The very first thing that the auditor does is they put you through an initial compliance interview.
An initial compliance interview serves a couple of different purposes. Number one, it’s to get background on the client. Number two, it’s to kind of put answers in place in case there’s any problem that come up later. For example, one of the questions they ask you is how many locations do you have? That way if they see something where you didn’t maybe disclose location you kind of dig yourself into trouble.
The initial compliance interview lays the framework for the auditors line of questioning. A lot of the times in federal tax audits, like with most audits, these auditors are basically writing a form audit report. They’re going through, they’re completing their due diligence in the beginning. They’re going to take your answers and incorporate them into their report later. At the California State payroll tax level, here are the questions that you’re going to be asked in the initial audit review.
They’re going to ask you when business operations commenced. They’re going to ask you what the nature of the business is and the hours of operation. They’re going to ask you how many employees you have and what they do. Then, they’re going to ask you how many independent contractors do you have. What services are performed by those independent contractors, are they full-time, seasonal or part-time? Was the business always incorporating or did the business have a different entity before.
How many locations does the business have? How many workers at each location? They’re going to ask you for a list of officers. Both the name, their titles, and their job responsibilities. Then they’re going to ask you who manages and directs the entities operations. They’re going to ask you who signs checks. Who prepares and files both income tax returns and payroll tax returns. What is the frequency of payroll? How often do people get pay?
Who provided the business with any guidance for any 1099s that they have. What’s the business mailing address? What is the personal mailing address to the officers. What the business’s total revenue was for the last year and potentially for a year to date. What is the salary amount for each officer? And what is the K1 amount for each officer? Let’s talk about some of those questions.
The very first thing they’re doing is they’re establishing a system for the business. They’re saying, “We have a retail store and the retail store has two locations. In each location we have anywhere between five and seven employees at a time.” They are developing a pattern within the business on who the key members of the business are. Who the people are in the business that perform services.
They are establishing a pattern of who the business’s workers are that function as employees. The reason they’re doing that obviously is to compare the employees to any independent contractors that the business may have. They’re going to look at the key functions that each employee performs. They’re going to compare, contrast that to independent contractors. They’re going to see if there’s similarities.
For example, you might have a situation where you have a business with both WP– salespeople who are on W2 salary and who are on 1099. If the functions of the 1099 worker and the employee are the same, the state is going to seek to reclassify the 1099 worker as an employee. Absent good justification why they should be treated as a contractor. The initial scope of those questions is to establish background on the business, create a framework for who the employees are in the business and what they do.
Obviously, they’re going to look into the form of entities. They’re going to look to see if there are maybe multiple payroll tax accounts associated with the business. For example, you often have time where you have a sole-prop business that will incorporate particularly in the audit period in question so they’ll go back and look at both accounts, to try and trace some of the normalcy.
Similarly, you’ll have an entity that may be associated with some bad behavior in the past. The new owner prior the audit just decided to scrap the entity, create a new entity. They’re going to be trying to look for similarities there. Then they’re looking for who is calling the shots at the business. Who is directing control? Who is managing operations? Who’s signing checks? Who is really the responsible party? This is important not only from an officer compensation standpoint.
They want to know who the officers are in the company and how they’re getting paid. But they’re also seeking to establish some level of control over the business. That way if there is an assessment later against the business and the business decides to shut down. The EDD will have information on who the responsible party is. They can pursue an assessment against those responsible parties.
The next thing they’re looking for is to look for reasonable compensation issues. They’re looking at the salaries of each officer. They’re looking at the K1 distributions associated with the officer. They’re making sure that the officer compensation is not set arbitrarily low. And/or the officer compensation has a fair distribution between what the officers’ salary is. Their job duties and responsibilities. Then, any K1 distributions that are appropriate.
Those initial questions just kind of go through some of the background information on the business and help to explain that.