Pursuant to its announcement last fall, the US Internal Revenue Service (IRS) is undertaking a national research initiative focusing on employment tax compliance and increasing tax collection. As part of the initiative, the IRS is training agents to audit 6,000 companies over the next three years. Training is occurring in February and March 2010, and the IRS has indicated that cases will be assigned to agents as soon as they complete training. The audited companies will be randomly selected; however, the IRS has indicated that approximately 20 percent of them will be large companies.

Employment taxes account for a significant percentage of the total taxes collected each year. In addition to its portion of employment taxes, an employer can also be held liable for the employee’s taxes (income taxes as well as the employee’s share of Federal Insurance Contributions Act (FICA) taxes) if the employer fails to withhold such taxes. Coupled with interest and penalties, employment tax obligations can quickly become a considerable tax liability for a noncompliant employer and can also raise accounting disclosure issues under Financial Accounting Standards Board Interpretation No. 48.

The IRS employment tax audits will examine worker classification issues (employee vs. independent contractor), since improper classification of a worker as an independent contractor results in an employer under-withholding and under-paying employment taxes. The audits will also examine employee benefits issues, including non-cash fringe benefits such as expense reimbursement arrangements, corporate credit cards, and personal use of automobiles and planes, and executive compensation issues such as equity grants and nonqualified deferred compensation. Reporting issues (Forms W-2 and 1099) as well as backup withholding obligations will also be examined.

An employer will be notified that it is included in this national research initiative by a letter from the IRS with the number 3850-B or 3851-B indicating “compliance research examination.”

As with any tax controversy, it is important to review employee benefits and employment tax practices before being contacted by the IRS. A proactive approach to addressing issues can often simplify the audit process and reduce penalties.