In November, the IRS launched a three-year National Research Program (NRP) initiative on employment taxes. The program is part of IRS efforts to close the tax gap - the difference between what taxpayers should have paid and what they actually paid on a timely basis.

There could be 2,000 or more randomly chosen audit “candidates” each year - and governmental entities will likely be among them. While any entry on an organization’s employment-tax returns may be scrutinized, the IRS has identified four primary areas where employment-tax issues frequently arise.

Worker Classification
In general, organizations are required to withhold income taxes, withhold and pay FICA (Social Security and Medicare) taxes, and pay unemployment taxes on employee wages. These requirements generally do not apply to payments made to independent contractors. Incorrectly classifying an employee as an independent contractor (when you have no reasonable basis for doing so) and failing to meet employment-tax responsibilities could result in a substantial tax bill and penalties.

If an IRS auditor suspects that a worker has been misclassified, the auditor will focus on the extent to which your organization directs and controls what the worker does and how the work is done, how the worker is paid, whether you have a written contract, if expenses are reimbursed, and who provides the necessary tools and supplies. Generally speaking, the more control your organization has, the more likely the worker should be classified as an employee.

Officers’ Compensation
The reasonableness of officer compensation has been an ongoing issue for the IRS. This area could receive considerable attention should you be chosen for an NRP audit. Following recommended guidelines for setting officer compensation should help this part of the audit go smoothly by ensuring that no excess benefit transactions have occurred.

Fringe Benefits
Another area an IRS audit is certain to focus on is the fringe benefits your organization provides. Fringe benefits are taxable and must be included in the recipient’s pay unless specifically excluded under the tax code.

Taxable fringe benefits provided to an employee are subject to employment taxes and have to be reported on the employee’s Form W-2. If the person receiving the fringe benefit is an independent contractor, the benefit is reportable on Form 1099-MISC. First-class or charter travel, companion travel, housing allowances, discretionary spending accounts, payments for the business use of personal property, and social or health club fees are a few high profile benefits that could attract attention.

Employers can provide various tax-free fringe benefits to their employees, including dependent-care and educational assistance and qualified health plan benefits. Various rules and limitations apply.

Reimbursed Expenses
A complete review of compensation for employment-tax purposes will probably include a review of reimbursed expenses. Are they compensation and, therefore, taxable? In short, not if they were covered by an “accountable plan.” Very basically, an accountable plan requires that the expenses be incurred in performing services as an employee, that the employee adequately account for the expenses within a reasonable time period, and that the employee return any excess amounts within a reasonable period. Payments not covered by an accountable plan represent taxable income to the recipients. Failure to properly report such amounts can make them an excess benefit transaction.

We Can Help
The prospect of an audit is never pleasant. However, we have the expertise to guide you through. If you have any questions please contact Lewis, Hooper & Dick, LLC at (620) 275-9267.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax related matter.

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