A 5-Step Guide to Preparing for an Unemployment Tax Audit

Receiving an unemployment tax audit notice can be worrisome, especially if you consider the time, scrutiny, and documentation that go into the entire auditing process.

However, a tax audit isn’t always a cause for worry, especially since there are different reasons why you may be considered for one.

That said if you are stressing over tax-related queries such as, ‘What is an unemployment tax audit?’ or ‘What happens when you get audited by the IRS?’, this article will answer everything you need to know about what auditing unemployment tax means and how you can prepare for it.

Let’s begin!

Key Takeaways

• An unemployment tax audit takes place when state unemployment agencies find discrepancies in an employer’s reported unemployment tax amounts.
• The Taxpayer Compliance Measurement Program audit, office, field, and correspondence audits are the different types of tax audits conducted by the IRS. Meanwhile, unemployment tax audits are carried out by state unemployment agencies.
• Taxpayers can appeal their audit notice. They can also request additional information about their audit and additional time to prepare all the documents required by their auditor.
• All tax audit notices are sent to the latest mailing address declared by the taxpayer in question. Audit notices conveyed via phone call are likely a form of tax scam.

What is a Tax Audit?

A tax audit is an official investigation conducted by the Internal Revenue Service (IRS) on an individual’s or business entity’s financial information, particularly their reported income and taxes, and accounts. Businesses and individual taxpayers get audited primarily because the IRS needs to affirm whether their reported taxes and income for the year are true and correct.

Typically, audits are triggered by odd or irregular details in your tax report. You may have also declared deductions that don’t seem to add up to your income, tax bracket, or eligibility for specific tax exemptions.

If your tax return is connected to another organization’s audited return in some way, then you can expect an audit from the IRS as well. While high-income taxpayers are more likely to be under scrutiny by the IRS, unfortunately, even taxpayers earning less than $25,000 are also more likely to undergo an investigation.

What’s more, small businesses that earn a particularly small profit when compared to similar businesses are much more likely to get audited under suspicion that they are not reporting their true profits.

Since the IRS grants the earned income tax credit to low-income households, the government agency must ensure that the tax credits are not being used or taken advantage of by scammers or criminals.

Conversely, tax audits can also be done at random, wherein the IRS uses a statistical formula with the help of a computer screening process. The IRS does this as part of its National Research Program, which aims to update and improve accumulated data on return selections.

Tax audits are conducted either via mail or through an in-person interview. In-person interviews can take place at the nearest IRS office (also called an office audit) in your location, at an accountant’s office, at your place of residence, or at your place of business (a field audit).

It is worth noting that there are four different types of tax audits, namely:

• Correspondence audit. It is the most common type of tax audit, and it commences with a letter or a notice from the IRS requesting specific adjustments or additional information on your returns.

• Field audit. In contrast, field audits are the most meticulous, and they involve an IRS agent visiting a taxpayer’s place of business or residence to thoroughly investigate their reported financial and tax information.

• Office audit. An office audit means that the taxpayer is summoned by the IRS to their office to conduct in-person audits. Office audits typically take place when the IRS needs to probe into a taxpayer’s business's losses and profits or itemized deductions.

• Tax Compliance Measurement Program (TCMP) audit. The TCMP audit is used in conjunction with the IRS’ discriminant function (DIF), which is the mechanism used by the IRS to select which returns to audit.

If you get selected for an investigation, you should receive a notification from the IRS via mail. The IRS never sends tax audit notifications via phone call. If someone calls you and says that you have been selected for a tax audit, it’s probably a scammer at the other end of the line.

On the bright side, you can appeal your audit within 30 days following the date indicated in your notice from the IRS.

Why is a Tax Audit Important?

Tax audits are important because they ensure taxpayers, business owners, and non-tax-exempt organizations comply with existing federal and state tax regulations. Some taxpayers and business owners attempt to tweak the system to try and qualify for deductions or reduce the amount of taxes they owe.

Unfortunately, attempting to manipulate your tax and income reports will only lead to further investigation and deeper probing from the IRS or, worse, penalties and federal charges.

Another reason why auditing tax returns is essential is for the federal government to have a reliable basis to improve existing tax laws. After all, nothing serves as a more reliable data source than the actual tax returns submitted by taxpayers themselves.

A most recent example of this is how the IRS reintroduced Form 1099-NEC after the 2020 tax year to report non-employee compensation. Prior to that, there had been confusion between the use of the 1099-NEC vs. the 1099-MISC due to some overlapping details when it comes to reporting miscellaneous and independent contractor income.

Now that we’ve explained what a tax audit is and how it works, let’s move on to discussing the processes involved in an unemployment tax audit.

A Guide to the Unemployment Tax Audit

Unemployment tax audits or unemployment audits take place to verify whether employers are dutifully fulfilling their FUTA and SUTA tax obligations.

Unemployment Taxes Explained

The federal and state governments impose unemployment taxes to generate funding for their unemployment insurance programs.

In turn, the government uses the said program to provide benefits in the form of insurance and assistance to workers who have been displaced from their jobs. Job displacements may be due to the recession and major economic changes.

Unemployment taxes are categorized as FUTA (Federal Unemployment Tax Act) and SUTA (State Unemployment Tax Act).

FUTA taxes are levied by the federal government on employers alone. These are employers who have paid a minimum of $1,500 in employee wages within any quarter of the calendar year. Employers who employed at least one employee who completed a minimum of 20 weeks at work are also subject to FUTA taxation.

As for the tax rates, the IRS imposes a fixed 6% rate on the first $7,000 worth of wages paid to each employee. Taxpayers can also use SUTA tax payments to take a maximum of 5.4% credit from their taxable earnings for FUTA.

Those qualified for the 5.4% credit are only required to pay 0.6% FUTA tax rates.

The deadlines for paying FUTA taxes are distributed quarterly, which means you must ensure you pay your FUTA taxes on or before the following due dates:

• January 31
• April 30
• July 31
• October 31

If you owe less than $500 in FUTA taxes, then it is more ideal to carry your FUTA tax liability over to the next quarter. If your tax liability for the next quarter is still worth less than $500, then you can continue carrying over your FUTA taxes until such time that it reaches $500 or more.

Once your FUTA taxes amount to $500 or more, you must deposit a minimum of one quarterly tax payment instead of following the set deadlines. You can deposit your FUTA tax payment on the last day of the month following the completion of a quarter.

SUTA tax rates and wage bases vary per state. As of writing, the states with the highest wage base for SUTA tax include Washington ($68,500), Hawaii ($59,900), Idaho ($53,500), and Oregon ($52,800).

Most states, except Alaska, Pennsylvania, and New Jersey, levy the SUTA tax on employers only. All SUTA taxes must be paid on or before the last day of the month at the end of each quarter.

For transparency purposes, you must include details of your paid FUTA and SUTA taxes on your employees’ paycheck stubs. In this manner, you have solid proof of fulfilling your tax obligations to your staff and to the IRS.

You can also use a pay stub generator to ensure you don’t miss any unemployment tax or any other payroll and income tax information on each employee’s payroll records.

What Triggers an Unemployment Audit?

You may be wondering, ‘What triggers an unemployment audit?’ In truth, there are several factors to consider in determining whether a business or employer is at risk of an unemployment audit.

These factors include:

• Company size. The total federal and state unemployment tax amounts you report in your returns should coincide with the number of employees you have.

• Amount of paid unemployment taxes. There are specific regulations to follow when paying federal and state unemployment taxes. Paying more or less than the required tax amount can potentially make authorities question your tax report.

• Withholding unemployment taxes from employee wages. Federal and state unemployment taxes are levied directly on the employer’s income. The only states that impose SUTA taxes on both employees and employers are Pennsylvania, Alaska, and New Jersey.

• Auditing history. If you have been audited in the previous tax years,you may find yourself a probable candidate for a tax return review.

• High turnover rates. Some industries, particularly those that are more prone to embracing contractual work setups, are more likely to get audited. With contractual employment only offering short-term jobs, most displaced contractors end up filing unemployment claims against the contractor or the employer.

• Employee complaints. If you’ve been the subject of multiple complaints filed byyour staff, particularly one that involves their compensation, benefits, and taxes, they may also be in line for an unemployment tax audit.

One of the main differences between a regular tax audit and an unemployment tax audit is that the latter is usually done by the state unemployment agency.

Concerned employers will receive a written unemployment audit letter, which is mailed to their last reported mailing address.

During an audit or investigation, the state unemployment agency reviews a company’s unemployment tax returns, wage reports, and paycheck records.

How to Prepare for an Unemployment Tax Audit in 5 Steps

Here’s how to prepare for an unemployment tax audit and stay ready to entertain any inquiries or follow-up questions from the auditing agencies:

#1. Review Your Tax Audit Notice

You have the power to reduce your chances of being audited for unemployment by carefully scrutinizing the details of your unemployment tax audit notice. Fortunately, you can dispute or appeal your audit, provided that you do so within 30 days from the date indicated in your notice.

Reviewing your tax audit notice also offers a chance to delay the auditing process. More specifically, you can request additional time to prepare the required documents for your investigation.

As long as your audit does not involve any form of tax fraud, you can take advantage of the IRS’ three-year window to complete a tax audit.

#2. Gather the Required Documents

Depending on the reason behind your unemployment tax audit, you may be required to gather any of the following documents:

• Your employees’ Form W-2 and Form W-3
• IRS payroll forms
• Employee timesheets
• Bank statements
• Financial statements
• Proof of non-payroll compensation
• Your business income tax returns

It is highly recommended to keep all your payroll records well-organized and updated at all times. Similarly, implementing an efficient payroll administration process also helps you keep track of all transactions and responsibilities involving taxes and unemployment claims.

#3. Get Informed About the Audit Criteria or Process

All taxpayers have the right to know the reason behind their tax audits. In fact, your right to be informed is the first item under Publication 1, Your Rights as a Taxpayer.

You are allowed to ask follow-up questions and request clarifications on your tax audit. If you find that some of the required documents may be challenging for you to acquire, it would also be more advantageous to inform your state unemployment agency of your dilemma.

#4. Prepare Explanations for Any Discrepancies

Don’t panic simply because your unemployment taxes are up for further evaluation. Instead, focus on composing yourself and preparing an explanation for any discrepancy or inconsistency that the auditing agency may present.

You must also be careful not to be too defensive or emotionally affected while addressing the auditor’s inquiries and findings. Doing so may potentially lead to suspicion and further investigation.

Remember, undergoing an unemployment tax audit does not necessarily and automatically mean you are involved with fraudulent tax practices. Moreover, if you have been a consistent, law-abiding taxpayer, then there should be no reason to worry.

#5. Seek Professional Assistance

Seeking professional assistance in the case of an unemployment audit means consulting with a tax attorney or a CPA. By gaining professional and legal advice, you get to make more informed decisions when it comes to acknowledging your audit notice.

Final Thoughts

An unemployment tax audit isn’t always a cause for concern, particularly for businesses that operate their trade legally and follow existing tax regulations.

That said, it is crucial to understand how tax auditing works and how you can prepare for the auditor’s assessment to ensure you prevent possible penalties or heavier charges from federal or state government agencies.

Unemployment Tax Audit FAQ

#1. Does every unemployment claim get audited?

No, not every unemployment claim gets audited. Realistically speaking, it would be impossible for the IRS and the designated state unemployment agencies to go through every single unemployment claim from all taxpayers within the country or the state.

Unless your claim contains questionable and illogical information, such as unreported income or inapplicable deductions, audits are usually selected at random.

#2. How do you pass a tax audit?

You can pass a tax audit by providing all the necessary documentation and proof to support your argument. It would also be helpful to seek the assistance of a Certified Public Accountant (CPA) or a tax professional and let them answer the IRS’ inquiries for you.

On the other hand, you must still prepare yourself to answer any possible interrogation. Remember to stay calm and objective when answering and explaining your tax records.

#3. What happens if you fail an unemployment audit?

If you fail an unemployment audit, you are subject to facing penalties, which will be added on top of the taxes you owe. Some of these penalties include penalty fees worth not less than 15% of the tax amount owed, repayment of falsely collected or claimed unemployment benefits, and criminal prosecution with corresponding fines.

Depending on your state unemployment agency’s regulations, you will be given specific instructions and a timeline on how you can pay your penalties and tax dues.

#4. Why am I being audited for unemployment tax?

There are different possible reasons why you are being subjected to an unemployment tax audit. As mentioned in the article, some of these reasons include discrepancies in the amount of unemployment tax you’ve paid and getting linked to other organizations being audited for FUTA or SUTA taxes.