Beginning in March 2010, the IRS has commenced a three-year employment tax audit initiative known as the National Research Project (the NRP), which is the most comprehensive study of worker classification since 1984. This audit initiative will focus primarily on potential misclassification of employees as independent contractors. Based on a report from the General Accounting Office, the IRS believes that payroll tax noncompliance is a serious strain on the U.S. Treasury. In addition the IRS will also be reviewing fringe benefits paid by employers, along with executive compensation, focusing on executive fringes, S corporations, and possibly Section 409A issues.

As part of the NRP, the IRS will randomly select 6,000 employers during the next three years and conduct comprehensive, in-depth audits of those taxpayers’ employment tax issues. In addition to detecting noncompliance among those audited, the IRS is using the program to determine generally the extent to which taxpayers and tax exempt entities properly comply with employment tax laws. IRS examination techniques will include internal sources of information, interviews, and publicly available employer policies obtained from various sources, including the internet.

In making its case, the IRS will utilize internal information which comes from Form SS-8, which is used to obtain an IRS ruling on whether an independent contractor is actually an employee, and Form 8991, a new form filed by an individual which is a declaration that a person is an employee and not an independent contractor. Using Form 8991, the employee pays half of FICA taxes and, in essence, informs the IRS that the employer is not in compliance. The IRS also reviews IRS Forms 941 (federal employment tax returns), Forms 1099, and tracks independent contractors who receive both 1099s and W-2’s. Agents have been trained to conduct interviews, read employment contracts, look at company policies, and review website information regarding applications for jobs available online.

To prepare for potential tax audits under the NRP, we recommend that employers (i) consider conducting a mock audit of their own to determine how worker classification is being handled within the company, while also focusing on executive compensation and fringe benefit practices; and (ii) review mitigation strategies which can be employed in advance, including Section 530 of the Revenue Act of 1978, which provides relief from employment tax obligations if certain conditions are met. In addition, the IRS has issued administrative settlement guidelines, and the taxpayer should analyze whether relief under such guidelines would be available.