If you own a business that has employees, at some point you might be contacted by a state or federal organization with questions concerning your obligations as an employer, including workers' compensation insurance, unemployment taxes, and Social Security and Medicare taxes.

Employment tax and regulatory audits can be worrisome, but there's no need to panic. Read on to learn what to expect from inquiries by government employment authorities.

Workers' compensation

Most states require that businesses pay for workers' compensation insurance. Premiums for workers' compensation insurance are typically a significant expense for small businesses. Yet this insurance can provide peace of mind — if one of your employees gets a work-related illness or injury, this insurance provides your employee with medical and disability coverage. Perhaps more importantly, your workers' compensation policy most likely protects your company from litigation related to work-related incidents.

The insurance premium that your organization pays is determined, in part, by occupation. For example, the premium for a relatively low-risk occupation, such as a sales clerk, might cost 30 cents per $100 of payroll. Premiums rise as jobs become more hazardous — premiums for construction workers might cost about $4 per $100, and premiums for truck drivers might cost as much as $10 per $100.

Your state may perform premium audits to determine whether your employees are classified with the correct premium rates for workers' compensation. During an audit, possible problems that might be identified include:

• Incorrect premium rate   An inappropriate premium rate might be applied to a group of employees.
• Math errors   Calculation errors might result in overpayment or underpayment of premiums.
• Incorrect payroll reporting   Misreporting of total payroll might result in underpayment of premiums.
• Worker misclassification   An employee might be misclassified as a subcontractor.
• Fraudulent claims   Employees might file false claims, or they might file a legitimate claim but continue to collect benefits after they have recovered from their illness or injury.

It's fairly common that a business pays a premium rate that is too high for the class of workers employed. An audit by the state authority might find such errors, but you can also hire an auditing firm to spot workers' compensation errors that prove to be costly for your organization. These specialized auditors can be found by performing a search on the Internet by using the keywords, "workers compensation auditor."

State unemployment taxes

Each state operates its own unemployment compensation program that is funded largely by taxes on employers — you don't withhold these taxes from your employees' wages.

Your state's department of labor routinely performs unemployment tax audits to collect compliance information and other data. Businesses are often selected for an audit at random, or they are selected because of questionable filings. For instance, your business might have filed a state tax return that differs from a federal tax return, or one of your former employees might have filed a claim for unemployment insurance with information that differs from a report submitted by your company.

You will be informed in writing in advance of the period to be audited. The notification letter that you will receive includes a list of documents that the auditor needs to inspect, such as 1099 forms, W-2 forms, state and federal filings for unemployment, and payroll records.

If your company receives notification of a state unemployment tax audit, decide who should represent your organization during the audit. As controller, you are likely the best candidate. But you can also delegate the task to your payroll department or your human resources department. If you anticipate possible problems, you might want to ask an accountant or another advisor outside your firm to represent you during the audit.

Federal unemployment and Social Security taxes

The Federal Unemployment Tax Act (FUTA) authorizes the Internal Revenue Service (IRS) to tax employers to fund state work force agencies. Employers pay this tax annually by filing IRS Form 940. In addition, employers withhold Social Security and Medicare taxes along with federal income tax from employee paychecks. These taxes are forwarded along with the employer's share of Social Security and Medicare payments to the IRS. Employers report Social Security and Medicare taxes quarterly by using IRS Form 941.

During an IRS audit of a company, auditors routinely survey Form 940 and Form 941 as part of their overall review of company records. If an auditor questions anything on these forms, he or she may expand the company audit to encompass employment tax forms.

Recommendations that an auditor may make following an employment tax audit can include:

• Reclassification of subcontractors or casual laborers to employees.
• Reclassification of payments, such as bonuses, from nonwage to wage payments.

If you disagree with the audit findings, don't feel compelled to accept them. Perform some research on tax law for your particular situation. Some good resources are:

• IRS Web site   On the IRS Web site (www.irs.gov), review IRS tax publications, particularly the Employer's Tax Guide (Publication 15, also known as Circular E) and the Employer's Supplemental Tax Guide (Publication 15-A).
• Outside accountant   If you don't already have one, hire an outside accountant to investigate worker classifications that are standard for your industry.
• Industry association   To learn more about your industry's standards, ask an industry association for advice.

If you must agree to the recommended reclassifications, find out from the IRS agent, your advisors, or the IRS Web site whether there are any relief options available for you.

Remember, employment tax and regulatory laws are complex and open to interpretation. If you disagree with audit findings, you can always appeal them. To learn more about these types of audits and the appeals process, view the Web sites maintained by the IRS, the Department of Labor (www.dol.gov), and the labor sites maintained by the state where your company conducts its business.