The Internal Revenue Service has announced a new National Research Program (“NRP”) initiative relating to employment taxes. The IRS started NRPs in 2001 to measure the “tax gap.” The “tax gap” is the difference between the amount of income that taxpayers voluntarily report and pay tax on, versus the amount of tax that the IRS perceives is actually due. An NRP assesses the effectiveness of the existing compliance programs so that taxpayers will report and pay tax on the full amount of taxpayer income (since the IRS’ stated goal is to promote voluntary taxpayer compliance). Basically, an NRP can be likened to an industry-wide audit. The IRS will use the data gathered from this “mass audit” to improve the IRS’ programs promoting voluntary compliance with regard to employment taxes.
New NRP Focusing on Four Employment Tax Issues
The new NRP will highlight four areas that the IRS believes currently are improperly reported by employers. The four areas are: (1) worker classification (employee vs. independent contractor); (2) fringe benefits; (3) officers' compensation; and (4) reimbursed expenses.
1. Worker Classification. This is a perennial IRS hot button issue. If a worker is an employee, then the employer is obliged to collect and remit all employment taxes (income tax withholding, FUTA, and both the employer’s and the employee’s portion of social security (FICA) taxes). However, if a worker is an independent contractor, then the employer does not have to collect employment taxes, and the worker is responsible for self-reporting and self-remitting the employment taxes to the IRS. The IRS has a bias toward classifying workers as employees, since then the burden of collecting and remitting employment taxes falls on the employer. The IRS would rather collect employment from one employer for all its employees than having to try to collect employment taxes from each individual worker. Additionally, if an employer fails to collect and remit employment taxes, then the employer’s “responsible persons” (basically, owners and executives in the finance department) may have personal liability for uncollected taxes, thus giving the IRS a secondary source to collect employment taxes.
A worker will be classified as an employee versus an independent contractor based on a twenty factor test developed by the IRS in Revenue Ruling 87-41, 1987-1 C.B. 296. Many of the factors relate to the extent of control that the employer has over the worker, for example, control over hours worked, manner of accomplishing the work, etc.
As part of the NRP, we anticipate that the IRS will closely examine all workers whom the employer classifies as non-employees using the twenty factor test from Revenue Ruling 87-41, and if the IRS concludes that a worker is improperly classified, the IRS likely will asses taxes. As mentioned above, the IRS can assess taxes against the employer, as well as personally against the employer’s responsible persons.
2. Fringe Benefits. Under the Internal Revenue Code, various fringe benefits can be provided to employees on a tax free basis (certain insurance benefits, dependent care benefits, etc.). However, an employer can provide these benefits on a tax free basis only to employees, not to independent contractors. Thus, the IRS focus on fringe benefits likely will be a subset of the worker classification issue discussed above, namely that the IRS will closely examine how an employer classifies workers as employees (eligible for tax free fringe benefits) versus independent contractors.
In regard to fringe benefits, the IRS has been soliciting comments to simplify the record keeping requirements applicable to employer-provided cell phones and other electronic communication devices. Under the Code, an employer-provided cell phone is a taxable fringe benefit to the extent that the employee uses the phone for personal use. The difficulty arises in trying to document personal versus business use. It is possible that the IRS will use the NRP to gather information relating to how employers currently handle personal versus business use of employer-provided cell phones and other electronic communication devices.
3. Officers' Compensation. This is another IRS tried-and-true audit issue. There are positions that an employer and its owners can jointly take that will reduce the amount of taxes for both, depending on what type of entity the employer is. For example, if the employer is a C corporation and the owner is an executive who actively works for the company, the owner would want to pay net business profits in the form of deductible compensation, so that the C corporation can recognize a deduction for the compensation paid, and the business profits will only be subject to a single level of tax in the owner’s hands. Alternatively, if the employer is an S corporation, the owner-executive will want to pay himself or herself a low salary, since salary is subject to FICA and FUTA, while distributions of net business profits as dividends are not subject to those employment taxes. Thus, the IRS likely will audit C corporations to make sure that they are not paying too much compensation, and audit S corporations to ensure that they are paying enough compensation.
In the event that the IRS concludes, as part of the NRP, that an employer has underpaid either its corporate income taxes or its employment taxes, an assessment of the underpaid taxes will likely result. As mentioned above, in the instance of employment taxes, the responsible persons of the employer may face personal liability for allegedly underpaid taxes.
4. Reimbursed Expenses. The last audit issue under the NRP relates to an employer’s reimbursement policy for business expenses that its employees incur. Typically, when an employee pays a business expense (whether picking up the tab for a client lunch, purchasing an airline ticket for a business trip, or buying office supplies), the employee will submit the receipt and simply be reimbursed. The intention of the employer and employee is generally that the employer should be entitled to report the business deduction and the employee should not have any tax results from simply picking up a business expense and being reimbursed.
However, unless the company has a written reimbursement plan that meets certain requirements in the Internal Revenue Code, employee reimbursements are treated as though the employer paid additional compensation to the employee (subject to withholding and employment taxes) and the employee has income that has to be reported as taxable income on the employee’s W-2. On the employee’s side, the expense is often non-deductible due to the miscellaneous itemized deduction rules.
The only way to avoid the adverse tax consequences is for the employer to have in effect at all times a written reimbursement policy that meets the requirements of the Internal Revenue Code. The requirement that an employer have a written reimbursement policy is truly a trap for the unwary. If the employer does not have a written reimbursement policy, we have seen the IRS impose taxes on both the employees and the employer. On the employee side, the IRS assesses income tax on the underreported income (which for a typical employer affects the sales staff and business executives disproportionately, since those are the categories of employees who most likely incur business expenses). On the employer side, the IRS will assess the employer and the responsible persons individually for the income tax withholding and employment taxes on the business reimbursements.
Ask Not for Whom the Audit Bell Tolls-It Tolls for Your Company
The IRS has already begun randomly selecting employers to be audited starting in the Fall, and the audit initiative will last for the next three years. Since the audit is random, there is little an employer can do at this point to avoid being subject to an audit. However, there are several steps that an employer should now take to protect itself, regardless of whether the employer is audited as part of the NRP or outside the NRP.
An employer needs documentation to protect itself from these types of employment tax audits. If an employer has any workers who are independent contractors, the employer should carefully document why its workers are properly independent contractors, as well as ensuring that the employer consistently treats the workers as such. For example, the employer should consistently issue the correct tax returns to the independent contractors, as well as consistently treat all employees who perform similar jobs as non-employees. Business owners should appropriately document their pay and follow the requisite corporate formalities in setting the amount of their pay. Waiting until the end of the year and determining pay based on the net income of the company is an extremely risky proposition.
Finally, the last audit point of reimbursed expenses is probably the easiest to correct. Each employer needs to have a written reimbursement policy in effect, and needs to make sure that it is updated and followed, since that likely would be among the first things that an IRS auditor requests during an examination.