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Employment Tax Audits Take Center Stage with Internal Revenue Service

AUGUST 2010

As published in the Mississippi Business Journal

Started with individual returns, then business and partnership returns.

The Internal Revenue Service is extending its National Research Program to cover employment taxes and their contribution to the tax gap. Businesses could face random audits under the program as soon as this fall. This program began with a concentration on individual returns and then moved on to examine business and partnership returns that some observers see as a natural progression of the program.

A CPA and tax specialist with the HORNE accounting firm in Jackson, Eustis Corrigan explains the program in layman's terms. "For the first time in 25 years, the IRS will randomly select 6,000 employers over the next three years for employment tax examinations under its first Employment Tax National Research Project," he said. "Examinations comprising the study will be conducted to collect data that will allow the IRS to understand the compliance characteristics of employment tax filers."

He continued by noting that the audits will focus on five primary employment tax issues - worker classification, fringe benefits, reimbursed expenses, officer compensation and non-filers.  When completed, this information will help the IRS select and audit future employment tax returns with the greatest compliance risk.

What exactly does this mean for business owners? "There is little that business owners can do except be prepared," Corrigan said. "The businesses' departments that handle the tax and payroll functions should review current payroll practices, focusing on the five areas identified by the initiative, as well as any other weakness areas. 

"Companies should also review the three most recent years' employment tax returns, along with the supporting documentation."

For companies selected for examination, he recommends that good IRS examination management practices be followed, including these tips:                                                            

• Designate a clear chain of command for responding to audit notices and other IRS communications. 
• Engage outside advisors early in the process.                                                                   
• Work to maintain control over the IRS audit by requesting additional time to respond to document requests or tailoring the scope of information requested, where appropriate.

"Detailed employment tax examinations will take place for 6,000 taxpayers.  The IRS will select 2,000 taxpayers per year over the next three years to be audited," Corrigan said.  "The audit initiative will target a broad cross-section of businesses of varying size and legal form, including tax-exempt employers.  The taxpayers will be selected at random, so there is nothing that companies can do to avoid being targeted."

The IRS began contacting the first 2,000 employers in March and will focus the audit on Forms 941 filed for tax year 2008. Selected employers will receive a letter notifying them that they have been selected to participate in the project and will have approximately 30 days to prepare their records prior to the commencement of the review. The IRS is slated to select the second 2,000 employers at the end of 2010 and will primarily focus on tax year 2009 for those employers. The examinations began in Feb. 2010 and will take place over the next three years.

"The IRS has trained a team of 200 auditors to conduct this study. These auditors are tasked with conducting reviews that are more comprehensive than a standard audit to ensure that sufficient data is collected for the study," Corrigan said. "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."

The IRS estimates each auditor will spend seven to eight months auditing each employer selected. Auditors will not only review normal tax records including W-2s, Forms 1099 and Forms 941 but also the business's accounting records such as check ledgers and accounts payable. 

"Targeted employers should ensure all records are updated and available, and prepare to substantiate in detail all tax treatments falling under any of the key areas of the study," he said. "We are telling our clients that while the chance of being selected for audit is fairly minimal, this program should serve as a catalyst to make sure they are in compliance with the payroll tax regulations.  This program will expand in future years so now is the time to correct any practices that need correcting."

As additional advice, Corrigan reminds businesses that an important tool to be aware of is an off-Code provision, Section 530 of the Revenue Act of 1978. Section 530 provides a safe harbor for employers seeking to classify workers as independent contractors. Employers found to qualify for Section 530 relief, will receive no-change letters.

"To qualify for the Section 530 safe harbor, employers must meet three requirements with respect to each worker," he said. "First, the employer must file all federal tax returns (including information returns) required to be filed by the taxpayer with respect to that worker. Specifically, failure to provide the worker with a Form 1099 will disqualify the employer from the Section 530 safe harbor. 

"Second, the taxpayer must have a reasonable basis for not treating the worker as an employee. A reasonable basis is provided by judicial precedent, IRS audits in which there were no assessments attributable to the treatment, and long-standing recognized practice of a significant segment (at least 25 percent) of the industry."

The employer will fail to meet the requirements if it has treated a different worker in a substantially similar position as an employee.