Depending on the strength of the lead, the auditor may or may not know information about your case ahead of time.
The first call on the audit is to figure out exactly what the auditor knows about the case. How much third-party information have they gathered and what access to that information do they have.
A lot of times what you are going to find is-- or especially early in the process, the auditor has not done the due diligence necessary to really investigate the client's circumstances. They are following up on a lead, there is usually a triggering issue, they've been assigned to the case and they have to go through the process of documenting a report and going from there.
Here is how you can deal with an issue that you suspect is the lead issue in the context of the payroll tax audit:
Step one, figure out what the auditor knows about the client.
Step two, repeat back what you know about the client to set the framework and the auditors mind for how they run their audit:
Step one, figure out what the auditor knows about the client.
Step two, repeat back what you know about the client to set the framework and the auditors mind for how they run their audit
For example, take a client we had who issued a high amount of 1099s for a business. They have six employees, they happened issue 30 1099s in the year in question. The auditor says, we asked the auditor, "Hey auditor, do you have any idea why the client is being audited?"
They say, "Well, it appears that the client is issuing a large amount of 1099 based on the number of employees they have."
"Okay. Let me just explain to you. We thought this was going to be an issue ahead of time. I just want you to know that the business in question uses a lot of independent things to help them do their job.
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They've also 1099'd their landlord, they've 1099-ing their SEO company, they're 1099-ing in their bookkeeper. I'll probably get 1099 at the end of the year. but anyway, that's why it has nothing to do with their employees or employees of employees.
They've got the same six people working in the business that have been working in the business for the last three years. One or two come and go but everything's pretty fine. But just so you know, we've got this 1099 issue addressed. We don't think there's going to be any real problems in the audit."
You see what we just did there? I've just set an expectation to the auditor. The auditor now has a fact in their mind. It's an unverified fact but I've already stated a position. I've already started crafting a narrative to the auditor.
Assuming that I can present evidence that will back up that narrative, the auditor is going to start to believe that story, the more the auditor believes your story, the deeper they go down the rabbit hole then they are going to basically mitigate any issues in their own mind without you having to do it for them.
This will speed up the pace of your audit, this will get you through your general ledger test a lot quicker.
This will get you through 1099 tests quicker because if the auditor believes your story, just like when you believe things, you have confirmed a belief that you think is true and you go from there.
After you've explained the position, after you've set the auditor mind, then you're going to want to go through the author's initial document request.
Hopefully, you want to try and limit the scope of the document request to one year for the client’s sake and your own.
Two Common Problems for Taxpayers in California Payroll Tax Audits
The first and biggest problem is the misunderstanding that the taxpayer has by thinking that just because they did not do anything wrong, there is no risk associated with the audit. That is a fallacy because a lot of times the EDD is auditing somebody because they have a reasonable suspicion that something they are doing is not correct.
It is very important for the taxpayer to understand what their risk is in the beginning of the audit and then take step things to mitigate that risk during the audit process.
The second common problem that we have in audits is with independent contractors. A lot of times the clients will insist that their independent contractors are really independent contractors, but the problem is that because of what the independent contractor says or does, or because of the circumstances of the situation, it actually convoluted the analysis.
The EDD is very aggressive towards the classification of workers. Whenever possible, it tries to classify workers as employees and the presumption is that they are employees, unless the taxpayer can demonstrate evidence to show that they are not.
Those by far the most common problems with EDD audits and those are the things that you should work to mitigate.
That list is not exhaustive, as there are a lot of other factors that go into the payroll tax audit analysis and things that tend to be problems for taxpayers.
Most importantly, pre-audit yourself and if you have a good presentation, you can usually screen out most of the issues before they could pop up and then before they create financial liability to you or your company.
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The Biggest Risk in a California Payroll Audit
Other than in cases where there is some sort of fraud involved, the biggest risk by far in a payroll tax audit is the penalties because the EDD has some really nasty penalties. In our tax law firm, we have seen situations with clients where the penalties would be four or five times the amount of tax. Those penalties really amplify the amount of the liability.
When we are looking at a payroll tax audit, our focus is really on penalties and what we can do to eliminate them, or at the very least, mitigate them. Number two, the risk in an EDD audit is if it turns into a fishing expedition. The auditor, if left unchecked, will ask for all sorts of things and will go through them with a fine-tooth comb. This naturally, as you can imagine, leads to more penalties
This creates a lot of back and forth and back and forth. However, much of this can be really mitigated if you pre-audit the situation and know what you are walking into. If you come into the audit with a very well-defined plan and a very well-defined presentation, you can lead the auditor through the audit — you are controlling the flow of information.
Controlling the flow of information in a payroll tax audit is the best thing that you can do. In a California payroll tax audit, remember that an ounce of prevention is really worth a pound of cure.
The California Payroll Tax Audit Process
Generally, EDD employment tax audits cover a three-year period, comprising the 12 most recently completed calendar quarters. However, in some situations, such as when no returns were filed, the audit period may be longer.
An audit begins with a formal notification of audit through postal mail. The auditor will send a list of requested documentation and a pre-audit questionnaire.
A minimum documentation request includes:
- Verification of business ownership
- Check registers and stubs
- Bank statements and canceled checks
- General ledger and journal
- Annual financial statements
- Vouchers and pay-out slips
- Forms 1099
The pre-audit questionnaire is designed to elicit admissions and give the auditor enough information to develop an audit plan. You must carefully plan your responses to avoid problems later.
If you have not yet consulted a skilled tax attorney, this would be a good time to do so. A tax attorney can help you minimize admissions that could cause problems down the road.
An audit typically covers a three-year period unless circumstances arise that cause the auditor to go back further.