The Internal Revenue Service (IRS) has recently begun a 3-year National Research Program to randomly select and intensely audit approximately 6,000 companies to focus on employment tax issues to include review of independent contractor status, executive compensation, fringe benefits and other employment tax issues. This is a first attempt (in approximately 25 years) where the IRS National Research Program has targeted employment tax. The goal of the IRS is to identify areas of noncompliance across industry sizes and sectors including nonprofits and governmental entities, with an ultimate goal of revenue collection.
The employment tax examination issues will include independent contractor/worker classification issues, including executives rehired as consultants, dual status employees and employee leasing arrangements.
Fringe benefits reimbursements examination for “personal use” including not only income tax but backup withholding of an additional 28% (including cell phone use, credit cards and other non-cash benefits). Executive compensation and fringe benefits include use of company cars, planes, executive retirement contracts, golden parachutes, stock options, etc.
Independent Contractor v. Employee
Perhaps the most common area of concern of small businesses is the classification of workers as independent contractors (not employees). This classification generally results in a decreased economic burden of the business to avoid payroll taxes and other economic costs associated with employees.
The determination of employment status is generally based on 20 factor common law test (not statutorily defined). Be advised that the IRS will almost always reclassify all workers as employees. These factors are designed to determine the degree of “control” of the paying entity and the elements of “economic risks” of the payee. Factors to be included in analysis by employers include:
- Compliance with instructions
- Training provided
- Integration with business activities
- Personal rendition of service
- Hiring, supervising and payment of assistants
- Existence of a continuing relationship
- Set hours of work
- Working on the employer’s premises
- Sequence of work done
- Reports recruited
- Payment by hour, week or month (not as a percentage of collections)
- Expense accounts
- Tools and materials supplied
- Facilities furnished
- Risk of loss to worker
- Number of “employers”
- Availability to general public
- Power to fire
- Termination damages
Generally, the greater the control of the payer; the greater the risk that it will be determined to be an employer. The use of a worker agreement in which the person acknowledges being an independent worker is irrelevant.
Safe Harbors or Exceptions
Fortunately, certain safe harbors are available (IRS Sec. 530). The main classifications of this exception include:
- Judicial precedents, published IRS rulings, technical advice memorandum or private letter ruling or determination ruling
- A log standing recognized practice of a significant segment of the industry in which the taxpayer is engaged (Industry segment should be 25% or more);
- Statute allows the taxpayer to demonstrate “reasonable basis” for its treatment of workers is some other manner
However, even if you satisfy one of the requirements of IRC Sec. 530 you must meet other requirements:
- Taxpayer must not have previously treated the individuals as employees;
- Taxpayer must have all required informational returns;
- Consistency requirement in how payees are treated
The burden of proof is on the IRS once the TP establishes a prima facie case (meet factors of IRC Sec. 530 and other requirements).
Consequences of a Payroll Examination
There are unfortunately various consequences to taxpayers that may be asserted by the IRS.
- The Company may be subject to backup withholding – current rate of 28%;
- There may be a disallowance of income tax deductions not paid pursuant to an accountable plan;
- There may be additional income taxes imposed upon recipients of employee benefits that are deemed to be wages or taxable income;
- There may be asserted negligence penalties of 20% on additional tax obligations;
- There may be asserted penalties for failure to provide Forms 1099 or W-2
What to Do
If selected for a payroll tax examination don’t panic — just get professional help. Review your current employment arrangements with your advisor and determine your degree of exposure, if any. Review the 20 factor test, see to what extent the safe harbor provisions apply and gather the necessary documentation in support of your positions. In summary, be prepared, hire professional advisors and take the necessary steps to reduce your exposure that you haven’t already.