How to Prepare for a State Payroll Tax Compliance Review

Quick overview

A state payroll tax compliance review is an administrative audit states use to check whether employers are withholding and remitting payroll taxes correctly. Reviews can be triggered by random selection, information mismatches between federal and state filings, claims from former employees, or referral from other agencies (e.g., unemployment or workers’ comp). Preparing in advance shortens the review timeline, improves the outcome, and often reduces penalties.

This guide gives step‑by‑step preparation advice, a document checklist, communication best practices, remediation steps when problems are found, and links to authoritative guidance.

Sources you can consult while preparing: the IRS Employer’s Tax Guide (Pub. 15) and the IRS employment taxes pages for federal context, plus state tax agency guidance for state‑specific rules (see IRS, DOL, SBA links below). For worker classification issues, federal resources such as the IRS and Department of Labor explain tests used by authorities (IRS SS‑8 process) (IRS, DOL).

Why preparation matters (real-world perspective)

In my practice helping employers through state reviews, the biggest time‑savers are organized records and a documented chain of decisions about how workers were classified and how payroll was run. When clients had consistent payroll registers, timely tax deposits, and clear contractor agreements, the review was often resolved in weeks rather than months. Conversely, poor documentation typically triggers back‑period calculations, interest, and fines.

Before a review: internal checklist to do now

Do the following routinely so you’re ready if a notice arrives:

• Maintain a centralized payroll file for each year containing payroll registers, W‑2s, 1099‑NEC forms, pay stubs, time sheets, and signed offer letters or contractor agreements.
• Keep copies of state quarterly wage reports and state unemployment insurance filings.
• Save proof of deposit and payment (bank records, ACH confirmations) for tax deposits and state returns.
• Document worker classification decisions and the facts supporting those decisions (job duties, contracts, degree of control, tools/equipment, hours).
• Keep HR policies, independent contractor questionnaires, and written subcontractor agreements.
• Run a quarterly internal payroll compliance review using a short checklist (see sample below).

Sample quarterly internal review (15–30 minutes):

• Compare payroll register totals to payroll tax returns for each quarter.
• Spot‑check 5–10 employee files for accurate classifications and wage basis.
• Confirm deposit frequency and amounts match payroll tax liabilities.
• Verify that Form 1099‑NEC was issued for contractors when payments meet the filing threshold.

Typical documents requested in a state review

Organize these before you need them; states commonly ask for:

• Payroll registers and general ledger supporting payroll expense
• Federal Forms W‑2 and W‑3, 1099‑NEC and related backup
• State quarterly wage reports and state unemployment insurance filings
• Copies of all payroll tax payments and deposit confirmations
• Employee files: offer letters, job descriptions, timecards, I‑9s, signed policies
• Independent contractor agreements, invoices, and 1099 filing evidence
• Benefit and fringe benefit records (pretax deductions, 401(k) deferrals)
• Documentation of payroll system changes, third‑party payroll provider agreements, and reconciliation memos

How to respond to a notice (step‑by‑step)

1. Read the notice carefully; note deadlines and the specific documents requested.
2. Confirm receipt in writing (email or certified mail). A brief acknowledgement preserves timelines and starts the communications record.
3. Gather documents and prepare a concise index or cover letter that maps your documents to each request item.
4. Deliver complete records on time. If you need more time, request an extension explaining why and offering a firm delivery date.
5. If you disagree with an initial finding, provide supporting documentation and a narrative explaining your position. Reserve formal appeals until after you receive a final determination.

Common issues reviewers focus on and how to handle them

• Worker misclassification (employee vs. independent contractor): Keep contemporaneous documentation of the factors used to determine status. If misclassification occurred, calculate payroll taxes owed back to the discovery date and be ready to negotiate mitigation or abatement.
• Unreported wages or underwithholding: Provide payroll registers, corrected wage reports, and proof of corrected deposits. Consider voluntary disclosure if you identify problems proactively — it may reduce penalties.
• Late or missed deposits: Present bank records, reconciliations, and explanations of system failures. Demonstrating prompt corrective action and updated internal controls helps when penalty relief is requested.

Mitigating penalties and negotiating with the state

States typically assess tax, interest, and penalties. Options to reduce exposure include:

• Voluntary disclosure or self‑correction programs (some states offer penalty relief for self‑reported issues).
• Requesting penalty abatement for first‑time or reasonable cause events (document the cause and corrective measures).
• Entering into an installment agreement for unpaid liabilities when full payment is impractical.

In my practice, well‑documented corrective steps and demonstrated new controls (e.g., automated deposits, employee training, updated contracts) make revenue agents more willing to recommend moderation of penalties.

Best practices during and after a review

• Be cooperative, timely, and factual in communications. Avoid volunteering information beyond what is requested without context. Keep a log of all communications.
• Use a single point of contact internally to coordinate document collection and responses.
• If the review involves complex classification or legal interpretation, engage a CPA or employment tax attorney early.
• After the review, implement any agreed corrective actions and keep documentation showing the problem is fixed (new payroll procedures, training records, or software change confirmations).

Record retention guidance

While state rules vary, many employers keep payroll records for at least four years; federal guidance (IRS) also recommends retaining employment tax records for at least four years after the date the tax becomes due or is paid, whichever is later. Check your state tax agency for specific retention periods and continue to preserve supporting evidence longer when an issue is under review (IRS employer records guidance).

When to bring in outside help

Bring in a payroll tax specialist, CPA, or employment tax attorney if any of the following apply:

• The review includes multiple years or significant underpayments
• Worker classification or joint employment questions are central
• The notice threatens liens, levies, or criminal referral
  A specialist can prepare a technical position, negotiate penalty relief, and manage appeals.

Practical tools and internal controls that reduce future risk

• Use direct deposit and automated payroll tax deposit scheduling through your payroll software.
• Run a monthly reconciliation of payroll expense to tax returns and deposits.
• Maintain written procedures for classifying workers and issuing contractor agreements.
• Train HR and payroll staff on common state‑specific payroll tax rules.

Further reading and internal resources

• When State Tax Agencies Audit Payroll: Employers’ Practical Checklist — a practical, step‑by‑step checklist to use during a review. When State Tax Agencies Audit Payroll: Employers’ Practical Checklist
• Payroll Tax Deposits: Rules, Frequencies, and Common Mistakes — explains deposit scheduling, federal rules that affect state timing, and how to avoid missed deposits. Payroll Tax Deposits: Rules, Frequencies, and Common Mistakes
• Protecting Your Business During an IRS Payroll Tax Examination — guidance for federal reviews that often overlap with state inquiries. Protecting Your Business During an IRS Payroll Tax Examination

Authoritative sources

• IRS — Employment Taxes and Employer’s Tax Guide (Pub. 15): https://www.irs.gov/businesses/small-businesses-self-employed/employment-taxes
• Department of Labor — Worker classification guidance: https://www.dol.gov/agencies/whd
• Small Business Administration — Payroll and taxes for small businesses: https://www.sba.gov/business-guide/manage-your-business/payroll-taxes

Professional disclaimer

This article is educational and does not replace personalized tax or legal advice. In my practice, I recommend contacting a qualified CPA or employment tax attorney for case‑specific guidance, especially when multi‑state exposures or potential penalties are at stake.

Final takeaway

A state payroll tax compliance review is easier to manage when records are organized, deposits are documented, and classification decisions are justified. Routine internal checks, quick, professional responses to notices, and early engagement of specialists when needed will reduce the chance of large assessments and shorten the review timeline.