How to Pre-Audit Yourself in Advance of Your EDD Payroll Tax Audit

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How to Pre-Audit Yourself in Advance of Your EDD Payroll Tax Audit 

Internally, we have developed the following list of issues based on our experience in past EDD payroll tax audits. Although not an exhaustive list, it will give you an idea of some of the mistakes that we have seen in preparing for audits and things to generally look out for.

So, we have already outlined the four tests that the EDD payroll tax auditor will go through in an audit: payroll taxable wages verification, payroll tax verification, general ledger and bank statement review, and independent contractor verification. You want to make sure that you do those four tests yourself, or some variation of them, because that's exactly what you are going to be put through for the audit. Here is what we use out screen out any issues though:

 

Conflicts between Payroll Journal and Other Documents in a Payroll Tax Audit

The very first thing you do is you take your 1099s and you make a list of the people on 1099s and you take your W2s and you make a list of the W2s, and you check that against the payroll journal, and/or any other information/records that you have for payroll.  

If you have multiple locations, you want to make sure you have all your employees ironed out on who is working where. If there are employees working at multiple locations, they should be under the same payroll umbrella. If they are not, you want to make sure that you can explain the hours tied to which location and that this is reconciled for the auditor in advance of the audit. For the most part, employees should be being issued one paycheck through an organization, and hopefully, you won't have those issues like we have had in that past.

 

General Ledger and General Journal Issues to Address Before EDD Does

Ideally, you want to see your 1099s that were issued line up and match exactly what your independent contractors were paid. You should be able to walk through this step by step with the tax auditor. So, you are going to go through the general journal, or general ledger and you are going to verify the checks that were written to the 1099s exactly as the were reported to the government. You want to go through and verify 1099s against source documents to make sure those records are complete. This will help alleviate any problems with document reporting.

One of the worst things that can happen in an EDD payroll tax audit is when you present information to the auditor, like a 1099, and that 1099 is inaccurate. If you do not have an explanation ready and on the spot, it will make the auditor doubt the accuracy of any of your filings.

So, you always want to make sure you go through and just check your 1099s to make sure they're okay and prescreen them ahead of time. Most of the time you are not going to have an issue and this does not need to be an extended process. Additionally, a well-organized payroll journal will make your life a whole lot easier. However, you still want to go through this process and screen for errors.

For clients with larger operations, you can take a sample if there's a large number of employees, but just make sure that you've got a good measure going at it and a high level of confidence in what you are doing. The auditor is going to use a similar sampling methods when you have hundreds of employees and/or contractors, so you should be able to mimic the auditor’s stress test and know if you are going to have any issues there.

 

The Importance of Tax Compliance in an EDD Payroll Tax Audit

The next thing that you want to do is you want to make sure you are in full tax compliance. We are not just talking payroll tax compliance, we are talking full tax compliance. Are all the 1040s submitted for corporate shareholders for entities that are pass through? All the 1120s, 1120Ss, 1065s submitted? Translation for non-tax people: Are the corporate tax returns and/or their partnership tax returns submitted? This is really important for verification purposes and to avoid potential penalties.

You want to basically write a check to make sure all their individual income tax, corporate income tax and payroll tax returns are filed, both at the federal and state level. It is going to look real bad if the client is not in tax compliance. With most payroll tax audits though, the businesses that are being audited, for the most part, unless they are extremely disorganized, are going to be in tax compliance. You want to run a six year check of filings just to be on the safe side, although a three-year look back period is standard for the EDD tax auditor (six years comes up in cases of substantial understatement and/or fraud.  

So, it is usually not something you need to worry about, but you do need to check it. Particularly income tax returns that haven’t been filed because it's kind of embarrassing. You need the income tax returns filed anyway during the audit, because it's one of the things that you're going to use to verify a source documentation in terms of what payroll was.

 

Addressing Reasonable Compensation and Officer Compensation Issues Before the Start 

Are the officers of the company receiving W2s? Just to be clear, regardless of what type of business it is, unless it is a completely passive investment, your ownership is going to provide some level of services for that business and, therefore, will need some sort of W2 compensation. The EDD auditor is not going to just let this go. Compensation associated with services provided for a business is taxable wages. This is very clear settled law in California. 

What do you do if your corporate owners/officers have not been issued W2s? Then you need to do the heavy lifting and assign them a reasonable level of compensation based on this. This is more of a tax attorney type of call, so I caution you about making this determination on your own without some help.

However, at some level, you want to make sure that you must take a position on reasonable compensation and walk into the audit with W2s prepared to back that up.

Even if they are late, at least they are prepared and at least that you can go through and make up that gap. This at least will give you a document to defend vs. going in front of the auditor and just trying a craft a reasonable compensation argument out of thin air. 

If you do not do this, the auditor is going to take all the compensation of the client and try and classify it as W2 wages. So, you want to make the opening position on that issue versus letting the auditor define what reasonable.

Even if you are aggressive in your determination, the bigger issue is not having W2s and leaving the auditor kind of a door to walk through and assigning all compensation of the client as taxable wages. It is a lot harder to dig your way back from that position than to take a stance and have the auditor trying to chip away your already formed position. A key negotiation strategy is making the opening offer because it gives you a starting point to frame the discussion.

 

Dealing with Questionable or “Off the Books Payments” in an EDD Payroll Tax Audit

The next thing is that you are going to want to go through that General Ledger in detail and make sure that it is organized appropriately and that there is no evidence of any off the books payments. Off the books payments are payments as compensation to people that were not issued a 1099, either as cash payments or personal charges that are buried into the accounting of the organization.

When dealing with this issue, the first thing you need to do is you need to go through and you need to look through expenses that you think, or items that you think, are going to raise any red flags. Blank journal entries are going to raise a red flag. Adjustment journal entries can raise a red flag. All sorts of other expenses, which are obviously on a case by case basis, will raise a red flag. So, take any items that are in the general ledger that you think are a red flag and put them on a punch list to address prior to the audit.

You are going to want to make sure that you isolate those issues first and then work through them internally to make sure you have clear explanations during the audit. If need be, and if the general journal is a complete mess, you may have to build your own general journal from bank statements. Yes, this is a tedious and time-consuming task, but having these issues opened up in front of the auditor is a real killer.

So, basically you take the general journal (hopefully produced in an Excel or other electronic format where you can manipulate the data and reorganize it. The goal here to to clean up your books and turn them into a format that the auditor can scan and not take any issues with.  

It is important that you understand what we are saying here. The most important thing is the presentation and the integrity of your data. The general journal/ledger needs to visually look correct and error free. You cannot delete things directly off the general journal (unless they do not belong there), but you are welcome to augment and add anything to the memo lines and descriptions as long as things are materially accurate.

Alternatively, although tedious and time consuming, you can also create a brand-new document for the purposes of your presentation to the tax auditor. Obviously, your business is probably not going to use it in the future, but at least for the terms of your presentation, it will be able to present a clean general journal versus the messy general journal. Do not be afraid to take certain things and present them in a better manner. So, as long as the information is materially accurate, then you can work with the information that the business has and present it in a better format. We do this all the time in audits. We take documents that the client may have in their possession and translate into clear, easy to understand spreadsheet. Clean work product really helps with the flow of the audit.

As an example, a lot of times what will happen is you'll have an owner of a business who writes a check for landscaping of the business property. If that person writes a check, they will write it out to the person who's actually mowing the lawn versus to the actual landscape company itself. The guy who is mowing the lawn will accept the check because he's just mowing the lawn and he's going to be able to cash it and spend the money, so he does not care. But on the general journal, it looks like a payment to an individual versus a payment to a business, which will raise a red flag with the auditor.

A lot of times you will have circumstances like this that cause confusion on the general journal level, where payments that are really meant for businesses appear to be going to individuals. During the course of an audit, you’ll be more than welcome to explain this as it pops up on the general journal, but the better thing to do is to adjust the general journal entries so that they reflect the payment to the business and not to the individual. That way you do not even have to deal with the issue and it explains itself right there on the document. You can put the individual's name in parentheses, and if the auditor pulls the copies of the checks for the bank statements of that period of time, you can go through and you can match those against the general journal.

 

Conclusion

The more organized, the better prepared you are, or the better prepared that you seem, the more credibility it lends to your narrative with the auditor. The more credibility, the faster the auditor works through the audit, and accepts your conclusions and goes from there. Audit meetings should be easy, and you should go into the audit confident in the materials that you have and feeling pretty relaxed. Being relaxed will convey confidence to your tax auditor. As such, cleaning up these issues prior to your EDD payroll tax audit will go a long way toward your success.