Employers of all sizes and types should be aware of a major IRS audit initiative focusing on underpayment of employment taxes.

This month, the IRS will launch a new employment tax National Research Program that it has been planning for at least a year. As part of the program?the first in the employment tax area since 1984?the IRS will randomly select 6,000 taxpayers (2,000 taxpayers in 2010 for the 2008 tax year and 2,000 taxpayers each in 2011 and 2012 for the 2009 and 2010 tax years, respectively) and conduct in-depth audits of those taxpayers’ employment tax issues, tracing them into federal income tax returns that report deductions of the payments as well as federal income tax returns that report the income from such payments. The IRS described the audits as “comprehensive in scope.” The IRS is using the program to accurately gauge the extent to which taxpayers and tax-exempt entities properly comply with employment tax laws.

The IRS has two main goals for the program:

  • Securing statistically valid information for computing the “gap” between taxes that are accurately reported to the IRS and those actually owed; and
  • Determining common compliance characteristics so that the IRS can concentrate on the most significant compliance issues.

The audits likely will begin with a review of IRS Forms 941 (federal employment tax returns) but will further involve detailed information requests by the IRS. In addition to identifying organizations that fail to file employment tax returns at all, the comprehensive audits will focus on at least four major employment tax issues:

  • Classification of workers as employees or independent contractors;
  • Reasonableness of executive compensation;
  • Tax treatment and reporting of fringe benefits as tax-free or as taxable compensation; and Tax treatment and reporting of employee reimbursements.

The IRS also will review the taxpayer’s history of reporting payments other than wages or compensation (e.g., such as dividends reported on IRS Forms 1099) and backup withholding. Additionally, we expect that the IRS will focus on recently promulgated Treasury Regulations that require disregarded entities to withhold, report, and pay employment taxes in their own name. (See “Final Regulations Treat Disregarded Entities as Separate for Employment Tax and Related Reporting Requirements” (December 11, 2007) and “Disregarded Entities Are Now Responsible for Their Own Employment Taxes” (July 20, 2009))

Although the reasonableness of executive compensation is usually thought to involve the payment of excessive compensation, the program likely will focus on the underpayment of compensation to shareholder-employees of S corporations. Such shareholder-employees are perceived to avoid employment tax by receiving dividends and other corporate distributions in lieu of compensation for services.

To the extent that a taxpayer has consistently treated workers as independent contractors and the IRS properly determines that the workers should have been treated as employees, the audited taxpayer still may avoid owing back taxes, interest, and penalties if it satisfies the now notorious Section 530 of the Revenue Act of 1978. If certain requirements are satisfied, Section 530 prevents the IRS from retroactively reclassifying workers. Although we do not know how much support there is in Congress, in the Fiscal Year 2011 budget, the Obama Administration proposed eliminating Section 530 and believes that a crackdown on employment tax issues could yield as much as $7 billion over the next 10 years.

Finally, the in-depth nature of the audits will provide the IRS with an opportunity to review an employer’s executive compensation arrangements. In addition to confirming that such arrangements are compliant with the employment tax rules, employers should review the extent to which their executive compensation arrangements are compliant with other federal income tax rules, such as the section 162(m) and section 280G deduction limits and the section 409A deferred compensation restrictions. Employers who act quickly may be able to take advantage of recent IRS correction guidance for section 409A violations, which offers the possibility of reduced penalties. (See “IRS Releases Section 409A Correction Program for Nonqualified Plan Document Failures” (January 6, 2010)