Nancy T. Bowen, Richard Lee Hunn, William S. Lee, Robert C. Morris, Jasper G. Taylor, III, Charles W. Hall, Andrius R. Kontrimas, Kathryn Keneally, Shawn R. O'Brien and Susan Virginia Sample
February 24, 2010
The IRS is about to start detailed employment tax audits of 6,000 U.S. employers to determine whether those employers are properly reporting and paying federal employment taxes. These audits will consist of a line-by-line review of the employers' employment tax returns by some of the IRS's most experienced and recently trained auditors. The audits will be conducted as part of the IRS's National Research Project and occur over a three year period, with at least 2,000 employers randomly selected each year for audit. The employers audited under this research initiative will include both large and small businesses, as well as tax-exempt organizations.
Employers selected for these detailed and random employment tax audits will be notified by letter in March of 2010. The letter will state that the employer's employment tax return for the 2008 tax year is subject to a "compliance research examination." A copy of the form Letters 3850-B and 3851-B that the IRS will use to notify taxpayers that they have been selected for a "compliance research examination" are available by clicking here and here. IRS Letters 3850-B and 3851-B are substantially similar, except Letter 3850-B will be accompanied by a Form 4564, Information Document Request. The audits will ultimately affect far more employers than the 6,000 initially selected, because the IRS plans to use the results of these audits to help select other employers for future employment tax audits.
Employee vs. Independent Contractor
One area that will receive intense scrutiny by the IRS is the employer's classification of workers as independent contractors vs. employees. Determining a worker's employment status for federal tax purposes is a critical and fact-intensive analysis. There is no universal test, and the classification of each worker generally depends on the degree of control that the employer may exercise over that worker. Although the IRS has published a list of 20 factors that employers may consider, there is no magic or set number of factors that cause a worker to be classified as an employee or independent contractor, and no one factor stands alone in making this determination. The IRS often scrutinizes arrangements between employers and workers very closely to make sure that the substance of the arrangement matches the form.
Federal Tax Consequences Vary Significantly Based Upon Employment Status
The federal tax consequences to employers vary significantly depending on whether a worker is classified as an employee or an independent contractor. Employers are generally not responsible for withholding or paying any federal taxes on amounts paid to independent contractors. Conversely, employers are responsible for remitting three different types of federal taxes on wages paid to employees: (1) Income taxes; (2) Social Security and Medicare taxes (FICA); and (3) Unemployment taxes (FUTA).
Employers That Misclassify Workers May Face Significant Adverse Consequences
Employers that misclassify workers may end up facing substantial tax bills. For example, if the IRS determines that an employer has misclassified employees as independent contractors, in addition to any employment taxes owed by the employer, the IRS typically seeks to hold the employer (or individuals who are found to be "responsible persons" if the employer does not pay) liable for any FICA and Federal income taxes that the employees failed to pay. Furthermore, the IRS often seeks to impose penalties for failure to pay employment taxes and failure to file the required information reporting and tax returns.
IRS Looking For More Than Just Misclassified Employees
In addition to searching for misclassified workers, the IRS employment tax auditors will also be looking for nonfilers and scrutinizing (1) fringe benefits, (2) employee expense reimbursement plans, and (3) executive compensation.
Although the general rule is that fringe benefits are taxable to employees, federal tax law provides a number of exceptions to that general rule so long as the benefits conform with certain standards and documentation requirements. These requirements are often complex and vary widely for different types of fringe benefits. If the fringe benefits do not meet these requirements, the non-conforming benefits may be considered wages that are subject to employment taxes.
Business expense reimbursements paid to employees are not considered wages subject to employment taxes if the reimbursements are made under an "Accountable Plan." An "Accountable Plan" requires (1) a business connection to the expenses; (2) adequate accounting for the expenses; and (3) repayment of any excess reimbursements within a reasonable time. Employers that fail to comply with the "Accountable Plan" requirements run the risk that the IRS will consider the reimbursed expenses to be wages subject to employment taxes.
The audit of executive compensation is likely to focus on the reasonableness of wages paid to officers and owners of closely held corporations who also receive dividends. This is a fact-intensive inquiry with no bright-line standards for determining whether wages are reasonable, or the appropriate allocation of compensation between wages and dividends. The distinction can be critical because wages are subject to employment taxes, while dividends are not.
IRS Believes Employment Taxes Fertile Ground
The IRS believes that this audit initiative will contribute to the IRS's ongoing efforts to close the estimated $350 billion tax gap. Reports recently issued by the Congressional Research Service and United States Government Accountability Office concluded that the misclassification of employees as independent contractors could be a "significant problem," and reported that the IRS's last estimate was that 15% of employers misclassified 3.4 million workers as independent contractors rather than employees.
The IRS also anticipates that its employment tax audit initiative will lead to additional income tax audits. If an employment tax auditor recognizes an income tax problem during the employment tax audit, the auditor will refer the employer for an income tax audit while continuing the employment tax audit. Moreover, adjustments to an employer's employment tax returns may result in related adjustments to the employer's income tax returns and may require the issuance of additional information reporting returns.
Employers Should Prepare Now
Because the employment tax audit initiative will begin soon and will almost certainly result in enhanced IRS enforcement for all employers in the future, employers should start preparing now for a possible IRS employment tax examination. Employers may consider reevaluating their current employment tax compliance practices, adjusting their practices prospectively, and taking any necessary corrective actions for past practices.
This article was prepared by Nancy T. Bowen, Richard L. Hunn (firstname.lastname@example.org or 713 651 5293), William S. Lee (email@example.com or 713 651 5633), Robert C. Morris (firstname.lastname@example.org or 713 651 8404) and Jasper G. "Jack" Taylor III (email@example.com or 713 651 5670) from Fulbright's Tax Controversies Practice Group and Labor & Employment Law Practice Group. If you have any questions or need any assistance related to these or any other tax controversy matters, please feel free to contact any of the authors listed above or Charles W. Hall (firstname.lastname@example.org or 713 651 5268), Andrius R. Kontrimas (email@example.com or 713 651 5482), Kathryn Keneally, Shawn R. O'Brien (firstname.lastname@example.org or 713 651 5285) or Susan V. Sample (email@example.com or 713 651 5458).
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter[s].
Nancy T. Bowen
Richard Lee Hunn
William S. Lee
Robert C. Morris
Jasper G. Taylor, III
Charles W. Hall
Andrius R. Kontrimas
Shawn R. O'Brien
Susan Virginia Sample