The Importance of Record Keeping in an Audit

By Terri Angle

In January 2007, I received a letter stating that EDD (Employment Development Department) in California was going to audit my payroll from 2004 to 2007. My heart sank. I hate audits.

My first thought was I was not a large day care in 2004, and I had no employees for that year. It would be easy enough to prove this on my 2004 tax return. When I decided to go into business for myself in 2002, I thought I should become educated in accounting for the child care profession. Since my accounting experience was in automotive, I took an online course in Child Day Care Management. I gained knowledge from this course in all areas of child care. However, I still had some unanswered questions on exactly how to break down my taxable expenses.

I found Tom Copeland I found the answers to my questions. His resources answered all my questions. These resources included the Family Child Care Record-Keeping Guide, Family Child Care Marketing Guide, Family Child Care Contracts and Policies, and the yearly Family Child Care 2007 Tax Workbook and Organizer. I now have a name for my business, a taxpayer identification number, and a state identification number. Tom Copeland suggested I use a payroll service to help me do the paperwork for my employees. I called Automatic Data Processing (ADP) and they came out to visit and set my payroll up the same day. I call with my payroll information and pay my employees on the 1st and the 15th of the month. It fits perfect into my busy schedule. I do not have the time to do my own books and keep track of payroll. ADP handles the quarterly reporting forms and they make the unemployment tax payments to the state for me. They also handle my workman’s compensation insurance. ADP sends me all the necessary paperwork I need for my records in case of a payroll audit or an IRS audit.

I keep documentation on everything that concerns my business; I have a separate business checking account. I write a check to myself from my business account and deposit it into my personal account. I make a copy of every deposit and transaction between both accounts. This keeps all personal transactions out of my business account.

I keep a cash journal on every transaction that transpires between my clients and myself. I also include the Food Program, the state subsidy program, and my Parent Summaries. I balance these figures to my bank deposits and my monthly receivables. At the end of the year, I give my parents an IRS Form W-10 and a copy of the Parent Summaries stating the exact amount of monies paid to me in that year. I have each parent sign my copy that states each parent did in fact receive the W-10 and a copy of their Parent Summary.

The EDD requested Check Registers, Check Stubs, Cancelled Checks, Bank Statements, General Ledger, General Journals, Annual Financial Statements, (income & expense statements balance sheets) Cash Payment Records (pay out slips and vouchers) Ownership Verification, City Business License, State Day Care License, State and Federal Income Tax Returns, and Form 1099. Providers should be aware that our helpers are employees and that they do not meet the requirements of an Independent Contractor.

Then the EDD letter asked for payroll records such as Payroll Journal, Individual Earnings Records, Payroll Summaries, etc, Federal Employment Tax Reports, Forms W-2 wage and Tax Statements; Forms W-4 Employee’s Withholding Allowance Certificates, Forms 941, Employers Quarterly Federal Unemployment Tax Returns, State Employment Tax Reports, DE6s, Quarterly Wage and Withholding Reports, DE7s, Annual Reconciliation Statements, DE678s, Tax and Wage Adjustments Forms, DE 4s, Employee Withholding Allowance Certificates, and Workman Compensation Reports! Fortunately, ADP made sure I had all the documentation I needed for my audit. I just kept a journal on my monthly expenses for my payroll expenses off the payroll summary they provided for me with each payroll.

I provided the state with every form they requested for each year, except for 2004 because I paid no payroll. EDD also checked for the federal and state employee posters that they require to be posted. I ordered the mini posters and posted them on the inside door of the hall closet where they would not be intrusive to my home.

EDD also wanted to know how I kept track of the hours that each employee worked. I told them by a time clock. EDD was happy to hear this. EDD verified that I paid overtime to my employees when they worked overtime. Because I am a childcare provider they did check for the forms that day care employees are required to sign by the state, on child abuse and employees personnel rights. My husband is on my payroll and he works for my business part-time. I have his file set up just like a regular employee. He has a job description and he is not paid a ridiculous salary that can be questioned. He keeps a separate daily log showing exactly what he does for my day care each day. EDD was okay with his salary, the log, and his employee file.

The audit process was about six hours long and the auditor was very pleased with my record keeping. I have Redleaf Press to thank for that compliment (Tom Copeland). The auditor did indicate they are looking at family day care more closely now than they used to. Although most audits are randomly selected, they are auditing more providers who use Form 1099 and are treating their helpers as independent contractors when they should be treated as employees. The auditor also said that the IRS can go back to the first day you were in business to verify that your employees were paid correctly as employees and not as independent contractors. They can go back and collect all back taxes and penalties.

Note from Tom Copeland:
Terri’s experience is a good example of how keeping accurate records can protect you in an audit by the IRS or your state. When you hire employees, there are many additional federal and state forms to file and additional taxes to pay. Unfortunately, many providers are treating their helpers as independent contractors and are not following the proper rules. My book Family Child Care Tax Workbook and Organizer explains how to fill out all the federal tax forms using examples. ADP is one of a number of bookkeeping services that you can hire to help you with payroll forms. Look in the Yellow Pages under Bookkeeping Services for a list of other companies.

Terri Angle has been a licensed family child care provider in California since 2002. She runs a large family day care with 12-14 children, ages 0-12 years old. Terri is required by California State Licensing to have herself and one other assistant present when there are nine children in her daycare. Terri’s husband helps her out with transporting the children back and forth from school while maintaining his own full-time job.

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