New IRS Employment Tax Initiative
Beginning February 2010, the Internal Revenue Service (IRS) will begin to randomly audit an estimated 6,000 U.S. companies as part of a new initiative, titled the IRS National Research Program (NRP). The NRP will have a two-fold purpose: (1) to generate revenue from non-compliant employers and (2) to help determine whether legislative or enforcement changes are necessary to address common employment tax evasion techniques.
This is one of IRS' largest campaigns since 1984. The results of the audits are expected to be completed within three years. The first round of audits, will affect 2,000 companies selected randomly, with another 2,000 companies selected for both 2011 and 2012 audits. Organizations selected for review will vary in size and business structure, and will include both for-profit and non-profit organizations.
Focus of IRS National Research Program
John Tuzynski, IRS Chief of Employment Tax Operations, has relayed that most audits will be conducted in person, but information may be obtained from other sources as well. The audits will primarily focus on five critical areas:
- Worker Classification (i.e. employee vs. independent contractor)
- Fringe Benefits
- Officers’ Compensation
- Employee Expense Reimbursements
Though the IRS will be reviewing all aspects of a company's employment and employment tax practices during these audits, it seems that the IRS has placed a heightened focus on the three areas of employee classification, executive compensation and taxable fringe benefits.
In particular, the IRS appears focused on whether a worker is properly classified as an employee or an independent contractor. Generally, the IRS favors classifying a worker as an employee and will only permit independent contractor classifications in clear circumstances. According to a report by the Government Accountability Office released in August 2009, only 3% of determinations submitted to the IRS showed workers to be true independent contractors, and in 2008 the IRS assessed over $64 million in taxes and penalties for worker misclassification. Understandably, the government seeks to remedy improper classification of employees as it cheats the government out of employment tax revenue obtained from employment relationships, which is much higher than from independent contractor relationships.
In addition to worker classification, these IRS audits will focus largely on fringe benefits and per diems as tax-free, rather than as compensation subject to income and employment taxes. Not all benefits, fringe or otherwise, are tax-free, and the IRS is concerned that employers do not properly include taxable benefits in wages. Lastly, with respect to the area of executive compensation, the focus will be determining: 1) reasonable salaries for officers; and 2) deferred compensation.
There are certainly actions employers can take now to minimize risk of liability and ensure employment tax recordkeeping and other compliance requirements are current, regardless of selection for an audit or not. Employers should consider the following:
- Conduct a review of all independent contractor classifications and solidify that all past and present independent contractors are properly categorized under the facts and circumstances test used by the IRS. In addition, ensure a properly worded agreement is in place.
- Review your organization’s benefit programs, including all nonqualified deferred compensation arrangements to determine whether the arrangements are exempt or compliant.
- Review expense reimbursement plans and policies to confirm that they are up-to-date and compliant with IRS guidelines.
- Determine if all salaries of the employee-shareholders are reasonable.
- Ensure that the value of taxable fringe benefits have been properly included in taxable income.
And most importantly, correct discovered noncompliance now, not later. Proactive correction will minimize any penalties and interest for which the organization may otherwise be responsible.
Employers of every size and type should realize that their compliance with federal employment tax obligations may be scrutinized, and that they should review their policies and records before audits begin. It is imperative to be proactive in assessing potential risks, especially with respect to improper classification of employees. From both this IRS National Research Program, and clear indications from the Obama Administration, the issues of employment tax are front and center. As evidence, in part of the 2011 proposed Budget, the Departments of Labor and Treasury are pursuing a joint proposal that enhances the ability of both agencies to penalize employers who misclassify and restores protections to employees who have been denied them because of their improper classification. The 2011 Budget includes an additional $25 million to target misclassification, 100 additional enforcement personnel and competitive grants to States to address this problem.