A new IRS employment tax audit initiative heightens the need for employers to review their practices for classifying workers and structuring compensation, benefit, and reimbursement plans.
The Employment Tax Audit Initiative (the “Initiative”), in which the IRS will audit 2,000 U.S. companies annually, commenced in February 2010. The Initiative was originally announced in September 2009 and will provide data for the IRS’ National Research Program (NRP) study of employment tax compliance. This will mark the first such study conducted by the IRS since 1984. Mary C. Gorman, assistant division counsel for prefiling, Office of Chief Counsel, SB/SE division, advised members of the American Bar Association Tax Section on 1/22/10 (“ABA Tax Section”), that this is in addition to the 60,000 employment tax audits that occur annually. The IRS is expected to focus during the audits initiated pursuant to the Initiative on the following five employment tax issues:
- Worker classification (employee vs. independent contractor).
- Fringe benefits.
- Officers’ compensation.
- Reimbursed expenses.
The Initiative is intended to help reduce the size of the tax gap—i.e., the difference between the tax the IRS estimates is due and the amount actually paid by taxpayers. The gap reflects significant lost revenue. On 7/8/09, the IRS released “Update on Reducing the Federal Tax Gap and Improving Voluntary Compliance.” 1 The report, relying on data from a 2001 NRP, concluded that the IRS failed to collect an estimated $54 billion in employment taxes, which accounted for nearly 16% of the total tax gap in 2001. This figure was similarly reported in “A Comprehensive Strategy for Reducing the Tax Gap,” issued on 9/26/06 by the U.S. Department of the Treasury, Office of Tax Policy. 2 Yet, IRS SB/SE Division Deputy Commissioner Faris Fink told the New York State Bar Association’s annual Tax Section meeting on 1/26/10 (“NY State Bar”) that the employment tax gap was $15 billion.
What is an NRP?
An NRP is a specific type of IRS examination designed to take a snapshot of a given taxpayer population in order to determinate the compliance within that population. Make no mistake, however; it is an audit. According to the IRS, “the guiding principles for an NRP are: (i) minimize taxpayer burden as data are collected and (ii) ensure that the collected data will meet business objectives and are used as a corporate asset.” 3 The data extracted from an NRP includes the amounts reported by taxpayers on their tax returns as well as the deficiency, if any, determined by the IRS.
The IRS started NRPs in 2001 to measure the tax gap. The belief is that by examining a wide variety of returns for different types of taxpayers from different industries, the IRS will gather sufficient statistical sampling to estimate the tax gap.
Perhaps the most notable characteristic of an NRP audit is its comprehensive nature. NRP audits are similar to the Taxpayer Compliance Measurement Program Audits previously conducted by the IRS in that every line item on a return potentially can be examined to determine the proper reporting of each item of income and deduction. NRPs are not examinations triggered by classified issues on a tax return; rather they are random examinations of a variety of taxpayers to determine overall compliance. The IRS uses the data collected in an NRP audit to set specific examination goals (sometimes referred to as Tier 1 and Tier 2 audit issues) and areas of noncompliance that are then applied in choosing taxpayers for examination. By fine-tuning the taxpayers subject to examination, the IRS can avoid engaging in taxpayer audits that result in “no change” letters being issued, as this constitutes a waste of time and energy for both the IRS and the taxpayers.
Seasoned employment tax auditors, who will be conducting the audits, received special training for the Initiative. If an employer receives Letter 3850-B or a letter indicating that it is subject to a compliance research examination, then it is part of the Initiative. It is unclear if examiners will use traditional NRP audit techniques during the Initiative. Ms. Gorman indicated during the ABA Tax Section meeting, however, that any employment tax issue that presents itself during the course of the audit will be examined. Since the IRS has targeted specific issues in these examinations, the examiners may very well limit the actual audits to the above-referenced issues and not otherwise conduct an examination of non-employment-tax-related items.
Because the Initiative is an NRP, however, the selection of companies for audit will not be based on objective criteria. Rather, companies will be chosen as part of a random selection process, which should encapsulate companies of varying size and form. Notwithstanding, Mr. Fink told the NY State Bar meeting that while the 6,000 audits will be “full-blown” and cover a variety of taxpayers, the majority will be small businesses.
Section 184.108.40.206 of the Internal Revenue Manual reflects that the IRS is “committed to evaluating and improving the employment tax program.” The IRS has three goals in the employment tax area, and they are reflected as ensuring that:
- All employers and workers are “in the system” (i.e., they are filing timely, accurate, and fully paid returns).
- Workers are properly classified as employees or independent contractors.
- All remuneration subject to employment tax is reported. 4
The Bureau of Labor Statistics reported that 7.4% of the total labor pool in 2005 were independent workers. It is unclear how many of these 10.3 million independent workers were misclassified. 5
Ensuring that workers are properly classified is a critical function. If a worker is classified as an employee, the employer is obligated to pay half of the worker’s 12.4% Social Security tax and 2.9% of the Medicare tax. The employer is similarly obligated to withhold the other half of those taxes from their employees’ salary. In addition, many states require employers operating within the state to contribute unemployment taxes. Employers are not required to make any of these payments if the worker is classified as an independent contractor.
Perhaps due to this potential for financial savings, the IRS believes that some workers are incorrectly classified as independent workers. The IRS, however, is not always correct. For example, in November 2009, FedEx announced that the IRS had dropped its second audit into the company’s classification of the parcel division drivers as independent contractors. 6 As recently as September 2009, the IRS was seeking to assess tax and penalties of $14 million for the 2002 tax year.
At the heart of the Initiative is the issue of worker classification. The determination as to whether a worker is an employee is premised on the facts and circumstances. The IRS uses the following 20-factor test:
- Who provides the instructions to the worker?
- Does the payor provide training to the worker?
- Is the worker integrated into the business operations?
- Must the services be rendered personally?
- Who hires, supervises, and pays assistants?
- Is the relationship continuous or permanent?
- Who sets work hours?\
- Is the worker required to work full-time?
- Does the worker perform his or her duties on the employer’s premises?
- Who sets the order or sequence of work?
- Is there a requirement of oral or written reports?
- Is the worker paid by the hour, week, or month?
- Does the payor pay for the worker’s business or traveling expenses?
- Does the payor furnish the worker with tools and materials?
- Is the worker making a significant investment of time to this employer?
- Does the worker realize a profit or loss?
- Does the worker provide services to more than one business at a time?
- Is the worker available to the general public?
- What are the payor’s rights to discharge worker?
- What are the worker’s rights to terminate relationship. 7
These 20 factors are based on common law definitions and can be grouped into three broad categories:
- Behavioral control.
- Financial control.
Each category seeks information illustrating an employer’s right to direct and control a worker. While no one category is outcome determinative, generally, an independent contractor is paid a flat rate, issued a Form 1099, and elects how to perform the job.
If a worker is an employee, the burden of collecting and remitting employment taxes falls on the employer. It is much easier for the IRS to collect employment taxes from one employer for all of its employees than having to try to collect employment taxes from a multitude of individual workers. Employers who hire nonresident aliens (NRAs) should review Notice 2009-91, 8 which provides guidance on the proper withholding for services performed by NRAs within the U.S.
If an employer fails to collect and remit employment taxes, the employer’s “responsible persons” (i.e., its financial officers and shareholders) may have personal liability for the uncollected taxes. The trust fund recovery penalty is imposed against responsible persons to the extent the company failed to remit to the IRS the employee withholding. 9
The IRS perennially assesses numerous trust fund recovery penalties, and court cases are decided on the issue each year. For instance, on 8/21/09, a district court held that there was no reasonable cause to abate penalties against a corporation that failed to timely file its employment returns and pay its taxes. 10 The court found that the officer responsible for filing the returns was incapacitated, but that the company made no effort to have someone assume the incapacitated employee’s responsibilities.
It appears logical that during the audits examiners will closely examine all workers classified as independent contractors by the businesses for which they provide services. If the examiner concludes that a worker is improperly classified, the company will be subject to employment taxes for all open tax years, or at least for all periods under examination. Once these employment taxes are assessed, the IRS will likely proceed promptly to collect the additional employment taxes. Because limitations periods may apply in certain cases, the examiners may seek to have employers sign Forms 872 extending the applicable period or otherwise go about having the IRS making prompt assessments.
Employees are permitted to receive certain fringe benefits from their employer without the benefits being subjected to income tax. Generally, the benefit must have a de minimis value to be excluded from tax. A benefit is classified as de minimis if the employer provides similar benefits to other employees on a frequent basis such that accounting for the benefit would prove to be a hardship. 11 A nonexclusive list of common de minimis benefits includes:
- Occasional typing of personal letters by a company secretary.
- Traditional holiday gifts of property (not cash) with a low fair market value.
- Occasional theater or sporting event tickets.
- Coffee and doughnuts.
- Soft drinks. 12
Employees are, however, also eligible to receive other benefits with more than a de minimis value and exclude the value of such benefits from income tax. Yet, permitting an employee to use a company car for personal excursions is not one of these; although it is often incorrectly treated as a tax-free benefit, in reality, it is taxable. 13 An examiner is likely to review all of the benefits provided to employees to make certain that they all qualify under Section 132 for exclusion from tax.
Regardless of the benefit received by an independent contractor, it is taxable. Consequently, an independent contractor who receives fringe benefits from the company must include the value of these fringe benefits in his or her compensation. If the independent contractor failed to include the value in his or her compensation, presumably the examiner would adjust the workers’ income to reflect the inclusion of these fringe benefits.
Since the Government began bailing out corporate America, the issue of executive compensation has become the focus of enhanced media coverage, as well as a highly political issue. Notwithstanding, examiners have often focused on the propriety of executive compensation.
The Tax Court and circuit courts have used a series of objective tests in determining the reasonableness of compensation provided by companies. Those tests usually include these categories:
- The employee’s qualifications and role in the company, including factors such as hours worked; the employee’s position, duties performed, and his or her overall contributions to the company. 14
- The character and condition of the company, including factors such as the size of the company, the complexity of its business, and the general economic conditions. 15
- A comparison of the employee’s compensation with the compensation paid by similar companies for comparable services. 16
- The salary policy of the company for all its employees, and the particular employee’s salary history with the company. 17
- The likelihood that a hypothetical, independent investor would be willing to compensate the employee at the levels paid by the company, taking into account dividends paid and capital growth. 18
- Whether a conflict of interest might permit the company to disguise nondeductible corporate distributions as salary. This factor warrants particular scrutiny when the employee is the corporation’s sole shareholder. 19
Examiners will likely carefully apply these tests to determine whether the compensation paid to the executives of the companies under audit is reasonable. The IRS is aware that closely held corporations, in particular, have a propensity to manipulate executive compensation.
For example, normally the shareholder of a C corporation would like to increase the compensation he or she receives from the corporation. The corporation is entitled to a deduction equal to the compensation paid to the shareholder. Consequently, excess compensation reduces corporate profits. In addition, Section 162(m) limits the deduction a corporation can take for compensation paid to covered employees (i.e., the CEO of the corporation, an individual acting as the corporation’s CEO, or one of the corporation’s four highest compensated officers) to $1 million in the case of a publicly traded company. This tax deductible treatment of compensation is contrary to the treatment of dividends issued by a corporation to the shareholder. The corporation cannot deduct the dividend, must pay corporate tax on its profits, and the shareholder pays tax on the receipt of the dividend.
Contrary to a shareholder-employee of a C corporation seeking to receive excessive compensation, an S corporation shareholder-employee will want to pay himself or herself a lower salary. This results from the fact that only amounts characterized as compensation are subject to employment taxes; profits distributed from an S corporation in the way of a dividend are not subject to employment taxes, nor is the S corporation taxed at the corporate level.
Employers can reimburse employees for work-related expenses and exclude such reimbursements from an employee’s compensation. In order to be excluded from taxes, however, the reimbursements need to be made pursuant to a “qualified accountable plan.” 20 In order to be deemed part of a qualified accountable plan, reimbursements must meet the following three requirements:
- A business connection.
- Returning amounts in excess of expenses. 21
Examiners will likely review company employee reimbursement plans to determine whether the plans are “qualified accountable plans” eligible for preferential tax treatment (i.e., exclusion). In addition, the examiners will likely pay attention to plans with significant reimbursements to ensure that no company is improperly characterizing a portion of an employee’s compensation as a reimbursement.
A reimbursement satisfies the business connection requirement if advances, allowances, or reimbursements are made for only specified deductible business expenses that are paid or incurred by the employee in connection with services provided as an employee. 22 A reimbursement satisfies the substantiation requirement if it mandates that the employee substantiate each business expense to the payor and it provides the reimbursement for an expense eligible under Section 274(d). 23 The third requirement to be an accountable plan is that the employee return all reimbursements to the employer in excess of the expense incurred, and the reimbursement must take place within a reasonable time. 24
A reimbursement that does not satisfy all three of these requirements is deemed to be paid under a “nonaccountable plan,” the consequence of which is that all payments to the employee are included as compensation and subject to employment tax. 25
Employers that have failed to comply with the employment tax laws and are examined under the Initiative should expect to incur significant penalties. Possible penalties include the following:
- Section 6651 failure to file penalty.
- Section 6656 failure to deposit penalty.
- In some instances where the failure to file is fraudulent, a Section 6651(f) fraudulent failure to file penalty.
If the failure to file a timely return is classified as fraudulent, the monthly penalty is 15%, and the maximum penalty is 75% of the total employment taxes due. 26 Consequently, employers with noncompliance would be wise to consider a voluntary disclosure. The Internal Revenue Manual defines a voluntary disclosure as having taken place when the taxpayer’s communication is truthful, timely, and complete. 27 These terms require that the taxpayer show a willingness to cooperate (and does in fact cooperate) with the IRS in determining its correct tax liability, and the taxpayer makes good faith arrangements with the IRS to pay (in full) the tax, interest, and any penalties determined by the IRS to be applicable. 28
When successfully applied to a taxpayer, the taxpayer can use the voluntary disclosure program to come into compliance and avoid criminal prosecution. Taxpayers need to be aware that not all voluntary disclosure submissions are accepted, and thus, criminal prosecution is a potential outcome from a disclosure that does not qualify. 29 Cases involving illegal-source income will not qualify. 30
Disclosures are timely if they are received before:
- The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation.
- The IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance.
- The IRS has initiated a civil examination or criminal investigation that is directly related to the specific liability of the taxpayer.
- The IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant or grand jury subpoena). 31
The IRS recently posted on its website that the voluntary disclosure practice is “a longstanding practice of IRS Criminal Investigation of taking timely, accurate, and complete voluntary disclosures into account in deciding whether to recommend to the Department of Justice that a taxpayer be criminally prosecuted. It enables noncompliant taxpayers to resolve their tax liabilities and minimize their chances of criminal prosecution. When a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution to the Department of Justice.” 32
In November 2008, the IRS issued guidance indicating that it would permit taxpayers with employment tax issues to use the voluntary disclosure program to resolve the liability.
A natural starting point to prepare for the Initiative would be to conduct an internal employment tax compliance review. Ideally, this would determine areas where the company may not have been entirely compliant. By conducting an internal review, the employer may be able to prepare for potential audit issues or adjustments that would arise should it be one of the companies selected for examination. If the employer detects any noncompliance, the company should aim to resolve the problem proactively to avoid its becoming a future audit issue. In the event the company is examined, it can then demonstrate to the IRS that it has proactively resolved the noncompliance, which may provide some relief from the accuracy penalty or even civil fraud penalties.
- In the area of worker classification, the employer should ensure that it has documentation clearly showing why some workers have been classified as employees and why some workers have been classified as independent contractors. For example, an employment agreement should be in place with those individuals who are classified as employees, and that agreement should clearly show the behavioral control, financial control, and the relationship of the parties in conformity with the common law tests applied by the IRS. To provide a contrast, the employer would ideally also have independent contractor service agreements in place with all workers classified as independent contractors, with all of the common law factor elements clearly showing the workers are independent contractors and not employees. Finally, in the particular case where a worker formerly treated as an employee is reclassified as an independent contractor (or vice versa), clear documentation should show why the change was made and what factors were altered to justify the reclassification.
- With regard to fringe benefits, employers should ensure that fringe benefits being offered are de minimis. If the fringe benefits offered do not fall within the exception, employees are subject to income and payroll tax on the value of the benefits. More importantly, employers should not offer fringe benefits to independent contractors; to the extent they have erroneously offered fringe benefits, employers should ensure that the value of these benefits is added to the compensation being paid for the independent contractor services.
- Compensation, especially that which is paid by a closely held business, should formally be established at the beginning of the year and memorialized via an employment agreement. The company should set the compensation so that it is reasonable. All corporate formalities should be followed to document properly the responsibilities of highly compensated individuals and the rationale for their compensation.
- All employers should have written reimbursement policies in effect, and need to make sure that such policies are updated, as needed, and followed. Accounting records and procedures should clearly reflect employee-provided receipts for expenses and that these expenses were related to the employer’s business (i.e., met the Section 274 substantiation requirements).
Following the steps identified above will help employers to be compliant with the employment tax laws. Of course, depending on its degree of past noncompliance, an employer may need to consider making a voluntary disclosure.
Whether or not an employer is selected for audit, all employers must realize that the Initiative is the beginning of a long-term emphasis by the IRS on employment tax issues. Once the Initiative has concluded, the IRS will use the data collected during the Initiative to tailor future employment tax audits at the specific areas determined under the Initiative where compliance is lacking. This is precisely why companies should proactively conduct their own compliance reviews now when they have options, such as voluntary disclosure, to resolve the noncompliance.
This article was published in Practical Tax Strategies magazine in the March 2010 issue.