IRS and State Payroll Employment Tax Disputes and Audits

A Comprehensive Guide to Resolving Payroll Tax Problems for Business Owners

By Mike Habib, EA | Licensed Enrolled Agent | Los Angeles, California

Payroll taxes represent one of the most serious areas of tax compliance for business owners. Unlike income taxes, which are owed by the taxpayer on their own earnings, payroll taxes are held in trust for employees and must be remitted to the government on their behalf. When businesses fall behind on payroll taxes or face disputes about worker classification, the consequences can be severe and swift. The IRS and state agencies like California’s Employment Development Department (EDD) treat payroll tax violations with particular seriousness because these funds belong to workers who are counting on them for Social Security, Medicare, and unemployment benefits.

This guide addresses the most common questions about payroll employment tax disputes and audits, explains how these issues differ from other tax problems, and demonstrates how professional representation can help business owners navigate these high-stakes situations effectively.

What Are Payroll Employment Taxes and Why Are They Treated So Seriously?

Payroll employment taxes consist of several components that employers are required to withhold from employee wages and remit to federal and state governments. At the federal level, these include Social Security tax (6.2% from employees, matched by employers), Medicare tax (1.45% from employees, matched by employers, plus an additional 0.9% on high earners), and federal income tax withholding. Employers are also responsible for paying federal unemployment tax (FUTA) on their own account.

In California, employers must also withhold state income tax and State Disability Insurance (SDI), while paying into the state unemployment insurance (UI) and Employment Training Tax (ETT) funds. These obligations are administered by the EDD, which is known for aggressive enforcement of payroll tax compliance.

The reason tax authorities treat payroll tax violations so seriously is that these are trust fund taxes. When you withhold Social Security and Medicare taxes from an employee’s paycheck, that money does not belong to your business. You are holding it in trust until it is deposited with the government. Failing to remit these funds is viewed not simply as owing taxes, but as misappropriating money that belongs to your employees. This is why payroll tax debts cannot be discharged in bankruptcy and why responsible individuals can be held personally liable even when the business is a corporation or LLC.

What Triggers a Payroll Tax Audit?

Payroll tax audits can be triggered by a variety of factors. At the federal level, the IRS may initiate an examination when discrepancies appear between information returns (such as W-2s and 1099s) and employment tax returns (Forms 941 and 940). Late or missing deposits, inconsistent reporting across quarters, or significant changes in reported wages can all raise red flags.

Worker classification issues are another common audit trigger. When a business pays workers as independent contractors rather than employees, the IRS and state agencies may examine whether this classification is correct. Misclassifying employees as contractors deprives workers of protections and benefits while allowing businesses to avoid payroll tax obligations. Both the IRS and California EDD actively pursue worker misclassification cases.

Former employees or workers who file for unemployment benefits can also trigger audits. When someone applies for unemployment and the EDD has no record of wages being reported for that individual, an investigation typically follows. Similarly, workers who believe they have been misclassified can file complaints with tax agencies and labor boards, initiating examinations of the business’s payroll practices.

Random selection, industry-wide initiatives targeting sectors with high rates of noncompliance, and information from other audits or investigations can also result in payroll tax examinations. Some industries, including construction, restaurants, healthcare staffing, and technology, face heightened scrutiny due to historical patterns of worker misclassification.

What Is the Trust Fund Recovery Penalty and Who Can Be Held Liable?

The Trust Fund Recovery Penalty (TFRP), also known as the 100% penalty, is one of the most powerful enforcement tools available to the IRS. It allows the government to assess the unpaid trust fund portion of payroll taxes (the employee withholdings for Social Security, Medicare, and income tax) against any individual who is considered a responsible person and who willfully failed to collect or pay over the taxes.

A responsible person is anyone with authority to direct the payment of creditors and who had knowledge that payroll taxes were not being paid. This typically includes business owners, corporate officers, directors, and sometimes key employees such as bookkeepers or controllers who had signature authority on bank accounts. The IRS can and often does assert the TFRP against multiple individuals for the same tax liability, and each responsible person is liable for the full amount.

Willfulness in this context does not require an intent to defraud. It simply means that the responsible person was aware of the outstanding taxes and either intentionally disregarded the obligation or was recklessly indifferent to it. Choosing to pay other creditors, such as vendors, landlords, or lenders, instead of remitting payroll taxes to the IRS constitutes willful behavior for TFRP purposes.

The practical effect of the TFRP is that owners and officers cannot escape payroll tax liability simply by closing their business or allowing it to fail. The IRS will pursue them personally, attaching their individual assets, wages, and bank accounts to collect the debt. California has similar provisions allowing the EDD and other state agencies to pursue personal liability for unpaid payroll taxes.

What Happens During an IRS Payroll Tax Audit?

An IRS payroll tax audit, formally known as an employment tax examination, typically begins with a notification letter informing you that your business has been selected for examination. The letter will identify the tax periods under review and request specific documents, which commonly include payroll records, bank statements, canceled checks, timekeeping records, independent contractor agreements, Forms W-2 and 1099, and quarterly and annual employment tax returns.

The examination may be conducted by correspondence, at your place of business, or at an IRS office. The examiner will review your records to verify that wages were correctly calculated and reported, that proper amounts were withheld, that deposits were made on time, and that workers were properly classified. If issues are identified, the examiner will propose adjustments and calculate any additional tax, penalties, and interest owed.

If the audit involves potential TFRP liability, the examiner will also conduct interviews to determine which individuals qualify as responsible persons. This typically involves asking questions about who had authority to sign checks, who made decisions about which bills to pay, who prepared or reviewed payroll, and who was aware that payroll taxes were not being deposited. These interviews are critical, and having professional representation during this phase can significantly impact the outcome.

At the conclusion of the audit, you will receive a report detailing the examiner’s findings and proposed adjustments. You have the right to agree with the findings, request a conference with a manager, or appeal to the IRS Independent Office of Appeals if you disagree. Understanding these rights and exercising them appropriately is essential to achieving the best possible outcome.

How Do California EDD Payroll Tax Audits Differ From IRS Audits?

California employers face scrutiny from the Employment Development Department (EDD) in addition to the IRS, and EDD audits have some distinctive characteristics. The EDD is responsible for enforcing California’s payroll tax requirements, including state income tax withholding, unemployment insurance, State Disability Insurance, and Employment Training Tax.

EDD audits are often triggered by unemployment claims filed by workers who were paid as independent contractors. When someone files for unemployment and the EDD cannot find wage records, they frequently initiate an audit of the business that paid the worker. California has some of the most aggressive worker classification enforcement in the country, particularly following the implementation of Assembly Bill 5 (AB5) and subsequent legislation that narrowed the criteria for treating workers as independent contractors.

The EDD uses the ABC test to determine worker status, which presumes that a worker is an employee unless the hiring entity can demonstrate that the worker is free from control and direction, performs work outside the usual course of the hiring entity’s business, and is customarily engaged in an independently established trade or business of the same nature. This test is generally more restrictive than the IRS common law test and can result in workers being classified as employees for California purposes even when they might be considered contractors federally.

EDD penalties can be substantial, including not only the unpaid taxes but also penalties for late payment, late filing, and in some cases fraud. The EDD can also assess personal liability against responsible individuals similar to the federal TFRP. Navigating an EDD audit requires familiarity with California-specific rules and procedures that differ significantly from federal requirements.

What Is the Difference Between an Employee and an Independent Contractor?

The distinction between employees and independent contractors is central to payroll tax compliance, and getting it wrong can result in significant liabilities. The classification determines whether you must withhold income taxes and payroll taxes, pay employer portions of Social Security and Medicare, provide workers’ compensation coverage, and contribute to unemployment insurance funds.

For federal purposes, the IRS uses a common law test that examines the degree of control and independence in the relationship. Factors considered include behavioral control (does the company direct what work is done and how), financial control (does the worker have unreimbursed expenses, opportunity for profit or loss, and significant investment in their own business), and the type of relationship (written contracts, benefits, permanency, and whether the work is a key aspect of the business). No single factor is determinative, and the overall relationship must be evaluated.

California’s ABC test, as noted above, is more stringent. Unless all three prongs of the test are satisfied, the worker is presumed to be an employee. This has had significant implications for businesses in California that previously relied on independent contractors, particularly in the gig economy, trucking, and professional services sectors.

If an audit results in worker reclassification, the business becomes liable for the employer’s share of Social Security and Medicare taxes, plus the employee’s share if it was not withheld, along with penalties and interest. The liability can extend back multiple years, and when combined with state assessments, the total can be financially devastating for a small business.

What Options Are Available to Resolve Payroll Tax Debt?

Businesses and individuals facing payroll tax debt have several potential resolution options, though these are generally more limited than options for income tax debt due to the trust fund nature of payroll taxes. Understanding which options apply to your situation requires careful analysis of your financial circumstances and the specifics of your liability.

Installment agreements allow you to pay the debt over time in monthly payments. For businesses that are current on their ongoing payroll tax obligations, the IRS may approve a payment plan for past-due amounts. However, the IRS is generally less flexible with payroll tax debts than with income tax debts, and they will want to see that you have corrected the underlying compliance issues before approving an agreement.

An Offer in Compromise (OIC) may be available in limited circumstances if you can demonstrate that you cannot pay the full liability through an installment agreement and that the offered amount represents the maximum the IRS can expect to collect. However, the IRS is particularly skeptical of offers involving trust fund taxes and will scrutinize these applications closely. Having professional assistance in preparing and negotiating an OIC for payroll taxes is virtually essential.

Penalty abatement may be available if you can establish reasonable cause for the failure to deposit or pay. First-time penalty abatement is also an option for businesses with a clean compliance history. While penalty relief does not reduce the underlying tax, it can significantly reduce your total liability.

For TFRP assessments against individuals, similar options apply, though the analysis is based on the individual’s personal financial situation rather than the business’s circumstances. In some cases, it may be possible to challenge the assessment itself by demonstrating that the individual was not actually a responsible person or did not act willfully.

Can I Appeal an IRS or EDD Payroll Tax Assessment?

Yes, you have the right to appeal payroll tax assessments if you disagree with the examiner’s findings. Understanding the appeals process and exercising your rights effectively can lead to significant reductions in assessed liabilities or even complete reversal of improper assessments.

At the federal level, you can request a conference with the examiner’s manager to discuss disputed issues before a formal assessment is made. If you cannot reach agreement at the examination level, you can appeal to the IRS Independent Office of Appeals, which is a separate function within the IRS that provides an independent review of your case. Appeals officers have authority to settle cases based on the hazards of litigation, meaning they consider the likelihood that the IRS would prevail if the case went to court.

For Trust Fund Recovery Penalty cases, you will receive a Letter 1153 proposing the penalty before it is assessed. You have 60 days to appeal this proposal to the Office of Appeals. This is a critical opportunity to present your case and potentially avoid personal liability. If you miss this deadline, your options become more limited, though you may still be able to pursue relief through collection due process procedures or by paying a portion and filing a refund claim.

California EDD assessments can be appealed through the California Unemployment Insurance Appeals Board (CUIAB). The process involves requesting a hearing before an administrative law judge who will review the evidence and issue a decision. Further appeals to the CUIAB itself and ultimately to state courts are possible if you disagree with the initial decision.

What Are the Penalties for Payroll Tax Violations?

Payroll tax penalties are among the most severe in the tax code, reflecting the trust fund nature of these obligations. Understanding the penalty structure helps illustrate why prompt compliance and professional assistance are so important when payroll tax issues arise.

The failure-to-deposit penalty applies when payroll taxes are not deposited on time. The penalty ranges from 2% for deposits made one to five days late, to 5% for deposits six to fifteen days late, to 10% for deposits more than fifteen days late, to 15% for amounts still unpaid more than ten days after the first IRS notice demanding payment or the day on which you receive notice of an immediate levy. These percentages apply to the amount of the underpayment.

The failure-to-file penalty for employment tax returns is 5% of the unpaid tax per month, up to a maximum of 25%. The failure-to-pay penalty is 0.5% per month, up to 25%. These penalties apply in addition to interest, which compounds daily. The Trust Fund Recovery Penalty, as discussed earlier, is 100% of the trust fund portion and applies to responsible individuals.

California imposes its own penalties for EDD violations, including a 15% penalty for late payment, additional penalties for fraud or intentional disregard of the law, and personal liability assessments against responsible persons. When federal and state penalties are combined with interest, the total liability can easily exceed the original tax by 50% or more.

How Can I Prevent Payroll Tax Problems in the Future?

Preventing payroll tax problems requires consistent attention to compliance and internal controls. The most fundamental rule is to never use payroll tax funds for other business purposes. The money you withhold from employees belongs to them and must be deposited according to the required schedule. Treating payroll tax obligations as non-negotiable, like rent or loan payments, helps ensure they are always paid on time.

Using a reputable payroll service can reduce compliance risk by ensuring accurate calculations, timely deposits, and proper reporting. However, it is important to understand that the business owner remains ultimately responsible even when using a third-party provider. Reviewing payroll reports regularly and verifying that deposits are being made is essential.

Worker classification decisions should be made carefully and documented thoroughly. If you engage workers as independent contractors, ensure the relationship genuinely meets the applicable tests under both federal and state law. When in doubt, treating a worker as an employee is the safer approach. Consider obtaining a determination letter from the IRS (Form SS-8) or consulting with a tax professional before engaging workers in ambiguous situations.

Maintaining accurate records is equally important. Keep detailed documentation of all wages paid, taxes withheld, deposits made, and returns filed. In the event of an audit, complete and organized records can substantiate your compliance and expedite the examination process. Incomplete or missing records often lead to unfavorable assumptions and higher assessments.

Why Work With Mike Habib, EA for Payroll Tax Disputes and Audits?

Mike Habib is a licensed Enrolled Agent based in Whittier, Los Angeles County, California, with extensive experience representing businesses and individuals in payroll tax disputes with both the IRS and California state agencies. As an Enrolled Agent, Mike holds unlimited practice rights before the Internal Revenue Service, meaning he can represent clients in audits, appeals, and collection matters with the same authority as attorneys and CPAs.

With over 20 years of financial experience including executive roles as Controller at Xerox Corporation and Director of Finance at AEG, Mike brings a business owner’s perspective to payroll tax representation. He understands the operational and financial pressures that businesses face and works to achieve resolutions that allow companies to survive and move forward while satisfying their tax obligations.

Mike’s practice includes representation before the IRS, California Franchise Tax Board (FTB), Employment Development Department (EDD), and California Department of Tax and Fee Administration (CDTFA). This comprehensive coverage means he can address all aspects of your payroll tax situation, whether it involves federal employment taxes, California payroll taxes, or both. Coordinating your defense across multiple agencies is essential to achieving consistent and favorable outcomes.

Unlike large accounting firms that charge premium rates and often assign your case to junior staff, working with Mike means direct access to an experienced professional who personally handles your matter. His competitive rates of $400-500 per hour compare favorably to the $850-1,500 hourly rates charged by major firms, and many engagements are structured on a value flat fee basis for cost predictability. Although based in the Los Angeles area, Mike serves business clients nationwide and Americans operating businesses overseas.

Payroll Tax Services Offered

Mike Habib, EA provides comprehensive payroll tax representation services for businesses facing IRS and state agency disputes. For businesses under audit, Mike represents clients throughout the examination process, responding to information requests, preparing for and attending interviews, and negotiating with examiners to minimize proposed adjustments. His goal is to resolve audits efficiently while protecting your interests at every stage.

For Trust Fund Recovery Penalty cases, Mike works to limit the assessment to truly responsible persons and to demonstrate the absence of willfulness where appropriate. He represents individuals in TFRP appeals and negotiates resolution of assessed penalties through installment agreements, Offers in Compromise, or other appropriate mechanisms.

Worker classification disputes require careful analysis of the facts under both federal and state standards. Mike assists businesses in responding to classification audits, presenting evidence supporting contractor treatment where appropriate, and negotiating favorable settlements when reclassification is unavoidable. He also advises businesses proactively on classification decisions to prevent future problems.

For businesses with existing payroll tax debt, Mike negotiates installment agreements, pursues penalty abatement, and evaluates eligibility for Offers in Compromise. He also assists with coming into current compliance, ensuring that ongoing obligations are met while past-due amounts are being resolved.

Taking Action on Your Payroll Tax Issues

Payroll tax disputes and audits are among the most serious tax problems a business can face. The combination of trust fund liability, personal responsibility for owners and officers, aggressive enforcement by both federal and state agencies, and substantial penalties creates significant risk for businesses that find themselves out of compliance.

The good news is that with experienced representation, even serious payroll tax problems can be resolved. Audits can be defended effectively when the facts support your position. Penalties can be abated when reasonable cause exists. Payment arrangements can be negotiated that allow your business to continue operating. Trust Fund Recovery Penalty assessments can be challenged when the responsible person or willfulness determinations are incorrect.

If you are facing an IRS or EDD payroll tax audit, have received a TFRP proposal letter, are dealing with worker classification challenges, or have accumulated payroll tax debt that you need help resolving, professional assistance can make a meaningful difference in your outcome. Acting promptly preserves your options and often leads to better results than waiting until enforcement actions are imminent.

Mike Habib, EA welcomes the opportunity to discuss your payroll tax situation and explain how professional representation can help protect your business and personal interests. With the right guidance, you can navigate these challenges and position your business for a compliant future.

Contact Mike Habib, EA

Tel: 1-562-204-6700 – Toll Free: 1-877-788-2937 [1877-78-TAXES]

Licensed Enrolled Agent | Whittier, Los Angeles County, California

Serving Business Clients Nationwide and Americans Operating Overseas

IRS Audit Representation | EDD Audit Defense | Payroll Tax Resolution | TFRP Defense | Worker Classification

Disclaimer: This article is provided for general informational purposes only and does not constitute tax or legal advice. Payroll tax matters are complex and fact-specific. The information presented may not apply to your particular situation. Every case is different, and outcomes depend on individual circumstances. Please consult with a qualified tax professional for advice tailored to your specific business situation.