Write 3 to 4 paragraphs on the subject, addressing the issues raised and answering the questions posed.

Your client, the wholesale importer who keeps all his records in a plastic bin, has been selected for an EDD audit. The auditor is requesting all accounting books and records, as well as payroll records for the last three years. The client, Justin Slick, whose company is Justin Slick, Inc., has three years of accounting "records" in the form of 3 plastic bins. Having already looked at these, you know the records are spotty at best. You can easily put together bank statements for his business account, but he has no check register or general ledger. You can also request payroll tax returns and W-2's from his payroll service company. The bigger problem is that your client has paid outside contractors and he himself is the only employee actually on payroll. He's always told you he files the proper 1099's at the end of the year, but you've never been involved in this part of his business (he says the payroll service does the filings) so you have no idea how good his records will be in this area. But you put together what you can find, which consists of check images provided by the bank, and copies of the 1099's filed.

You go through the assembled records and come up with the following possible problem areas:

1.In each of the three audit years, payments were made to two individuals as follows: Wendy Elba $21,590, $22,765 and $21,245, for years 1, 2, and 3 respectively, and Matthew Cor busier$36,760, $39,500, and $39,575, for the same years respectively. 1099's were issued to these people. When you ask Justin why he didn't put these people on the payroll, he said it was "more convenient" to pay them as independent contractors. Also, he says, they asked to be paid via that format.

2.Justin's payroll tax returns tie in with the W-3/W-2 transmittal ssent in at the end of each year. However, a review of the check images shows that there was much more money paid out to Justin than is accounted for as payroll. Since the checks have no information on them to indicate whether they're payroll checks, loans, or distributions from his corporation, there's no clear trail tying in to net payroll. But you know that these excess checks were recorded as distributions to him from the corporation. The way you know this is that every year you make a calculation as to how much of his profit he needs to "bonus out" to himself on a W-2 and how much can come out of corporate profit as after-tax distributions.

Questions to answer:

- How will you prepare for the EDD audit? Specifically, how will you support the client's classification of the 1099 workers as independent contractors instead of employees of the company? What issues do you need to clarify with Justin so as to be able to show the auditor that these workers are independent contractors and not employees under his control?

- How will you prove to the auditor that the proper payroll has been reported for Justin, and that the other amounts paid to him are distributions from his S corporation rather than compensation?

- What advice will you give to Justin about recordkeeping going forward after the audit is over?