Although there is no way to avoid the NRP’s random employment tax audits, there are strategies to help businesses avoid potential trouble spots.
By Mark E. Battersby
The government’s own figures indicate that the payroll tax and self-employment tax gap (the difference between taxes owned and those actually paid) amounts to more than $200 billion annually. One result: With little public fanfare and no advance warning, the Internal Revenue Service (IRS) has begun a National Research Project (NRP) to collect data that will allow it to understand the compliance characteristics of employment tax filers.
The information provided is expected to allow the IRS to zero in on those areas in which mistakes are most likely to occur, and focus their attention on those most likely to have erred or cheated. They will also use the study results to issue new guidelines and regulations and incidentally increase tax, interest and penalty revenue.
Although there is no way to avoid the random employment tax audits of the NRP, there are guidelines and strategies that can help business owners correct employment tax mistakes and avoid potential trouble spots.
Beware the study
The NRP will randomly select 2,000 small, large and self-employed taxpayers to examine their employment tax returns each year for the next three years, as well as continuing to conduct their routine, less targeted audits. The IRS will not discriminate when it comes to the taxpayers it engulfs; the audits will occur in every geographic region of the country and will target both large and small taxpayers. Publicly traded or privately owned, large or small, in the red or in the black, for-profit or not-for-profit, public sector or private sector, anyone is a potential target.
The notice received by selected employers will describe the extremely detailed NRP process, which includes face-to-face meetings with IRS auditors and line-by-line reviews of the employer’s Form 941s and income tax returns. The examinations will reportedly focus on the following issues:
- Worker misclassification (labeling employees as independent contractors or vice versa);
- Fringe benefits;
- Owner/officer compensation; and
- Review of Form 1099s with either no taxpayer identification number (TIN), or TIN/name mismatches.
Worker misclassification. According to recent reports, approximately 30 percent of all IRS audits currently focus on the employee versus independent contractor issue. Although re-classification of a worker most often occurs after an audit, either workers or an employer can ask the IRS to determine whether the worker is an employee or a nonemployee for federal employment tax purposes at any time, audit target or not.
Fringe benefits are a thorny issue. First, offering fringe benefits generally entitles a business to a tax deduction. Receipt of many types of fringe benefits is tax-free to the recipient—sometimes.
Enter the complication of employment taxes. If a fringe benefit plan discriminates in some manner, such as rewarding only the operation’s owners or key employees, the fringe benefit may in reality be “compensation.” And, compensation in most forms means the payment is subject to employment taxes.
While many noncash benefits, including no-additional-cost services such as the free standby flights airlines allow their workers, qualified employee discounts, working condition fringe benefits (a company car for business purposes) or so-called “de minimis” (minor) fringe benefits, are usually deductible by the business and free to the recipient, the rules are complex and confusing.
Compensating the owner/shareholder. The IRS frequently second-guesses business taxpayers, particularly closely held businesses, when it comes to labeling the compensation of the operation’s owner or shareholder who also works in the business. Payment of amounts in the form of a dividend don’t require withholding of payroll taxes, nor do those payments qualify the business for a tax deduction. Dividends are a nondeductible distribution of profits.
Even worse, dividends are a common strategy for distributing an operation’s profits, and are subject to a double tax. First, the manufacturer pays taxes on its profits. When those profits are distributed in the form of dividends, the shareholder pays taxes on the dividend at his or her individual tax rate.
The key question: Would the shareholder/officer providing services to the business be better off receiving a profit distribution in the form of a dividend, or would the business be better off paying the shareholder compensation—and the accompanying payroll taxes—for which the business could claim a tax deduction?
Not surprisingly, the IRS is empowered to render a decision on whether the amounts paid were dividends or compensation. They can also decide whether the amount of officer/shareholder compensation is “reasonable,” which can lead to some fairly impassioned disagreements.
The 100 percent mistake tax
One of the nastiest and most feared taxes currently imposed is the Trust Fund Penalty Tax, a whopping 100 percent penalty on payroll taxes not withheld from a business’s employees and/or not forwarded to the federal government. The fear stems from the IRS’s authority to assess the penalty on all “responsible parties,” a label that can include a business’ owners, shareholders, partners, members, managers and officers.
Ultimately, however, a responsible person is determined by position or status. The owner of a business is usually responsible, but the IRS investigation doesn’t stop there. The IRS also looks at who controlled the finances, signed the checks, and decided which bills were to be paid. This can include outside accountants and bookkeepers, or be assessed against an official or employee of a bank or other financial institution with the authority to direct the financial affairs of the business.
Plenty to go around…
The Government Accountability Office, Congress’s watchdog, reported that last year 1.6 million businesses owed more than $58 billion in unpaid payroll taxes. Not surprising, considering the tax laws’ complex, often confusing requirements.
Payroll tax penalties can be devastating, especially for a small business. Fortunately, there are steps that business owners can take to reduce a payroll tax penalty.
Most obviously, payroll tax penalties can be avoided by making sure that all employment taxes are collected, accounted for and paid to the IRS when required. Reducing payroll tax penalties levied as the result of an IRS audit, or even resulting from errors detected by the operation itself, begins with asking the IRS to abate or eliminate the payroll tax penalty. Auditors do have the discretion to waive penalties, especially if the penalty is the exception, not the rule.
When avoiding payroll tax penalties, especially those that may result from the extensive NRP audits now underway, it also helps to understand the basic rules for withholding payroll taxes—and paying over withheld amounts. The results of the NRP study will be a two-edged sword, allowing the IRS to better target those who have failed to comply with the payroll tax withholding laws and regulations, and also collecting more from those found guilty of not understanding those laws and regulations. If you’re not sure whether your business would pass an NRP audit, conduct your own internal audit, and check with a tax professional if there are any questionable areas.