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By Michael M. Lloyd
The Internal Revenue Service is taking a "back-to-basics" approach to 6,000 employment tax examinations it is conducting under a research program run by the Small-Business/Self-Employed Division ("SB/SE"). But that doesn't mean it will be easy for companies to pass muster.
SB/SE employment tax examiners are the most battle-tested employment tax examiners within the IRS and were specifically chosen to perform targeted audits of a cross-section of employers between 2010 and 2012, including large employers.
And not all of the issues the IRS plans to examine are necessarily unsophisticated, though the significant focus is on fundamental compliance issues targets areas that are critical to effectiveness of the US tax system. Employers should therefore take steps to prepare for these audits by strengthening procedures and interdepartmental cooperation and communication before being selected for audit.
These audits test two important elements of the US tax system -- employment taxation and information reporting. Federal employment taxes, which include federal income tax withholding taxes, Federal Unemployment Tax Act taxes, and Federal Insurance Contribution Act taxes, make up a substantial portion of federal tax receipts. Noncompliance related to federal employment taxes alone makes up a significant portion of the federal tax gap -- the difference between federal taxes due compared to the tax actually collected. The 6,000 audits will occur evenly over the three-year period that commenced in January of 2010; thus, approximately 2,000 of these audits will be performed each year. Employers of all types and sizes are being selected, from small employers and nonprofits to Fortune 500 companies.
Examiners are instructed to focus on worker classification, fringe benefits, domestic information reporting (Forms 1099-MISC) and backup withholding, and executive compensation issues, including 409A compliance related to deferred-compensation arrangements.
One remarkable point is how prepared the examiners should be regarding the employer's tax situation before they arrive. Examiners will have researched the company's activities and will have complete copies of each employer's federal income tax return, Forms 1099, Forms W-2, and all notices issued during the previous three years that relate to missing or mismatched taxpayer identification numbers ("TINs"). Examiners have been instructed to comb through employer records to identify fringe benefits that should have been treated as taxable compensation as well as payments that should have been subjected to backup withholding. Employers that failed to include taxable fringe benefits in wages and that failed to backup withhold when required are subject to strict liability for unwithheld taxes and may also face penalties.
Further, examiners have also been instructed to thoroughly review worker classification issues and claims for safe harbor relief under section 530 of the Revenue Act of 1978. In cases in which section 530 relief is appropriately claimed, the IRS plans to quantify the revenue effect of the benefit to the US Treasury. Presumably, the IRS will share its section 530 research with Congress, which has considered repeal of section 530 relief in recent years.
Inaction and playing the audit lottery is a dangerous strategy for employers. The best preparation plan for employers is to preemptively establish an internal compliance team at the direction of counsel (internal or external), and strongly encourage teamwork and communication between key departments such as payroll, accounts payable, tax, legal, HR, and sometimes purchasing or procurement. Compliance efforts undertaken at the direction of counsel improves the likelihood that privilege claims will be sustained if challenged by the IRS. To ensure that internal compliance procedures operate as intended, interdepartmental communication is critical. For example, payroll and accounts payable need to collectively address claims for travel and other reimbursements to ensure that the accountable plan requirements under section 62(c) of the Internal Revenue Code are satisfied. If they are not, such reimbursements must be treated as wages. Accordingly, communication is critical in such situations.
The IRS's plan to examine payroll and accounts payable records (e.g., vendor activity files, purchases journals, and cash disbursement registers) may not only identify omitted fringe benefits and backup withholding problems due to missing TINs, but may also detect deficiencies in an employer's accountable plan practices. In recent years, examiners have taken a decidedly harder line with respect to noncompliance with accountable rules, and it is not unusual for examiners to propose plan disqualification under the anti-abuse rule of Treas. Reg. § 1.62-2(k), which converts all reimbursements under the plan to wages.
The employment tax examination program launched by the IRS should prompt all employers to review their payroll and accounts payable procedures to confirm the proper treatment of employee wages as well as information reporting and withholding on payments to third parties. Employers should establish a compliance team at the direction of counsel to evaluate the effectiveness of existing procedures and implement improved procedures, if necessary. It is always advisable to take corrective action before the IRS announces its plans to audit because self-correction may negate the imposition of penalties.
Michael M. Lloyd is a partner in the law firm of Miller & Chevalier Chartered
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