The federal and state governments are moving on several fronts
to counteract what they consider to be a significant contributor to
the income tax gap: underreporting of employment taxes. The IRS is
embarking upon a major employment tax enforcement effort. Beginning
this month and continuing over the next three years, newly trained
IRS employment tax agents will audit 6,000 companies as part of an
"Employment Tax Compliance Program" announced last year.
A primary focus of the compliance audits will be the company's
classification of certain persons as independent contractors rather
than employees.
The President's fiscal 2011 budget allocates funds for hiring
additional agents to assist in this process. According to the
budget report, increased enforcement in this area will increase
Treasury receipts by more than $7 billion over ten years. For its
part, Congress is expected to consider legislation that would
substantially limit the availability of certain safe harbor
provisions included in the Revenue Act of 1978, which have severely
hampered the IRS's enforcement efforts in employee
reclassification cases. Finally, many state governments are
stepping up their enforcement efforts, on their own initiative or
in conjunction with the Federal program.
Employers should become familiar with the IRS's audit game plan
and be aware of their individual vulnerabilities, so that they can
adequately defend themselves when and if they are contacted by the
Service. Furthermore, even if they are not selected for audit in
the Compliance Program, employers should know that their employment
taxes may be examined in connection with a general audit of their
income tax returns. It may be appropriate for certain employers to
reevaluate and consider changing their practices in light of the
enhanced enforcement activity and opportunity to avoid certain
penalties if they do so voluntarily.
IRS Compliance Audit Game Plan and What You Need to Do to Be Prepared
According to the IRS Chief of Employment Tax Operations, most of
the employment tax compliance audits will be conducted
"face-to-face" at the employer's place of business,
with additional information gathered from IRS internal sources and
the internet.
A primary focus of the compliance audits will be the company's
classification of workers as independent contractors rather than
employees. Worker classification has always been a primary IRS
concern. The IRS strongly favors employee status because subjecting
compensation to the withholding system assures more accurate
reporting of income and more reliable payment of income and social
security taxes. Unfortunately there is no bright-line standard for
classifying a worker as an independent contractor or employee. The
multi-factor common law test, applied in these circumstances, is
confusing, uncertain of application, and susceptible to varying
interpretation depending upon the philosophical bent of the
decision maker. What this means is that employers must generally be
prepared for an aggressive interpretation of the common law test by
IRS examiners, resulting in long drawn-out, fact-intensive battles
over the classification of certain workers.
What can you do to be prepared? First, you should be aware of your
vulnerabilities. Certain workers are more likely to be scrutinized
than others. Are you a member of the construction, ground delivery,
car service, trucking, consulting, leased employee, industries, to
name a few? Do you engage as independent contractors part-time
personnel, "temporary" workers, certain technical
workers, former employees (including executives) who have retired
from or terminated their employment with your company, workers who
received continuing payments from you during the year or over
several years, workers who received in the same year or over
several consecutive years a Form W-2 and Form 1099 from your
company? Each of these situations presents a potential employee
classification issue. In each case, you should muster the facts and
documents in support of your position. You should consider
modifying the terms and facts of your relationship with the
particular individuals going forward to strengthen your position
for independent contractor classification in future periods. If you
consider your position weak and irremediable, you should consider
converting the individuals to employees and attempting to work out
a favorable settlement with the Service. There are several Code
provisions (e.g. reduced employment tax rates, interest-free
adjustments) and an IRS settlement initiative that could make this
conversion virtually painless, insofar as past years are concerned,
and possibly avoid any criminal penalties associated with the
misclassification. Of course, as part of any settlement, you would
probably have to agree to treat the workers as employees in future
periods.
One further word of advice: Do not lose sight of Section 530 of the
Revenue Act of 1978. This "off-Code" provision was signed
into law in 1978 in response to the Service's aggressive (and
arguably unreasonable) application of the common law test to
reclassify as employees large groups of individuals in recognized
industries who had historically been treated as independent
contractors. The provision allows companies to continue treating
workers as independent contractors without regard to how they might
be classified under the common law test provided that the
requirements for "substantive consistency,"
"reporting consistency" and "reasonable basis"
are met. Revenue agents are obligated to apprise employers of the
availability of the Section 530 defense and accord them the
opportunity to mount a defense under that section.
Other areas to be covered by the employment tax compliance audits
include executive compensation (reasonableness in the case of
Subchapter S corporations and treatment of certain portions as
non-qualified deferred compensation under section 409A of the Code)
and taxable fringe benefits. Examination by the IRS of the latter
will likely focus on personal use of company-owned vehicles,
aircraft, etc. In addition, the IRS may always choose to broaden
the scope of an employment tax examination, for example to include
other withholding tax substantive and technical issues, withholding
practices of related entities both domestic and foreign, and the
income tax returns of company executives.
This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.
