Charles Read, CPA, USTCP, IRSAC
President/CEO GetPayroll
Find me on LinkedIn

Audit – “an official inspection of an individual’s or organization’s accounts”

There are as many types of tax audits as there are taxes.

You will get lots of answers on income tax audits so I am going to address employment tax audits.  70% of all the revenue that the IRS collects comes from taxes accessed on the payroll.  The IRS accesses six billion dollars of employment tax penalties, per the 2018 IRS Databook, and 40% of small businesses are accessed an employment tax penalty annually.

The IRS can audit your payroll tax records, deposits, and reports based on a number of things.

  • Non-payment of Taxes
  • Late Payment of Taxes
  • You don’t file your tax returns
  • You have other tax problems so they want to make sure you are not shorting your employment taxes
  • Your business goes out of business still owing taxes
  • They get a tip that you are cheating on your taxes
  • You’re the unlucky random audit
  • Any reason they can think up

One terrible consequence of not paying taxes that you have withheld from your employees is a “Trust Fund Penalty”.  This penalty is 100% of the taxes withheld and not paid plus interest.  The penalty is not dischargeable in entity or personal bankruptcy.  So if you are a “Responsible Party” and are hit with a “Trust Fund Penalty” you have to pay it or endure 10 years of concerted collection efforts by the IRS; until the statute on collections runs out, 10 years after the penalty is accessed.

Beyond the IRS and the States auditing the withholding taxes you also have the State Unemployment Department; called different things in different States, auditing your unemployment tax deposits and filings.  All the States have random audits of unemployment tax accounts for businesses.  They want to make sure that you are recording and paying all unemployment taxes.  They particularly want to make sure that you are classifying employees as employees and not independent contractors.  They will want to look your business records including the following:

  • All canceled checks, check stubs, check registers and bank statements
  • Timecards
  • Cash vouchers
  • Cash disbursement journal
  • General ledger
  • Individual earnings records
  • Payroll journal
  • Quarterly tax reports
  • IRS forms 940 and 941
  • W-3 and W-2s
  • IRS forms 1099, 1096
  • Master vendor files
  • Petty cash
  • Chart of accounts
  • Profit and loss statement
  • Corporate minutes
  • Federal tax returns (1040 Schedule C, 1120, 1120S, etc.)
  • Any other records which may reflect services

In addition to random audits, the State will also audit based on complaints or tips from current, former, or prospective employees.  They will also take complaints from competitors who may complain you are paying people as independent contractors which your competitors may think gives you a competitive advantage.

This happens on a regular basis, that a worker you are paying as an independent contractor goes and files for unemployment.  There is no record of his payroll because you were paying them as a contractor and not paying unemployment taxes.  The State will audit and if they feel you have misclassified a worker as a contractor, that should have been an employee, the consequences can be major.  All of the unemployment taxes that should have been paid along with penalties and interest going back for the life of the worker!  Plus they can refer your case to the IRS and they will want all of the withholding along with penalties and interest for the career of the worker with your business as well.

The States and the Feds take misclassification very seriously because the withholding and reporting of income on  W2s makes for much higher tax compliance both in filing and collections.  So businesses should remember if there might be a classification problem, a single disgruntled ex-worker could destroy your business.

The best way to avoid compliance issues is to hire a payroll bureau so you have peace of mind.


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