The current likelihood that your business will become involved in an employment tax audit or an employment-related income tax audit has increased. The Internal Revenue Service (IRS) is aggressively attempting to reduce the “tax gap” of uncollected revenues in a time of increasing budget austerity. Employment tax noncompliance is estimated by the IRS to account for approximately $54 billion of the tax gap, which is made up of the under-reporting of:

  • FICA – $14 billion
  • Self-employment tax – $39 billion;
  • Unemployment tax – $1 billion

Add to the already existing over $50 billion in estimated employment-associated income tax lost as a result of missteps in withholding obligations, tip reporting and proper fringe benefit classification and loss is significant.

Employers Be Forewarned

The IRS is stepping up its auditing in these areas and has been conducting studies to maximize the best use of its agents’ time to do so.

Currently the IRS is conducting an intensive audit of 6,000 employment tax returns to obtain an up-to-date picture of taxpayers’ employment tax practices. This will enable the IRS to better devote its compliance resources to the most important areas of noncompliance and to the taxpayers most likely not to be in compliance.

Based on these audits, the IRS’s Chief of Employment Tax Policy has spotlighted several areas of concern the IRS will focus on including:

Backup withholding – Backup withholding is the number one problem uncovered in the audits. The IRS can impose backup withholding on income reported on Forms 1099 that is not ordinarily subject to withholding, such as interest, dividends and nonemployee compensation. Failure to provide a taxpayer identification number (TIN) on the Form 1099, an incorrect TIN or a TIN that does not match the name on the form can trigger backup withholding. A taxpayer’s failure to report the income can also trigger backup withholding.

Tip reporting – Tip reporting is a major concern of the IRS. The IRS considers noncompliance a widespread problem, especially for small businesses that are not aware of the issues. The IRS has been focusing on educating employers, and is not auditing employment tax returns filed before 2014. An important issue is the failure to differentiate between service charges and tips. A payment that is automatically added to a bill may be a service charge. A service charge is characterized as Social Security wages, rather than Social Security tips. The distinction is important, because employers can claim a Social Security credit for FICA obligations attributable to tips that exceed the minimum wage, but cannot claim a credit for taxes paid on service charges.

Worker misclassification – To avoid FICA and FUTA taxes and income tax withholding, some employers intentionally classify employees as independent contractors. This has been a longstanding concern for the IRS, and the recent audits have shown that the problem continues. The agency regularly conducts employment tax audits to reclassify workers as employees. To facilitate reclassification to employee status, the IRS has two settlement programs for employers:

  1. Classification Settlement Program (CSP) for taxpayers under audit
  2. Voluntary Classification Settlement Program (VCSP) for companies that are not under an employment tax audit and meet other requirements.

The IRS has received 1,550 applications under the VCSP and has reclassified approximately 25,000 workers. Companies that agree to prospectively treat workers as employees generally pay reduced taxes and may get audit protection for past years.

Fringe benefit reporting – Fringe benefits can be cash or noncash benefits provided in addition to regular wages. As a compliance matter, fringe benefits are taxable and must be included in the recipient’s income, unless the Tax Code specifically excludes the benefit from taxable income. Moreover, if the recipient is an employee, the value of the benefit is additional compensation subject to employment taxes. Fringe benefits can be a particular problem for small companies, where owners seek to reduce their taxable income by taking noncash benefits, such as the use of company vehicles. A bargain sale of a house to an employee could also generate taxable income subject to employment taxes.

Proper Planning

Employment taxes present an increasing risk to employers as the IRS steps up focuses on what it suspects is a heretofore largely untapped source of revenue. The IRS is certain to use the data now being harvested through its latest audit surveys. Wondering how you employment tax compliance will measures up against this new degree of scrutiny? Contact our dedicated tax advisors in Michigan, Houston or Ft. Lauderdale to help review your current employment tax process and ensure you are in compliance in the event of an audit.