Get ready for the IRS employment-tax audit blitz starting in February

Starting Feb. 1, the IRS will begin intensive audits looking into employment tax compliance of 6,000 randomly selected employers. The audit project, which was quietly announced by the IRS in October, is the tax agency's "most significant audit initiative in decades," according to a report by the Morgan Lewis law firm.

These National Research Program (NRP) audits will generate the IRS’ first statistical snapshot of employment tax compliance since 1984. According to Morgan Lewis, the audits are expected to initially focus on the following four areas before expanding to other issues:

1. Worker classification / independent contractors. The focus will include traditional misclassification of employees as independent contractors (IC) and exclusion of misclassified workers from benefits, as well as possible focus on three-party relationships, W-2 vendors and staff leasing relationships.

2. Executive compensation. The IRS will apparently devote special attention to executive compensation such as loans, executive travel, nonqualified deferred compensation, retirement contracts, stock-based compensation and golden parachutes.

3. Fringe benefits. The auditors will look at a number of executive fringe benefits associated with officer compensation, such as company cars, club dues, spousal travel and housing. The fringe benefits aspects of the audit will also cast a wider net, seeking to challenge more broad-based noncash fringe benefits such as expense reimbursement arrangements, gift cards, working condition fringes, club memberships, employer cafeterias and athletic facilities.

4. Payroll taxes. The audits will be structured as payroll tax audits of Forms 941 and will be influenced by an experienced corps of employment tax agents. The audits will focus on more traditional employment tax inquiries, including next-day deposit requirements, backup withholding, B Notices and Form W-2/Form 1099 compliance.

The audits will stretch across all industries and company sizes and mainly focus on tax years 2007 and 2008. They'll include face-to-face interviews, plus a line-by-line review of the company’s employment tax returns.

"The IRS has stated that these payroll tax audits are intended to impose as little burden as possible on businesses. However, the sheer number of companies targeted (6,000) and the methodology employed (taxpayer compliance audits) suggest precisely the opposite," says the Morgan Lewis report. "This initiative comes on the heels of renewed congressional scrutiny of IC issues, and the GAO’s own report urging the IRS to focus its 'efforts to probe the improper classification of workers' as ICs and—perhaps most ominous—to invoke its penalty authority to deter misclassification."

Misclassifications on the rise

IRS officials believe tough economic times have led more employers to classify members of their workforce—often incorrectly—as independent contractors.

Slapping the contractor label on a worker saves the employer money, as they don’t need to pay for independent contractors’ insurance, benefits or for the employers’ half of the Social Security and Medicare taxes on workers’ wages.

But if the IRS, Department of Labor or a state agency determines that you’ve misclassified workers, the mistake can lead to tremendous liability. In addition to overtime, your former independent contractors may seek employee status to collect workers’ comp, unemployment benefits or damages in a civil rights lawsuit.

Making the decision. The fault line in the great “employee or contractor” divide lies in how much control the employer has over the worker’s schedule, materials, behavior, risk level, etc. Labels don’t count. If it works like an employee and is paid like an employee, it’s probably an employee.

The last time the IRS studied misclassification, in 1984, it estimated that about 15% of employers nationally misclassified a total of 3.4 million employees as independent contractors. A 2005 government report said 10.3 million American workers—or about 7.4% of the workforce—were classified as independent contractors.

FedEx is the poster child for the contractor battle. The IRS originally hit the company with a $319 million tax assessment for improperly classifying 12,000 of its drivers as independent contractors. But in November, the IRS backed off the assessment and allowed the workers to be classified as employees. Still, several states aren’t giving up the fight ... they plan to sue FedEx over those classifications.

FedEx isn’t the only state target. States are cracking down on improper misclassifications across the board. To read a state-by-state summary of recently enacted laws on independent contractor misclassification, go to www.theHRSpecialist.com/contractor-state.

How to respond if you are audited

If your company is selected for examination, follow good IRS examination management practices, including:

Designate a clear chain of command for responding to IRS communications
Retain expert outside advisors early in the process
Maintain control over the IRS audit by requesting additional time to respond to information document requests, or tailoring the scope of information requested, where appropriate.

Online resources: For more advice, read our white paper, Independent Contractor or Employee? How to Make the Call at www.theHRSpecialist.com/contractor.

Self-test: Making the contractor vs. employee call

Determining a worker’s status hinges on one key point: degree of control. The more control you exert over the person’s schedule and duties, the more likely he or she will be deemed an employee—not an independent contractor. Some issues to consider:

1. Are instructions given and taken? Employees are typically subject to the business’s instructions about when, where and how to work; an independent contractor is not.

2. What training do you provide? Employees may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.

3. Can the worker incur a loss? Contractors can make a profit or suffer a loss. Employees can only make a profit.

4. Is the worker available for other jobs? Evidence includes online or Yellow Pages ads and proof of working for more than one firm.

5. How do you pay the worker? Employees are generally paid by the hour, week or month. Independent contractors are generally paid a flat fee or by the job.

6. Do you provide benefits? Perks like insurance, pension plans, paid vacation and sick days are typically not granted to independent contractors.

7. How essential is the worker? If the worker provides services that are a key aspect of the business, it’s more likely this person would be an employee.

8. What’s the long-term plan? If you hire a worker with the expectation that the relationship will continue indefinitely—rather than a specific project or period—this is generally considered evidence that the intent was to create an employer-employee relationship.

Note: Employers must weigh all these factors. As the IRS says, “There is no set number of factors that ‘makes’ the worker an employee or an independent contractor. … The key is to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”

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