UGH! You’ve received notice of an upcoming audit from your state Unemployment department. Take a deep breath – it will be okay!
The department will provide you with a (long) list of items required to conduct the audit. I am speaking of my experiences with Massachusetts, but I am sure other states have similar requirements. In MA they will ask for the following for the audit period:
Federal Tax Return (hard copy)
W-2s, W-3, 940 and 941’s
Summary payroll report showing gross wages paid to each employee
Employee earnings detail record
General Ledger, Chart of Accounts, Check Register, Check Stubs, Petty Cash
Bank statements INCLUDING copies of cancelled checks
Invoices, Vouchers, Employee Expense Reports
Work Schedules and Time Cards
1099 and 1096 forms and supporting documentation (hard copies). Documentation includes certificates of insurance, invoices, business cards etc. for payments to 1099 recipients and subcontractors. They may also ask for quarterly payment totals for each 1099 vendor.
On the last audit I was involved with I provided the auditor with digital copies of everything requested which she uploaded to her computer. She also took the hard copies I provided (and subsequently needed replacements – a story for a different day!)
It has been my experience that they are most commonly looking for payments made to vendors who should be treated as employees. The state takes a very hard line on who can be considered an independent contractor and if you have treated someone as an independent contractor who they think should be on your payroll you will probably get whacked for the payroll taxes (and penalties on these taxes that should have been paid). In Massachusetts there is a three-pronged test. You must determine that ALL of these factors are in place in order to treat someone as an independent contractor:
Work is completed without your direction and control
Work is performed outside the usual course of your business
Work is done by an individual who has their own independent trade or business doing that type of work.
If the auditor finds enough evidence of misclassification, they may, on the spot, broaden the audit period and will ask you to provide the same documentation for additional periods (breathing comes in handy here too!).
The real take away from all of this is – be as helpful as possible. Don’t be defensive or combative, as that will only make things worse. Have everything ready upon the auditor’s arrival in order to limit the time it will take. And certainly be aware, going forward, that it is safer to treat someone as an employee if there is any doubt in your mind about how they should be classified. It’s painful to set someone up as an employee, but in the long run, if there is any question about whether they are an independent contract, or an employee, to just set them up as an employee.