

• Paying workers in envelopes
• Keeping two sets of payroll records
• Using cash sales to pay wages
• Filing false Forms 941
• Failing to issue Forms W-2
• Disguising employee wages as subcontractor payments
• Creating false invoices
• Paying workers through another person’s account
• Continuing the pattern after a prior warning from a CPA, payroll company, EDD, or IRS representative

If the cash workers don’t have legal status to work in the US, the civil and criminal exposure is exponentially worse.

The primary federal criminal payroll tax statute is U.S.C. Section 7202. IRS criminal materials identify the elements as a duty to collect, truthfully account for, and pay over tax; a failure to collect or truthfully account for and pay over the tax; and willfulness.

The IRS also explains that the duty to truthfully account for and pay over tax is an inseparable dual obligation, so filing a return without paying doesn’t fully satisfy the duty. Section 7202 is a felony statute and can expose a convicted taxpayer to imprisonment, fines, and prosecution costs.

California also has criminal payroll tax provisions. EDD’s penalty chart includes fraud or intent-to-evade penalties equal to 50% of the assessed contributions in certain cases, and additional penalties for failing to provide information returns to workers.

California Unemployment Insurance Code Sections 2117 and 2117.5 create criminal exposure for false or fraudulent payroll tax information and willful failures involving intent to evade tax. A payroll tax problem can therefore create parallel consequences at the federal and state levels in California.

A criminal payroll tax case can lead to various consequences, including:

• Indictment
• Arrest
• Public filings
• Devastating legal fees
• Restitution
• Probation
• Incarceration
• Professional licensing consequences
• Immigration complications
• Loss of banking relationships
• Reputational ruin
• Permanent damage to a family business

Employers should never try to “clean up” cash payroll by backdating records, inventing worker invoices, deleting messages, changing time records, or pressuring workers to support a false story. Once a business identifies off-the-books payroll, it should preserve records, determine the payroll tax exposure, and address the issue before auditors develop the facts first.

The longer cash payroll continues, the harder it becomes to frame the problem as a correctable compliance failure rather than intentional tax evasion.

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

Author Information

David Klasing is founder and managing partner of the Tax Law Offices of David W. Klasing in Irvine, Calif.

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