Documents You Will Need for the Tax Auditor
What usually happens in a payroll tax audit is that the auditor will send you a laundry list of documents that they want to examine. Of the different types of audits, payroll tax audits are usually the ones that have the most flexibility because in a payroll tax audit they are basically running tests.
The auditors are running a test on a payroll that was paid, taxable wages, the tax that was paid, payroll tax, expenses that are on the general ledger, and independent contractors.
The auditors are going to ask for three years of records including tax returns, payroll tax returns, internal accounting documents and any other information that they might need. Just remember to be cooperative. If you refuse to hand over requested documents, the EDD can subpoena them and you do not want to go there.
Before you go and tackle that big list of documents, the best thing to do is to talk to the auditor because at the beginning of the payroll tax audit, you have the best opportunity to limit the scope of the documents requested.
For some people, providing payroll records for three years is not that big a deal, but for other companies, particularly companies that utilize a large workforce or a large number of independent contractors, it can be a huge deal to have to come up with all the 1099s and W-2s and everything that gets filed.
The best opportunity you have with respect to documents is to really try and limit the scope. Most EDD auditors will limit the scope of the records that they have requested at least for the first audit meeting to one year. They will ask for three years of tax returns and they may ask for three years of bank statements, but they will limit the other documents to one year.
This is the best thing to do because if you can go through a limited testing period, establish that there is no error and the auditor has a chance to complete their process and check the box, problem solved.
When going through a payroll tax audit, do not just accept the initial document request. Work with the auditors to do what is actually needed so that you are not overproducing records and digging yourself into a bigger hole that is going to take you a lot of time to get out of.
Minimum Required Records During EDD Tax Audit
Sections 1085 and 1092 of the CUIC require all employing units to make business records available to the EDD during normal business hours. These records include:
- Check Registers, Check Stubs, Canceled Checks, and Bank Statements
- General Ledger and General Journal
- Annual Financial Statements (Income and Expense Statements, Balance Sheet, etc.)
- Cash Payments Records (pay out slips and vouchers)
- Ownership Verification
- City Business License
- Board of Equalization Sales Tax License
- Any license required to operate business, such as a liquor license, California State contractor’s license, etc.
- Written Agreements (for example, Partnership Agreement or Articles of Incorporation)
- Federal/State Income Tax Returns
- Form 1099 Series, Federal Information Returns and Worksheets
Additional Records Required for Verification of Acknowledged Payroll
Payroll records such as Payroll Journal, Individual Earnings Records, Payroll Summaries, etc.
Federal Employment Tax Reports
Form W-2, Wage and Tax Statement
Form W-4, Employee’s Withholding Allowance Certificate
Form 941, Employer’s Quarterly Federal Tax Return
Form 940, Employer’s Annual Federal Unemployment Tax Return
State Employment Tax Reports
DE 9, Quarterly Contribution Return and Report of Wages
DE 9C, Quarterly Contribution Return and Report of Wages (Continuation)
DE 9ADJ, Quarterly Contribution and Wage Adjustment Form
DE 6, Quarterly Wage and Withholding Report
DE 7, Annual Reconciliation Statement
DE 678, Tax and Wage Adjustment Form
DE 4, Employee’s Withholding Allowance Certificate
As part of the audit, the auditor will arrange for an exit interview, either in person or by phone, to review the audit findings, identify any other information that should be considered and attempt to resolve disputed issues, if any.
If the employer does not reach an agreement with the auditor, they may request a pre-assessment conference with the supervisor of the auditor.
The audit will result in one of the following outcomes:
- A no-change audit, where no differences are found
- An overpayment, where a credit or refund will be issued
- An underpayment, where the differences will be assessed
- Both an underpayment and overpayment
If an assessment is issued, the employer will receive information about appeal rights. The employer may petition for reassessment with an independent third party, the California Unemployment Insurance Appeals Board, for a hearing before an Administrative Law Judge.
The Records Gathering Process in a California Payroll Tax Audit
Gathering records is one of the most important things in a California payroll tax audit. One of the things that the payroll tax auditors will judge the client on is the accuracy and completeness of the records that are being provided. We have a saying in our firm that we look at the “integrity of data.” The integrity of data is not a concrete thing, but rather a feeling you get when looking a set of records as to how complete they are. Does this person/company have their affairs in order or do I get the sense from the records that are being provided that there might be errors or omissions in what I am being presented? It is essentially your job during the records gather process to bolster confidence in the data being presented to your payroll tax auditor.
First, let us start by saying that there is a lot of information that needs to be gathered in the course of a payroll tax audit. Unless you are super organized and even if you are, it is just a lot of data to get and sort through. The auditor will usually give you thirty days from the time of your initial phone call to the first audit meeting, but I caution you that if you are still gathering records on day 29, you will be in a bit of trouble. The first thing that you want to do when discussing records with the auditor is really trying to pair down the amount of documentation that you are going to be asked for. Typically, you are going to want to try the audit period to a test year or toss some of the ancillary documents that do not directly relate to the four tests that the auditor is going to put you through.
The way that we think about things in an audit is that if we are given a month, the first 10 days should go toward gathering and organizing records and the remainder of the time should be spent preparing for the audit. Obviously, this target will fluctuate given the size of the business and the amount of data that we have to gather. Particularly on the subject of independent contractors, there is a lot of data that we like to have ready to present to the tax auditor in order to make a better case for independence from the hiring unit.
Not to belabor the point, but just to remind, you have to get everybody's 1099s, you have to gather the remaining W2s and payroll records from the payroll company (generally even if you are successful in limiting scope, they are going to want a full three years. Then there is financial information. The EDD tax auditor is going to want to see bank statements, they want to see the general in journal, they want to see any profit-loss statements, and they want to see the income tax returns.
Just keep in mind it's probably going to be about a week or two before the client gathers all the data. They gathered sooner and you're presently surprised but buy your client two weeks to reasonably put together all the documents that you're requesting.
Again, factor all these things in your mind when plotting out your first meeting with the auditor. It's better to ask for more time up front and to give yourself a little extra lead time going into that meeting. You want to be prepared, you want to be your best, and you want to have everything ready to go for the auditor. Take it from experience: it is far better than walking into an audit meeting unprepared, not organized, not ready to go.