Business Tax Audits

A business can be examined by four different agencies, on four different taxes, at the same time — and the clocks run independently. The IRS examines income and payroll tax. The EDD examines payroll and worker classification. CDTFA examines sales and use tax. The FTB examines income and franchise tax.

What separates business examinations from individual ones is that the liability does not necessarily stay with the business. Unpaid payroll taxes can be assessed personally against owners, officers, and others, and dissolving the entity does not end the exposure.

This page covers entity-level examinations. For individual and general examination procedure — the 30-day letter, Appeals, and Tax Court — see IRS audits. We defend businesses in Temecula, Murrieta, San Diego, Riverside, and San Bernardino.

Payroll Tax and Personal Liability

Trust fund taxes — income tax, Social Security, and Medicare withheld from employee wages — are the government’s money held by the employer. That characterization drives everything about how these cases are handled.

Under IRC 6672, the trust fund recovery penalty can be assessed personally against any person who was responsible for collecting and paying over the taxes and who willfully failed to do so. The penalty equals the full trust fund portion of the liability.

Both elements are read broadly. “Responsible” is a functional test — check-signing authority, control over which creditors get paid, authority to hire and fire — and it reaches officers, bookkeepers, and sometimes outside advisors. It is not limited to owners. “Willful” does not require bad intent; it is satisfied by knowing the taxes were unpaid and paying other creditors instead. Paying suppliers to keep the doors open while payroll taxes go unpaid is the classic fact pattern, and it meets the standard.

The assessment is developed through Form 4180 interviews. Those interviews determine who gets assessed, and they should not be attended without representation — answers about who signed checks and who decided which bills to pay are the case.

Multiple people can be assessed for the same liability, each for the full amount. The IRS collects once but pursues everyone. And closing the business does not extinguish it: the entity’s dissolution simply redirects collection to the individuals.

California mirrors this. Under R&TC 6829, CDTFA can assess unpaid sales tax personally against responsible persons when an entity terminates or becomes insolvent, and the EDD has parallel authority for payroll tax.

Worker Classification

The most common California business examination, and the most expensive to lose.

California applies the ABC test under AB 5. A worker is presumed an employee unless the hiring entity establishes all three: the worker is free from control and direction in fact and under the contract; the work is outside the usual course of the hiring entity’s business; and the worker is customarily engaged in an independently established trade of the same nature.

Prong B is the one that defeats most classifications. A construction company engaging framers, a restaurant engaging cooks, a law firm engaging attorneys — the work is squarely within the usual course of business, so the classification fails regardless of how much autonomy the worker has or what the agreement says.

Statutory exemptions exist for specified professions and business-to-business relationships, each with its own conditions, and they are narrower than commonly assumed.

A reclassification produces assessments for unpaid payroll taxes, penalties, and interest across all open periods, and it frequently triggers parallel exposure — federal employment tax, wage and hour claims, workers’ compensation, and benefits. A single EDD audit can generate liabilities well beyond the tax at issue.

Federal relief under Section 530 can protect an employer that had a reasonable basis for its treatment, treated all similar workers consistently, and filed the required information returns. It has no California equivalent.

Sales and Use Tax Examinations

CDTFA auditors rarely check arithmetic. They test whether reported taxable sales are plausible given purchases, deposits, card ratios, and markup — and where records are incomplete, they estimate.

The methods each have known weaknesses: markup analysis that ignores discounting, spoilage, and comped items; observation tests projecting an unrepresentative day across years; bank deposit analysis treating loan proceeds and transfers as sales; and card-ratio methods assuming a fixed cash mix that has in fact shifted.

Two issues appear in nearly every audit — resale certificates that were incomplete or gathered after the fact, and use tax on out-of-state purchases and inventory withdrawn for business use.

The Notice of Determination starts a 30-day clock to file a Petition for Redetermination. Miss it and the liability becomes final, due, and payable.

Income and Franchise Tax Examinations

Recurring entity-level issues include reasonable compensation — challenged as too low in an S corporation and too high in a C corporation — related-party transactions requiring arm’s-length terms, shareholder loans lacking notes and repayment history, personal expenses run through the business, and R&D credit claims.

Multistate businesses face apportionment and nexus questions. California uses a single sales factor with market-based sourcing, so a company can have substantial California income without any physical presence here. See corporate tax.

The Employee Retention Credit remains an active enforcement area with a six-year audit window.

Managing a Business Examination

Control the scope. Information document requests should be answered with what is responsive. Producing three years of records to answer a question about one account invites examination of everything in them.

Control the interviews. Agents ask open questions about operations, recordkeeping, and decision-making. In a payroll case those answers determine who is assessed personally.

Watch for expansion. Field examinations can extend to related entities, related returns, and additional years. An income tax audit that starts asking about worker classification has changed character.

Recognize criminal indicators. An agent who stops requesting documents, unexplained delays, or a summons served on a bank may signal a referral. Unreported cash, two sets of books, or documents created during the audit change the posture entirely. See IRS fraud accusations.

Report federal adjustments to California. Under R&TC 18622, within six months — or the state’s assessment window stays open indefinitely.

Records, and What Happens Without Them

Business examinations are ultimately record contests, and the quality of the records determines whether the agency accepts your numbers or substitutes its own.

The baseline expectation is a general ledger reconciled to bank statements, sales records tying to reported receipts, purchase invoices supporting cost of goods sold, payroll records including time records and classification documentation, and asset records supporting depreciation. For businesses claiming credits, the contemporaneous project and time documentation supporting them.

Where records are inadequate, agencies estimate — and the estimates run against the taxpayer by design. The Cohan rule permits reasonable approximation for some expenses where records are imperfect, but it does not apply to categories under Section 274 with strict substantiation requirements: travel, meals, vehicle, and gifts. For those, missing records generally mean disallowed deductions regardless of how genuine the expense was.

Two practices materially improve outcomes and cost almost nothing. Keep business and personal accounts genuinely separate, because commingling invites the treatment of unexplained deposits as unreported income. And retain records for the full assessment period rather than a calendar year — six years where a substantial omission is possible, and indefinitely for years where no return was filed.

Frequently Asked Questions

Can I be held personally liable for my company’s payroll taxes?

Yes. The trust fund recovery penalty under IRC 6672 reaches responsible persons who willfully failed to pay, and California has parallel provisions. Closing the business does not end the exposure.

What does “willful” mean for the trust fund penalty?

Knowing the taxes were unpaid and paying other creditors instead. Bad intent is not required — keeping the business running while payroll taxes go unpaid satisfies the standard.

My workers signed contractor agreements. Does that settle classification?

No. California applies the ABC test to the actual relationship. Prong B — whether the work is outside the usual course of your business — defeats most classifications regardless of the contract.

Can several agencies audit me at once?

Yes, and they share information. The IRS, EDD, CDTFA, and FTB each run their own examinations with independent deadlines that do not pause for one another.

What if my records are incomplete?

Auditors may estimate using indirect methods. Those estimates are rebuttable, but the burden shifts to you, which is why the audit stage is where these cases are won or lost.

Does an EDD reclassification affect my federal taxes?

Often. The agencies share information, and a state reclassification frequently prompts federal employment tax exposure along with wage and hour and benefits claims.

How far back can a business audit go?

Generally three years federally, six where more than 25% of gross income was omitted, and without limit for fraud or unfiled returns. California agencies have their own periods, and unfiled returns leave the window open indefinitely.

Get Counsel Before the Interviews

Business examinations are decided early — in what gets produced, what gets said in a Form 4180 or classification interview, and whether the scope stays where it started. Personal liability in particular is determined by facts developed in the first few weeks.

Pietro Canestrelli holds an LL.M. in Taxation and defends businesses before the IRS, EDD, CDTFA, FTB, the Office of Tax Appeals, and the United States Tax Court. Schedule a consultation, or review our IRS representation and business law services.