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April 20, 2018

I. Introduction

California taxation of members of limited liability companies ("LLC") has been in conflict with federal law for years, since at least 1994 when California enacted the Beverly-Killea Limited Liability Company Act. Under federal law, members of a partnership, including members of an LLC, are considered self-employed individuals when performing services for the partnership or LLC. They are not subject to payroll tax deductions, and the LLC is not required to pay an entity's portion of employment taxes. However, for years the California Employment Development Department refused to adhere to the law and collected payroll taxes from California LLCs set up under partnership rules. Only employees are subject to payroll tax deductions, as it is impossible for an individual to be both an employee and self-employed at the same time. In 2011, the California Legislature enacted Unemployment Insurance Code section 623 ("UIC") and issued clean-up legislation in 2015 in WC 13004.6, each of which provides: "'Employee' does not include any member of a limited liability company that is treated as a partnership for federal income tax purposes." The purpose of the California legislation is to harmonize California with federal law and provide employers with straightforward taxation rules by which they would know who to deduct payroll taxes from and who not to. In actuality, as the Decision teaches, the State of California was attempting to collect too much in payroll taxes from this particular entity - an LLC treated as a partnership for the purpose of federal taxation.

II. Legal Significance of the Case

Kenneth Sargoy persuaded the CUIAB not only that LLCs taxed as partnerships are should not be withholding payroll taxes from LLC members and paying an entity's portion of employment taxes, but that even before the 2011 enactment of U1C 623, the EDD had been required to apply federal law, which classified LLC members as self-employed individuals, rather than state law, which classified them as employees. For several years, the EDD had violated the law by requiring such LLCs to withhold payroll taxes and pay an entity's portion of employment taxes.

III. Facts of the Case

In 2000, the client, a home healthcare agency, filed its articles of organization as an LLC with the state of California. Its services providers were, denominated LLC members and not employees, were registered nurses, licensed vocational nurses, certified home health aides, and clerical staff. The mission of the company was to provide home healthcare services for severely disabled patients. All healthcare services were performed under the treatment plan of the patient's physician(s).

From 2000 through 2003, the newly-formed LLC treated its members as employees and deducted federal and state payroll taxes from the member's semi-monthly paycheck. However, effective January 1, 2004, the LLC stopped making payroll deductions and stopped paying employment taxes, labeling the service providers members of the LLC rather than employees. In consideration for the conversion, the members entered into contracts with the LLC that changed their at-will status to discipline and termination only after a hearing and "just cause" determination, which further granted the member opportunity to cure unsatisfactory performance, In addition, members became eligible for company profit sharing.

In 2006, two healthcare providers left the LLC and filed for unemployment benefits. The LLC argued at the California Unemployment Insurance Appeals Board ("CUIAB") hearing that the providers were not employees; they were self-employed individuals and therefore not eligible for unemployment benefits. The prosecuting agency, the California Employment Development Department ("EDD"), argued that the healthcare providers were employees, citing the employer's "right of control" test under well-established common law principles set out in Tieberg v. Cal. Unemp. Ins. App. Bd. (1970) 2 Ca1.3d 943 and Empire Star Mines Co. v. Cal. Emp. Corn. (1946) 28 Ca1.2d 33, and other state authorities. The hearing officer found in favor of the employees and ordered the LLC to pay unemployment benefits, The LLC filed a Petition for Reconsideration to the CUIAB Office of Tax Petitions, which consolidated the service providers' cases.

At or about the time of the 2006 CUIAB proceedings, the EDD conducted an audit of the LLC's nearly 100 members and issued a Determination finding that the members were employees and not independent contractors (i.e., the equivalent of being self-employed), and that their remuneration was subject to payroll deductions from the employees and employment tax payments from the LLC. The CUIAB ordered charges the LLC's account under the UIC.

IV. The Petition for Reconsideration

A. Background

The Tax Petition Reconsideration Hearing commenced with a one-day hearing in October 2007. For reasons unknown to counsel, the case was continued and did not resume until 2016. By the time the case resumed, the LLC had incurred payroll tax charges, penalties, and interest of approximately $500,000.

B. CUIAB Hearing of Petition for Reconsideration

In 2016, over the course of four days of hearings, the LLC introduced evidence of the bona fide conversion of members from the status of employees to self-employed individuals. This included members' testimony, declarations, the LLC Operating Agreement, and other contractual documents signed by each LLC member. The LLC offered testimony of a federal tax expert, an Enrolled Agent, who testified that under IRS Revenue Ruling 69-184 and other specific IRS regulations, members of a partnership, including members of an LLC, were self-employed when performing services for the partnership or LLC. Their remuneration was not wages and was not subject to FICA and FUTA withholding. The expert further testified that during the audit period, 2003 to 2006, federal and California law had an irreconcilable conflict because applying the same factors, state law classified LLC members as employees and federal law classified them as being self-employed; thus, under state law, the entity was required to withhold payroll taxes and pay the entity's employment taxes, but under federal law, the entity was not permitted to withhold. An individual could not simultaneously be an employee and self-employed; such status was impossible.

(1) Witness Examination

The LLC called the EDD tax auditor as a hostile witness and cross examined her. With the cross examination, the theory of the LLC's case became clear to the EDD and CUIAB: The LLC members were self-employed individuals not subject to payroll tax withholding. Under cross examination, the auditor admitted that profit sharing was generally an attribute of a partnership or LLC and that the operating agreement and practice was to provide profit sharing. However, the auditor incorrectly decided the LLCs profit sharing was a bonus, a term generally associated with employment. The auditor further admitted that to her knowledge the EDD does not consider federal law when investigating an employment tax case, and she did not in this case. She was aware, however, that the law has changed and that currently members of an LLC taxed as a partnership for purposes of federal income taxation are not subject to payroll tax withholding. However, the change was recent (post 2011) and the audit was conducted in 2006, well before the law changed.

(2) Legal Analysis and Decision

The LLC argued principles of applicable law: That federal tax law pre-empted conflicting state regulations and prohibited the exercise of state regulations incompatible with the federal counterpart. Without directly addressing the pre-emption issue, the CUIAB reasoned that under state law and its own precedent, the EDD was required to not only consider federal law but to give it "great weight" when the purposes of state and federal law were comparable. The CUIAB found that during the audit period IRS Revenue Ruling 69-184 and federal case law provided self-employment status for partners of a partnership and members of an LLC taxed as a partnership for purposes of federal taxation. Thus, in 2011 when California enacted UIC 623 and 13004.6 (enacted in 2015), it was to harmonize state with long-standing federal law.

The CUIAB reasoned that the EDD auditor failed to satisfy the state's duty to consider federal law when issuing the determination against the LLC back in 2006. Reviewing the legislative history of the UIC sections, the CUIAB concluded that their purpose was to harmonize state with federal law through the 2011 enactment of UIC 623 and the subsequent 2015 clean-up statute, section 13004.6. Had the EDD considered those statutes, the CUIAB determined, the auditor would have issued a Determination that the LLC members were self-employed individuals, and not employees of the entity.

Consequently, the CUIAB granted the LLCs Petition for Reassessment, holding that the LLC was not liable for any payroll taxes, penalties, or interest.

SIGNIFICANCE OF DECISION FOR EMPLOYERS: Should employers rush out to convert employees to LLC members and stop paying payroll taxes? DEFINITELY NOT! The Decision does not stand for the proposition that an entity can change its business structure to avoid paying payroll taxes and other burdens of employment such as workers' compensation insurance for employees. In fact, the Legislature amended California Labor Code section 3351, by adding subdivision (f) and enacting Labor Code section 3352, which require non-managing members of partnerships or LLCs to be covered by workers' compensation insurance. Additionally, common law principles set forth in the landmark case, S.G. Borello & Sons, Inc. v. Dept. of Industrial Relations (1989) 48 Ca1.3d 341 and other precedent hold that the status of workers cannot be determined by labeling them "employees," "LLC members" or "independent contractors" as a subterfuge to avoid worker protections such as workers' compensation insurance and other employee benefits.

EDD publication DE 231LLC Rev. 2 (12-14), readily available on the Internet, sets forth the basic regulations for taxation of LLC members under California law. The publication and competent counsel should be consulted before starting an LLC or making any changes of employment status.

Navigating employment and business taxation laws is difficult. The California Employment Development Department and the United States Department of Labor are emphasizing misclassification of employee cases and are seeking back payroll taxes when it has cause to believe individuals have been misclassified. Private attorneys and the California Labor Commissioner (aka, Department of Industrial Relations, Division of Labor Standards Enforcement) file against employers for wage and hour violations alleged failure to pay overtime, minimum wages, and to provide meal and rest breaks.

Kenneth J. Sargoy, Esq. provides counseling and representation in California and federal courts and state and federal governmental agencies in connection with employment matters. Questions may be directed to Ken at telephone (310) 208-1003 or (310) 472-7113 or to his e-mail, [email protected]. The office is located at 815 Moraga Drive, Los Angeles, CA 90049. To view the website of the Law Office of Kenneth J. Sargoy, click here: http://sargoylaw.com

NOTE: This Employment Alert is designed to provide general information. It is not intended to, nor does it, offer solutions to individual problems. Persons having specific questions should contact Mr. Sargoy directly. THE ALERT IS CLASSIFIED AS A NEWSLETTER AND CONSTITUTES ADVERTISING MATERIAL UNDER APPLICABLE RULES OF PROFESSIONAL CONDUCT.

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Los Angeles, CA 90049
Phone: 310-208-1003 
Phone: 310-472-7113
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