During a payroll tax audit, the EDD is next going to go through the business’s general ledger in detail, the general ledger is important because the general ledger contains a record of all the payments the business made during the audit period in question. When the auditor goes through the general ledger, they are going to be looking for a couple of different things. Number one, is they're going to be looking for payments to people. The auditor is looking for payments to people who may or may not have been a 1099 and they are going to be looking for payments to the business’s employees and toward 1099 contractors that were not listed on the W2 or the 1099 for whatever reason.
When they go through the general ledger, the state is looking specifically at the situations surrounding payments that were issued to individuals. Then the state is going to put scrutiny on those payments to individuals on a case by case basis. There's a couple of different things that are red flag issues for many businesses. The first thing is payments to day laborers, cleaning companies, window people, and small payments being made to individuals. For example, a lot of companies will employ a janitorial service. Sometimes that janitorial service is just an independent contact that will come and clean the office once a week and the business owner will just write them a small check each time they come and clean the office. If the aggregate of payments made are above $600 in any given year, then a 1099 should have been issued for that company. Businesses tend to get into trouble for small issues like that, but the additional worker information penalties that come as a result of those little failures to file can add up significantly.
The auditor will be examining the general ledger to look for payments like that, but they are also looking for differences that do not reconcile or other evidence of payments that were misclassified or that may have been reported off the books. Any time you have a business who is dealing with a high level of, like construction or you're dealing with a lot of car washes, or restaurants and bars, the auditor is going to be looking for evidence that there are people that are receiving cash from the business as compensation for services and who are not getting picked up in payroll.
The good thing about the general ledger depending on the nature of the business, you should have a clear idea of whether or not this is an issue ahead of time. But make sure that when you do your own review of the general ledger, you go through and are able to explain each payment to any individual in detail. You will need to explain whether or not it is compensation for services, or whether it's compensation for something else.