California Tax Reporting and Controversy
Janathan Allen discusses 3 of the primary California tax agencies: Franchise Tax Board (FTB), the Employment Development Department (EDD) and the California Department of Tax and Fee Administration (CDTFA).
In this overview of California taxation, Episode 10 – California Tax Reporting and Controversy discusses all forms of tax including personal and business tax returns, payroll audits as well as sales and use taxes. The discussion centers in on the process of an audit, the efforts of the EDD to identify employee misclassification and the impact of California taxation on internet transactions in the state.
Jan
Welcome to AB cast integrating legal tax accounting and business solutions. I’m Janathan Allen. This podcast Is about California tax reporting and controversy.
Neil
So Jan let’s have an opening conversation about California tax reporting and associated controversies. When we talk about California tax, what are the three major California tax authorities? And what areas do they manage?
Jan
Well, the three major tax authorities in California would be the Franchise Tax Board. And it’s devoted primarily to income tax, both personal and corporate. So anything that has to do with income tax, trusts and estates, individuals, corporations, LLCs, whatever the tax compliance and the tax controversy work is done primarily by the Franchise Tax Board. The next corporate tax authority, most people would be familiar with is probably the EDD or the Employment Development Department. And that handles the majority of payroll taxes, which of course includes unemployment insurance, employment, earnings, tax, state, disability, and anything that has payroll or payroll tax related issues. The third one is the in acronym is CDTFA. And that stands for the California Department of Tax and Fee Administration. And it handles the ancillary miscellaneous taxes such as sales use fuel tax, tobacco, alcohol tax cannabis, and the other excise types taxes that we find ourselves subjected to here in California.
Neil
So let’s start with the FTB. It’s probably one of the most common that Californian’s interface with. You’ve often told me something that’s a little surprising about the FTB compared to the IRS. Would you share that with our listeners?
Jan
Well, what I can do is I can tell you a story. And when I moved from my home state of Montana to California, I had been doing taxes, federal and state taxes in Montana. And when I came down to California and realized the length and breadth of the tax regulations in California is probably equal to, or more excessive than the federal tax regulations. It gave me the sense that it was more complex, which it is, but it also goes back and it leads into the compliance piece of it. And the fears that most people have about the IRS are really second to those, to the FTB, because the FTB in terms of its compliance is far more aggressive than even the IRS’s. So the compliance in terms of, or the complexity of the tax and the compliance in terms of being in California, I think the more difficult of the two taxing authorities would be that franchise tax board outweighs the feds in, in most instances, in terms of severity and audits and complexity,
Neil
Jan in much the same way that the IRS taxes us citizens on their income worldwide, the FTB takes quite a similar approach, doesn’t it?
Jan
They do. And it’s somewhat surprising. I think to people, for example, those that have earned and worked and put into, for example, pension plans in the state of California, feel that when they move and they’re getting ready to retire and they go to a non-tax state that somehow their pensions and their earnings will not be subject to California tax. And of course that’s not true. I think the other surprising issue that arises that most people don’t know of is if there is a trust that’s created in the state of California, of course it would be taxed here, but I don’t think people understand that if you have a trust that has a fiduciary, in other words, an executor of that particular trust or the executor of that estate, if that fiduciary is in the state of California, then that entity that trust or estate will be taxed in California as well. Hmm.
Neil
So part of the advice and council that we can give to our clients is not only how to structure their personal and professional assets and strategies, but also how they’re managed and executed.
Jan
Absolutely. It becomes part of that transactional plan theme that we concentrate on in terms of putting together the plan for individuals that is most helpful. And of course, the selection of the state, both for living working, and then hence retirement is critically important to that component. So when you put together a transactional plan, the state, how long you live in the state, the taxes that will be subjected to from that state, and then what happens. For example, if you move are all critical components of that type of plan.
Neil
So let’s focus on the tax reporting and controversy side of the equation. And let’s begin with the FTB, the Franchise Tax Board. What do you need to know about managing an FTB audit? What should you do if you receive a notification of an FTB audit?
Jan
The first step that I would take, which I advise all clients to do, regardless of the taxing authority behind the audit is to contact a service provider that really has experience with these types of audits. Whichever one, whichever taxing authority is initiating the audit. And the reason is that there are certain things that are very, very specific to most audits, the request for information, the type of information that’s requested the way in which the information is presented. But most importantly, knowing why it is that the auditor is requesting that information. And the one thing that as a taxpayer you want to avoid is when you are advised of an audit, it generally covers a specific period of time. But once under audit, what the auditors have the ability to do is to extend either in front of you. For example, if the audit is for 2021, they can go into 2022 books or they can go backwards. And the issue is, is that you want to control and you want to contain whatever the issue is. That is being audited. And the reason that you want to do that is you don’t want to open up additional issues coming from other years, that will go back and potentially confuse the ongoing audit from any particular jurisdiction.
Neil
You often talk about people trying to be good people and they wind up bending over backwards and then providing a lot more than they need to. And by doing so they actually harm their own interests.
Jan
That’s right. That’s exactly what happens because it gives the auditor more information than one that they have requested. And two can open up all sorts of other issues that the taxpayer may be totally unaware of.
Neil
Right. The other thing is, you mentioned the auditor has a strategy. They have a plan, right? They’re not just willy-nilly picking audits and going after … they know what they’re going after and they have a goal and they have a number in mind that they’re coming for. So as a tax attorney, and as an experienced tax professional, you have the ability to kind of sniff out where they’re headed and what they’re trying to accomplish.
Jan
Absolutely. That comes from the legal process. Because as an attorney, you always want to know where it is that someone is going. For example, if you’re in litigation and you have opposing counsel, that’s questioning your client, you want to be able to guide them in terms of what it is and where it is that they’re going, the same thing with an audit, you know, what the auditor’s going to, or is going for the issues that could be potentially found or misinterpreted. And what you want to be able to do again, is to contain the types of information, the amount of information that’s given to an auditor, not so that you don’t comply with the regulations and the information that they’ve requested, but really to go back and put a container around how far they can go, either in the future or in the past,
Neil
Jan are most of our clients surprised by the fact that they may not even have to talk to the FTB if we are representing them.
Jan
Yes. The first thing that I advise a client is to sign a power of attorney. And when they sign that power of attorney, what they do is they turn over essentially the communications with the taxing authority to our firm. And the reason that that’s important is because as an attorney that gives my client attorney client privilege. Whereas if you’re working, for example, with an accountant or a CPA, that privilege does not exist, it does exist when you’re working with an attorney. And when you have an attorney representing you with the taxing authorities, they may have a more generalized idea of where it is that the taxing authorities are going to try and look for issues, which may be mitigated by providing certain types of information that will assuage or answer the questions that they have relating to that particular audit issue.
Neil
And then this is not an attempt to disparage any FTB revenue officers or auditors, but I think most taxpayers would be shocked to learn: They’re neither usually an accountant or a tax expert.
Jan
Yes, that’s generally true. I think the issue that I’ve found in my own practice is that most of a lot of the issues that we find coming under audit go directly back to accounting issues. And those accounting issues of course, is the accumulation of data in a standardized format that can then go back and be interpreted because there is that standardization. But for me, whether it’s a corporate or a company audit or an individual audit, most of the time, the underlying issues that come from those audits are issues that are directly related initially with accounting.
Neil
And so what you can do that the taxpayer themselves can’t, and that the auditor can’t even do is to understand the underlying GAAP principles and how things have been done and why, and therefore what the implications are ultimately from a tax perspective.
Jan
Yes, it allows us to do that. It also allows us to go back and be more exploratory in terms of our explanation to that particular revenue officer. I remember one particular instance in that the sole issue of an underlying audit was the computation of cost of good sold and whether or not it was on a cash or an accrual basis. And of course, if you go back and you do the computation on a cash basis, the answer would be different than if it were on an accrual basis. And so that particular audit came down to going back in a simple computation of cost of good sold on either a cash or accrual basis made a difference of tens of thousands of dollars to a client who was being audited because of the issue relating to that cost of good sold computation.
Neil
And if a California taxpayer doesn’t get an outcome they are happy with during the audit, is there an appeal process?
Jan
Yes. As in all audits, there is always an appeal process. The appeal process is very stringent. There are very specific deadlines that you have to go back and ensure that you are in compliance with, but there is always an appeal process under any taxing jurisdictions audit procedures.
Neil
So one of the other pieces of advice I hear you give our clients a lot. And that you’ve given me personally, is it’s not just the knock on the door from the FTB, as soon as they’re finished. The next knock is coming from the IRS
Jan
Generally. Yes, because of the sharing of information between taxing jurisdictions is not only just between, for example, treasury and foreign countries, but treasury goes back and shares information with the state taxing authorities and state tax authorities go back and will share information with the IRS. So for example, if you go through a sales tax audit, and there has been a change in whatever financial statement information that was provided at the state level, then chances are upon the conclusion of that audit. Then the IRS will come knocking at your door as well, because that change whether it increases or decreases income, of course, we’ll go back and affect the federal tax liability as well. So it’s that sharing of information between the state and the feds that goes back and can lead to far more complications because of an audit that’s initiated at the state level will often bring in federal audits as well.
Neil
So when our clients are facing the FTB and you’re representative, that’s one of the thoughts that’s foremost in your mind is I’m not just looking at what’s going to happen here. It’s going to have an impact outside of here as well.
Jan
Absolutely. That’s the one thing that we try to explain to our clients is it’s not just the current audit. It’s what that current audit could go back and lead to as well.
Neil
The EDD the Employment Development Department primarily handles payroll audits. How would you describe a payroll audit Jan?
Jan
Well, payroll audits are quite common here in the state of California. As a matter of fact, most companies will undergo a payroll audit every three years. Hmm. And that payroll audit will go back and it will be from a timeframe that current year and three years passed. So essentially you’re being audited virtually every year on payroll. And what the EDD is looking for is it’s looking for compliance of course, with state withholding. But it’s also looking to ensure that the regulations that surround unemployment and SDI, which is State Disability Insurance, are also being complied with. And of course, that leads directly into the issue of whether or not someone who is working with a company is classified as a worker or as a w two employee.
Neil
Well, now you’ve done it. You’ve opened up a huge can of worms. So there’s a pretty massive change recently in how California presumes workers to be employees in that. If they’re not, then it’s up to the employer to prove otherwise, how has that changed recently?
Jan
Well, a couple of years ago, there was a decision that came out called the Dynamex decision that essentially eliminated the prior test for the determination of whether or not a worker was an employee, or for example, a 1099 worker. And the change was fairly profound prior to the Dynamex decision. There was a series of about 21 elements that you would go back and utilized to assess whether or not a worker fit into an employee category or a 1099 classification with the change due to the decision essentially what’s occurred is that the definition has changed from these 21 elements to a fairly simple test. And the fairly simple test is whether or not the individual that’s working for the company and the fruits of that individual’s labor, isn’t contributing to the overall earning of revenue by the company. And that was a very, very profound change. So if, take, for example, my firm, if I were to have 1099 workers in my firm and they were doing, let’s say accounting, or they were doing payroll or some sort of work that I would go back and subsequently bill a client for, whereas I could utilize a 1099 contractor and they might meet the 21 elements prior to the dynamics decision now because of the type of work that they do, they will be deemed a w two employee because their efforts go back and contribute directly to the revenue earned by our firm.
Neil
So a lot of employers, Jan, I believe just don’t want to believe or accept, or it just doesn’t work with their business model to have employees instead of independent contractors. So how does this blow up on them? How does the EDD become aware that they have 1099 or independent contractors instead of what they should have as employees?
Jan
Well, that’s a fairly simple answer. And the answer is, is that the individual who’s employing a 1099 contractor is required to report that employee as a 1099 contract worker by filing 1099 at the end of the year. So the state has immediate access to information as to whether or not you’re paying someone either as a w two employee or as a 1099 contractor. And it’s generally because of the excessive amount of contractors that can go back and trigger an EDD audit that would be looking for essentially the reclassification of the 1099 workers into employees, or it could be because you had a 1099 employee for whatever reason that employee is terminated. And they go down to the state and request unemployment benefits, 1099 workers are not allowed unemployment benefits because they’re not w two employees. So when a 1099 worker reports to the state that they’ve been terminated, they want unemployment. And they find themselves being classified as a 1099 employee. Oftentimes the state will go back and open up an audit simply because of that inquiry as to unemployment benefits.
Neil
Wow. So the EDD is quite powerful.
Jan
Well, the EDD has yes, indeed it does have a lot of power. I think the most important and critical component for a taxpayer to understand is that it’s important that you structure your business properly. And it’s important that, you know, and understand the classification differences between 1099 contractors and employees and structure your business so that you can avoid these fairly long lengthy compliance issues relating from the reclassification of employees from 1099 workers to employees.
Neil
Sure. And the same conversation we had with the FTB being represented by a tax attorney, as opposed to a CPA or a tax preparer, if you’re going into an EDD audit, it’s going to make night and day difference.
Jan
Yes, the same principles apply because again, you still have the client attorney privilege and the information that flows through between an attorney and the client, and also with the attorney going back and acting as a representative and the communications relating to all aspects of the audit flowing through that individual.
Neil
And Jan, when we were talking about this earlier, I was thinking about the client reviews that I’ve read and the notes that I’ve seen, where they talk about the peace of mind that you’re handling it, it just how the, it takes the whole burden of the process off their shoulders. That’s got to be an important element for our clients.
Jan
I think for most individuals, that would be the case. It’s very, I think there’s a lot of angst that can be created when one talks to a taxing authority, really not understanding the process, really not understanding the issues and really not understanding how it is to respond to the numerous inquiries that they may get. So when that particular task is eliminated and it’s taken over by a professional, that’s done this over and over again. I do think that that gives our clients a peace of mind that others may not have
Neil
I do too. I’ve seen it in their words. So the last major California tax reporting agency we’re going to discuss is the CDTFA and that’s sales tax audits. What businesses need to know about sales tax audits and what are the risks sales tax audits?
Jan
Well, sales tax in general is probably one of the most complex issues relating to tax in California. And that’s because of the classification of the types of items that are for sale in California, the differing tax rates that can go from county and into cities, depending on where the, the product or products are being sold. It’s just a complex area. It’s one that is really easy to sort of gloss over and not think too much about until you get the knock on the door. And it’s the CDTFA agent looking for sales tax information and looking to reclass some of the items that you have that you probably have missed as being subjected to sales tax, simply because of the type of business that you’re running. And I’ll give you an example of that. Oftentimes we have a lot of service providers.
We have individuals that will go back for hair salons, for example, or spas, places where you can go back and you can get individualized products and think shampoos or facial cleansers or whatever. And when you’re in those particular businesses, what ends up happening is oftentimes there will be product that will be used at it’s called the back bar. And so when I go in and I get my hair washed and they use shampoo from the back bar, most business owners don’t realize that the tax on that shampoo is P is still taxed in the state of California under the same rates as a sales tax, because it’s not just sales tax, it’s sales and use tax. So to the extent that you may use your own products in your own business and be the idea that you haven’t sold them to yourself, that does not mitigate the fact that they, and those products will be subjected to use tax, which is the equivalent of sales tax in California.
Neil
And the internet is another one of those tools that opens a business potentially to a huge tax controversy and exposure.
Jan
It does. And the reason for that is because of contract law. So when you have a website that goes back and there is essentially an offer to sell. So if I have a website in and I’m selling shampoos or I’m selling soap or perfume, or whatever that offer to sell, when it’s accepted, if it’s accepted by someone, living in the state of California is where in essence, the contract is formed and under contract law where the contract is formed is where the transaction takes place. So the C D T F a can go back and get a lot of out of state purveyors who are not in the state, have no nexus to the state other than the fact that they’re selling through the website here in California, and feel that they’re not subjected to sales tax and nothing could be further from the truth. So you have to be careful if you are selling in California to California residents, you are going to be subjected to sales tax here in the state of California.
Neil
So along with tax exposure comes inevitable, tax controversies. We typically define those as collections, liens, levies, garnishment, Jan, how do we help people who are facing collection issues, garnishment, levies against their bank accounts?
Jan
Well, hopefully by assisting them and having them never be subjected to those types of collection or effective enforcement tools. And for us in terms of collections, if the state taxing authorities are in a collections mode, they can be very, very ruthless. And their job is to go back and obtain the tax that has remained unpaid, or is unpaid for whatever reason, but there are mitigating circumstances and there are mitigating things that can be done to lessen the collection efforts, go back and put at bay liens, levies, and garnishments. And that’s generally with a negotiation with a taxing authority to set up some sort of plan to take care of the liability. The one issue that we have that most people want. And the first thing that hits them is if they have unpaid tax and the taxes remained unpaid for a fairly long period of time, oftentimes the state will go back and file a lien against any assets that a taxpayer may have in the state of California.
That lien, unfortunately, we are unable to remove until the tax has been paid. So there are negotiations, there are ways to go back and create offers and installment agreements that allow for the payment of the tax over a period of time and also at a reduced amount, but those are time consuming and they are information intensive, and they’re a very, they’re a difficult process into themselves. So our goal would be to go back and assist clients to avoid those types of controversies that lead to collections or liens or levies so that we can avoid those types of issues in the additional cost, penalties and interests that may be incurred because of those controversies,
Neil
Without making any false claim or representation here. I would think that a tax agency speaking with a tax attorney, that conversation is going to happen with a different tenor and a different level of trust than it might with the taxpayer themselves. Is that accurate?
Jan
Yes. I think that’s accurate simply because both of the initial parties that you just mentioned have done this, they understand the processes, they understand the procedures, whereas an individual attempting to go in and represent themselves may not have really the clarity with which to understand what it is that’s happening and what their options and alternative procedures may or may not be.
Neil
So Jan, just to sum up California tax reporting and controversies, what would be your basic general advice for anyone who’s been contacted by a California tax agency?
Jan
My piece of advice would be to find someone that can go back and represent you in that matter. And from our perspective, of course, we feel that the legal representation is preferable, but whether you use a law firm or a CPA firm, it’s important that you find someone that understands the process, the procedures, and knows, and can explain to you your rights as a taxpayer under audit, learn more about our integrated legal tax accounting and business solutions and visit Alan barren.com or call (866) 631-3470 to schedule a free consultation.
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