Independent Contractor Compliance Blog - by Collabrus™

If you have ever been on the wrong side of a government tax audit, you probably have wondered what the Tax Auditor is doing locked up in your conference room with your records all day? (Later, you most likely found out). The detailed procedures can vary from agency-to-agency and even from auditor-to-auditor within the same agency, but in general here is what an employment tax auditor is looking for in your accounting records.

The first step the auditor will take is to define the “Test Period” and the “Statutory Period.” What, you might be asking yourself, do these terms mean?

The Test Period is typically one year or one quarter within the statutory period (see below). To make his job a little bit easier and more efficient, the auditor will examine the records in this limited time period to test for:

• Does the accounting system following normally accepted standards and practices?
• Can the accounting records be trusted to reflect the actual business operations and financial transactions?
• Are there any errors in the “Admitted Payroll?” (i.e. can they verify that the gross wages you reported to the government matched what’s reflected in the Individual Payroll Records, Payroll Journal and General ledger). 
• The auditor will look at your disbursement journal, check registers and expense accounts to see if any payments were made to anything that looks like a misclassified IC. (I’ll cover this next time in the segment on Hot Buttons for Auditors).
• If there are what types of personal services are involved?
• Make a judgment as to if other time periods will need to inspected in detail or if only summary records will be examined outside the test period.
• Verify that the legal entity reflected on the government’s data base is the way you are actually organized and doing business. (You’d be surprised how many small, privately owned corporations are operated as if they were really sole proprietorships, or corporations that have never paid their fees with the Secretary of State, or companies that operate like a sole proprietorship but file income taxes as a partnership, etc). All of these situations can affect the outcome of an employment tax audit and how any liability is assessed.

Generally, the auditor will scrutinize your records in detail for the test period. If he/she finds errors (from the government’s point of view) then the examination will be expanded into the full statutory period looking for more of the same type of errors. Typically, the auditor will not look for other types of errors not found in the test period. So if, for example, the only questionable items found in the test period are payments to consultants in your IT department, then it is highly likely the auditor will only look for payments to consultants in other years, ignoring other payments.

The Statutory Period is the full length of time the government is allowed by law to go back in time and look for errors. It is the statute of limitations for taxes. For employment tax audits this is usually three full years from the last complete calendar quarter. The only authority an auditor will have to go back further in time would be fraud or a few other special circumstances that don’t apply to 99.8% of all business. In most audits only problems identified in the “Test Period” are searched for in the full Statutory Period.

Others things the auditor will be doing.

• Run a test of your withholding of employee withheld taxes (SSA, disability, personal income tax, etc) to verify the correct amount was withheld and all of it was reported and paid to the government.
• Find collection information in the event your company owes money at the end of the audit and does not pay it promptly. Where does he/she find collection information? Your bank accounts, accounts receivables (your clients and customers that can be levied on by the government), hard assets you own that can be seized and sold at auction, the names and personal information about responsible officers of the corporation that may be held personally liable for the money owed if they had control of the corporate money and choose not to pay the tax assessment but to use the money for something else.
• Compile names, addresses and contact information of workers who the auditor suspects of being misclassified.
• Prepare an accounting schedule of all “Questionable Items” (a common auditor term for suspected misclassified workers), including the dates and dollar amounts paid, in the entire Statutory Period.

By the time an experienced auditor leaves their quiet room and wants to discuss items with you or has a few questions, he/she has already obtained all this information from your accounting records. Experience teaches auditors that once a business suspects a large tax assessment is pending their level of cooperation begins to fall off rapidly. So the experienced auditor will want to gather all the information possible before you realize where the audit is going.

Now you might be thinking, “Okay, I won’t let the auditor see anything and I won’t answer his questions. He can’t assess me for something he doesn’t know-right?”

This is a very bad idea. Government tax auditors don’t respond well to hostility or any attempt at a cover-up. I’ll cover this in the next segment.

What’s next?

Hot buttons for auditors: Things in your records, and statements you can make, that guarantee closer scrutiny of your business and are almost guaranteed to get you into more trouble.