No large or small business owner wants to hear that they are being audited – especially if they have never experienced the situation before. As a CPA firm, it is your job to help clients navigate the process, help them prepare for the audit, and ultimately put their minds at ease.
Because payroll tax can sometimes be included in an R&D tax credit claim, we have put together this quick guide for explaining IRS payroll tax audits to clients in a digestible and easy to understand way.
Explain How the Payroll Audit Will be Conducted
First, explain to the client how audit notices are issued. Audit notices are typically sent if the IRS believes that the taxpayer failed to properly report payroll taxes.
Many receive these notices because their returns were scored as having a high potential for error based on an IRS algorithm that screens tax returns.
The most common types of errors include:
- Improperly classifying workers
- Miscalculating overtime wages
- Paying the wrong tax rates
- Filing late
You will need to explain what type of audit your client will be receiving: a compliance check or a full audit.
Compliance Check: Explain to the client that this involves a look at a company’s federal employment tax forms and a brief interview centering on the factors deemed important.
Full Audit: Explain to the client that this is an extensive and detailed investigation and assessment of corporate books and records that show payment activity, business activities, and more.
Examination and Analysis Before the Audit
The CPA should tell the client that this is a thorough review that is conducted to ensure all financial information and worker classification is correct before the official audit is conducted by the IRS.
After your team determines and explains the type of audit that will be carried out, they will need to examine and discuss the nature of the relationships of the workers employed by the client and gather the following information from them and explain that your team will be doing a thorough review to determine discrepancies.
- A list of workers, outside vendors and other entities used as independent contractors.
- All 1099 and W-2 forms the client issued.
Once the documents above are gathered, set up meetings to interview management, human resources, payroll and legal departments. There may also need to be meetings set to speak with the workers to ensure the worker classification is inline with their duties.
This is also when a review of all documents will be examined to determine whether workers were classified correctly as a 1099 or W2 employee and consistently from year to year. With this information, a CPA can then determine which workers may need to be reclassified and analyze the potential tax exposure associated with that reclassification.
Initial Interview with the Auditor
The first interview with an auditor will likely make the client feel overwhelmed but the auditor will explain why the audit is taking place, how it will work, and ask general questions about your business. You’ll have the opportunity to ask the auditor questions, too.
You and your client should read over all of the initial documents concerning the audit carefully, and respond to all requests in a timely manner. The client may want to seek legal counsel at this point to help them build a more robust case and establish the reasonableness of the worker classifications. These classifications will need to be organized and clearly presented when the time comes.
First Level of IRS Review: Compliance Check
Proper compliance and cooperation at this stage can help avoid a full audit. This is when the IRS agent will look into filings and returns for accuracy. They will also review any supporting documents that have been provided.
In some cases, the compliance check is the first and only stop in the audit process, but you should still make sure your client understands what happens next if a full audit is conducted.
Second Level of IRS Review: A Deeper Investigation Into Employee Pay and Business Activity
If the agent finds that the information provided during the first review is not compliant or there are errors, they will then conduct a full audit. This will likely include a look back at all filings, worker classifications and payroll ledgers from the last 3 years, interviews with workers and supervisors, and more.
The agent may request additional information to get a better idea of business activity at this point, also. Make sure your client knows that a full audit is by no means a quick process and generally take about a year to complete.
Resolving Issues and Settlements
Some businesses come out of a full audit without the IRS finding any issues, or the issues found were from a very small, easy to resolve error. However, some businesses will have to take steps to resolve their position with the IRS if larger issues are found.
Luckily, if larger issues are uncovered by the IRS, there are several programs that act as incentives to encourage taxpayers to resolve classification issues as early in the administrative process as possible. Penalties and fines may need to be paid, but it is not the end of the world.
Avoiding an Audit in the First Place
The best way to avoid an audit (and the negative consequences that come with it) is an ironclad tax return that leaves nothing up to question and reporting the proper taxable amount reduces their chances of triggering an IRS audit.
Tri-Merit gives CPA firms the support they need to ensure that their client’s tax records hold up against the most stringent IRS audits. With strict attention to detail and a firm grasp of qualified activities for R&D tax credits, our team will defend our work during an IRS audit if the time comes.
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