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April 20, 2018

I. Introduction

Only employees are subject to payroll tax deductions. Self-employed individuals and independent contractors are not. It is impossible to be both a self-employed individual and employee at the same time. However, for years the California Employment Development Department, the state agency charged with collection of payroll taxes, improperly collected payroll taxes from self-employed individuals and charged the entities to which they provided services with employment taxes.

Under federal law, members of a partnership, including members of a limited liability company (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 the entity’s portion of employment taxes.

In 2011, the California Legislature enacted Unemployment Insurance Code section 623 (UIC). In 2015, UIC 13004.6 followed as clean-up legislation. Each of the code sections expressly mirrors federal law: “Employee does not include any member of a limited liability company that is treated as a partnership for federal income tax purposes.” The stated intent of the legislation was to harmonize California with federal law and provide employers with straightforward taxation rules by which they would know from whom to deduct payroll taxes and from whom not to. In actuality, as the Decision instructs, the State of California’s attempt to collect payroll taxes from this particular entity – an LLC treated as a partnership for the purpose of federal taxation – was unlawful.

II. Legal Significance of the Case

Kenneth Sargoy represented the client, a home healthcare agency, before the California Unemployment Insurance Appeals Board (CUIAB) in a decision of first impression in which the CUIAB held that the EDD unlawfully charged and sought to collect employment payroll taxes from the entity. The Decision further held that the EDD should have applied federal law when it conducted its payroll audit of the LLC in 2006, despite the fact that the state’s harmonization with federal law did not occur until five years later, in 2011.

III. Facts of the Case

In 2000, the home healthcare agency filed articles of organization as an LLC with the State of California. All of the company’s workers were denominated LLC members, and not employees. The members included Registered Nurses, Licensed Vocational Nurses, and Certified Home Health Aides as well as clerical and office staff. The company’s mission 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 the healthcare workers as employees and deducted payroll taxes from the members semi-monthly paychecks. However, effective January 1, 2004, the LLC stopped making payroll deductions and stopped paying employment taxes. In consideration for the conversion, the members entered into contracts with the LLC changing their “at-will” status to “just cause” for termination, and permitting termination only after a hearing and the opportunity to cure unsatisfactory performance. Further consideration included eligibility for profit sharing.

In 2006, two healthcare providers left the LLC and filed for unemployment benefits. The LLC contested the claims and argued at the CUIAB hearing that the healthcare providers were self-employed individuals and therefore not eligible for unemployment benefits. The EDD, the prosecuting agency, argued that the claimants were employees, citing the employer’s “right of control” test under well-established common law principles set out in Tieberg v. CUIAB (1970) 2 Ca1.3d 943 and Empire Star Mines Co. v. Cal. Emp. Com. (1946) 28 Cal.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 healthcare providers’ cases.

As a result of the 2006 proceedings, the EDD conducted an audit of the LLC’s nearly 100 members and issued a Determination that the members had been misclassified and were employees and not independent contractors (i.e., the equivalent of being self-employed members), and that remuneration was subject to payroll deductions from the employee healthcare workers and employment tax payments from the LLC. The CUIAB ordered charges against the LLC’s account.

IV. The Petition for Reconsideration

A. Background

Trial on reconsideration of the tax petition commenced with a one-day trial in October 2007. For reasons unknown to counsel, the case was continued and did not resume until 2016. By the time it resumed, the LLC had incurred payroll tax charges, penalties, and interest of approximately $500,000.00.

B. CUIAB Trial of Petition for Reconsideration

Over the course of a four-day trial in 2016, the LLC introduced evidence of the bona fide conversion of members from employees to self-employed individuals. This included testimony of an LLC managing member explaining the background and conversion, members’ testimony, declarations, and introduction of the LLC Operating Agreement and supporting contractual documents signed by LLC members. The LLC proffered 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 were in an irreconcilable conflict because applying the same factors, state law classified LLC members as employees and federal law classified the same individuals as 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 self-employed and an employee. Hence, the irreconcilable conflict.

The LLC called the EDD tax auditor as a hostile witness and cross examined her. Under cross examination, the auditor admitted that profit sharing was generally an attribute of a partnership or LLC and that the operating agreement and the LLC’s practice included profit sharing. However, the auditor admitted that she had labeled the LLC’s profit sharing as a bonus, a term associated with employment. Most importantly, 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 consider federal law in this case. She was aware, however, that the law changed, and currently members of an LLC taxed as a partnership for purposes of federal income taxation are not subject to withholding. However, the change was recent, in 2011, and the audit had been conducted in 2006, well before the law changed.

C. Legal Analysis and Decision

The LLC argued that federal tax law preempted conflicting state regulations and prohibited the exercise of state regulations incompatible with its federal counterpart. Without directly addressing the preemption issue, the CUIAB reasoned that under state law and CUIAB 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 classified partners and LLC members as self-employed individuals when the entity was taxed as a partnership for purposes of federal taxation. Thus, when the Legislature enacted UIC 623 in 2011 and UIC 13004.6 in 2015, the CUIAB found, it was merely to harmonize state with existing federal law.

The CUIAB found that the auditor failed to satisfy the EDD’s duty to consider federal law when issuing the Determination against the LLC back in 2006. Had the EDD considered federal law, as it was required, the CUIAB concluded, the auditor should have issued a Determination that the LLC members were self-employed individuals, not employees of the entity. Accordingly, the CUIAB granted the Petition for Reassessment and 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. Following the Decision, the Legislature amended California Labor Code section 3351 by adding subdivision (f) and enacted Labor Code section 3352. The code sections require non-managing members of partnerships or LLCs to be covered by workers’ compensation insurance. Furthermore, 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 determined by the employer simply labeling them “employees,” “LLC members,” or “independent contractors” as a subterfuge to avoid paying payroll taxes, 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 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 employment status changes.

Navigating employment 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. In addition, private attorneys and the California Labor Commissioner (aka, Department of Industrial Relations, Department of Labor Standards Enforcement) file against employers for wage and hour violations such as alleged failure to pay overtime, minimum wages, and meal and rest breaks.

Kenneth J. Sargoy, Esq. provides counseling and representation in California and federal courts and state and federal government agencies in connection with employment matters. Questions may be directed to Ken at telephone 310-208-1003 or or to his email, . 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:

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.