California Payroll Tax Audits and Employee Reimbursements

One of the biggest problems that we come across in payroll audits is employee reimbursements and independent contractor reimbursements. A lot of the times what will happen is an employee will get paid a normal paycheck and then they will spend their own money outside the context of the business to buy materials, to buy supplies, go post office do whatever. The business will write the employee a check out of their operating account and not run it through payroll.

As this progresses, and depending on the size of business and how often the employees are counted on to front their own expenses, you could have several large checks being issued to employees that on the surface would look like compensation on the surface level. However, you are going to have to dive into those payments specifically to find out if they are truly reimbursements (non-taxable) or disguised payments for services (taxable). And not to mention the fact that we have not discussed whether or not the business can even substantiate these reimbursements.

The truth of the matter when it comes to reimbursements is that businesses tend to keep poor records when it comes to reimbursements, which they do not save the substantiation for because they have written a check and have a corresponding accounting entry. Once the employee has been paid out, the reimbursement is just simply verification for the owner so that the owner knows that the employee did actually incur those expenses. Once the issue has been settled with the employee, the business generally does not think about keeping the substantiation. In these cases, it is critically important to be prepared to discuss these items in the audit and have as much detailed information surrounding the reimbursements as possible. Actual receipts are not an absolute, but having information and having those expenses look credible in an audit is a must in order to not have them treated as taxable wages.

How do you do this? You can rely on the testimony of the employee or obtain written statements about the nature of the expenses being reimbursed. You can talk about the materials that were purchased, especially if reimbursements are an industry standard. You can try and obtain third-party invoicing through a third-party depending on what it is. However, gather as much outside information that you are can and/or try to screen out whether this is a potential audit issue in advance. Casual labor and employee reimbursements are always hot topics in payroll tax audits, so you need to be prepared going in as much as possible.