The IRS is extending its National Research Program (NRP) to investigate tax compliance related to employment taxes. This month the IRS is commencing a three-year project to conduct detailed employment tax audits of 6,000 randomly selected U.S. Companies. One of the objectives of this project is to provide an updated estimate of the amount that employment tax non-compliance contributes to the “tax gap.” This gap is the difference between the tax that taxpayers should pay and what they actually pay on a timely basis. The most recent estimate by the IRS of the size of the tax gap was $345 billion for tax year 2001, of which approximately $15 billion was attributed to FICA and unemployment tax issues.
It is anticipated that this audit initiative will be very broad-based and will include businesses of all legal forms and sizes in all areas of the country. According to the IRS, these audits will be conducted by more than 200 of its most highly experienced agents. It is anticipated that these agents will conduct exhaustive reviews of a company’s employment tax returns for calendar years 2007 and 2008 and may also review related filings such as income tax and informational returns.
The audit initiative will primarily focus on five specific employment tax issues: worker classification (employee or independent contractor), fringe benefits, officer compensation, reimbursed expenses, and non-filers.
Worker Classification. A critical issue for all businesses is to properly classify workers as employees or independent contractors. For employees you must withhold federal and state income taxes, withhold and pay Social Security (FICA) and Medicare taxes, and pay unemployment tax on their wages. You do not generally have to withhold or pay any taxes on payments made to independent contractors. If you misclassify an employee as an independent contractor and the IRS audits you, the IRS will reclassify the worker to employee, recalculate the taxes you should have withheld, calculate interest, possibly apply penalties, and bill you for all of these charges.
Fringe Benefits. Certain benefits provided by employers to employees are non-taxable because they are by statute specifically excluded as fringe benefits. If a benefit provided to an employee is improperly treated as a fringe benefit, the employer does not include the value of the benefit in the employee’s compensation, and the employer therefore does not withhold the required income tax or pay the required employment taxes on the value of the benefit. As part of these audits, the IRS will look for non-conforming benefits, that were treated as non-taxable fringe benefits, but that must be treated as wages subject to employment taxes.
Officer Compensation. The audits will look at the reasonableness of officer or owner compensation when the individual receives both wages and dividends. This is a very common issue for S corporations. When a shareholder is also an employee of the S corporation, the shareholder receives both compensation as an employee and dividends as a shareholder. However, only the compensation is subject to employment taxes. When it appears to the IRS that an officer or owner receives lower compensation than warranted by the services provided to the corporation, the IRS may challenge whether reasonable compensation has been paid and whether the company has paid employment taxes on an appropriate level of compensation.
Reimbursed Expenses. Employer payments made to reimburse employees for qualified business expenses are not compensation subject to employment tax. However, to qualify for this tax-free status, the reimbursed expenses must have a valid business relationship, must be reasonable, and must be subject to appropriate accounting. Reimbursement payments that fail to meet these tests may be subject to the employment tax.
Non-filers. The IRS has obvious concerns about any companies that fail to file required employment tax returns.
Although the probability of any one business being selected for an IRS employment tax audit is relatively small, there is no way to completely eliminate this possibility. The IRS has made employment tax compliance a priority, and now is a good time for all businesses to proactively review their fringe benefit and payroll policies and procedures for tax compliance. In conducting the review, companies should focus on the above five areas. Companies should also consider reviewing their last two or three years of employment tax returns including supporting documentation, and should ensure that specific plans governing business expense reimbursement and policies to distinguish employees from independent contractors are in place.
If you would like more information about this topic, or other legal issues, please contact a member of our Tax, Estate Planning and Employee Benefits Group 208.344.6000.