PREPARING FOR AN IRS PAYROLL AUDIT.

A payroll audit by the IRS is not something to be afraid of but it is something you want to handle properly.

What To Expect

The IRS will contact you to establish a mutually satisfactory time for the audit. You will be provided with a list of the forms and records that the

auditor will want to look at. The auditor will visit your place of business, or a mutually agreed upon location, and review reports, payroll records, check registers, general ledger, and other documents to obtain the necessary information. When the audit is completed, the auditor will discuss the results of the audit with you, provide a copy of the audit and clarify any reporting requirements or problem areas.

The best time to prepare for an audit is when you begin preparing your first payroll each year. Step one is keeping all your work papers and backup information organized so you can retrieve it easily.

Basic Information

Figure 1 lists the basic information the IRS auditor will expect you to have on every employee.

Your payroll records should contain sufficient information to permit an independent party to calculate your payroll tax and pension contribution liability.

Recordkeeping Requirements

For federal income tax and social security purposes, you must maintain records for four years from the due date of the tax and the related return or the date the tax is paid, whichever is later. Retention periods also vary by state. The minimum is three years. Figure 2 shows the information you are required to keep for each employee. You are subject to fines and penalties for noncompliance with these recordkeeping requirements.

In addition to records for tax purposes, other government agencies, such as OSHA, EEOC, etc., may require you to maintain records.

Not only must you maintain the records identified above, but you must also be able to retrieve them within a relatively short period.

Unclaimed Paychecks

Special rules apply to unclaimed paychecks. You cannot keep the money. Every state has "escheat" rules, which require employers to hold unclaimed and uncashed employee checks for a specified period. At the expiration of this period, the monies must be turned over to the state's escheat division. In addition, the checks remain a permanent part of the employee's earnings record and must be reported on the employee's W-2. You should be able to separate these checks by date. You must attempt to locate the employee. Keep documentation on your efforts.

Withholding Considerations

If you believe a worker who has performed services for you should not be considered your employee, it is important that you fully explain your reasons to the auditor. Anyone who performs services for you is your employee if you can control what will be done and how it will be done. People who are in business for themselves generally are not your employees, and you are not required to withhold taxes for them. Direct sellers and qualified real estate agents are considered non-employees by law.

Some other payroll issues to keep in mind include:

* Payments for the services of a child of yours under age 18 who works for you in your business are not subject to social security and Medicare taxes.

* The wages you pay your spouse for services performed in your business are subject to income tax withholding, social security, and Medicare taxes, but nor to FUTA tax.

* Wages paid to a parent who works for you are not subject to FUTA tax.

* Payments in kind (non-cash payments) made to employees may be in the form of goods, lodging, food, clothing, or services.

Generally, the fair market value of such payments at the time they are provided is subject to income tax withholding and social security, Medicare, and FUTA taxes.

Depositing Withholdings

Failure to deposit tax monies properly also may create problems during an audit. In general, you must deposit income tax withheld and both the employer and employee social security, and Medicare taxes (minus any advance EIC payments) to an authorized financial institution or Federal Reserve Bank. There are two deposit schedules--monthly or semiweekly--for determining when you deposit social security, Medicare, and withheld income taxes. Before the beginning of each calendar year, you must determine which of the two deposit schedules applies to you. The deposit schedule you must use is based on the total tax liability you reported on Form 941 during a four-quarter "lookback period." The lookback period for 1999 began on July 1, 1997, and ended on June 30, 1998. If you reported $50,000 or less of taxes for the lookback period, you are a monthly schedule depositor. If you reported more than $50,000, you are a semiweekly schedule depositor.

If you accumulate a tax liability (reduced by any advance ETC payments) of $100,000 or more on any day during a deposit period, you must deposit the tax by the next banking day, whether you are a monthly or semiweekly schedule depositor. You are required to deposit 100 percent of your tax liability on or before the deposit due date. However, penalties will not be applied for depositing less than 100 percent if both of the following conditions are met:

* Any deposit shortfall does not exceed the greater of $100 or 2 percent of the amount of taxes otherwise required to be deposited; and

* The deposit shortfall is paid or deposited by the shortfall "makeup" date, which varies depending on whether you are on a monthly or semiweekly deposit schedule.

If you are dealing honestly and in good faith, your main concern should be that your records are complete and correct. If you are prepared, undergoing an audit may not be a pleasure, but it won't be a nightmare either.

Milton Zall is a freelance writer based in Silver Spring, MD, who specializes in taxes, investments, and business issues. He is a Certified Internal Auditor and a Registered Investment Advisor.

EMPLOYEE INFO

Name and address

Social security number

Federal withholding certificate (W-4)

State withholding certificate (some states accept the federal W-4)

State residency status

Salary or rate

Job classification

Pension plan status

Normal work hours per period for hourly and salary employees

Employee gender

RETAINED RECORDS

Name

Address

Social security number

Date and amount of each payment of wages and other remuneration (whether cash or non-cash)

Period covered by each payment

Amount withheld for income taxes and FICA or voluntary deductions

Reconciliation of differences in total remuneration and payments subject to taxation

Reconciliation of differences in total remuneration and amounts subject to FICA

W-4 withholding certificate

Any notifications from the IRS requiring you to change the employee's W-4

Copies, of all statements provided by tipped employees (if you have any) for the reporting of cash tips

Copies of any return, statement, or other document filed by you that was required by law.