Employment Tax Audits
Practical Tips for Accountants

By G.J. Stillson MacDonnell and William Hays Weissman

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Four federal payroll taxes come within the parameters of employment or payroll taxes:

• Social Security tax;
• Medicare tax;
• Federal unemployment insurance tax; and
• Personal income tax withholding.

Social Security and Medicare taxes, collectively known as FICA, are paid one-half by the employer and one-half by the employee. Federal unemployment taxes, known by FUTA, are paid entirely by the employer. Personal income tax is paid entirely by the employee, but the employer is obligated to withhold and remit such tax to the IRS.

In addition, all states have some kind of state unemployment insurance (UI) tax. Most states have income taxes, while only some states have some form of disability insurance or paid family leave, which may be payable by the employer, the employee, or both.

Employment Tax Audit Leads

Although dedicated employment tax audits at the federal level have been relatively rare in recent years, the IRS has recently threatened to increase its activity in this area. and beginning in Fall 2007 has been entering into agreements (called MOUs) with the state agencies administering unemployment insurance to provide for active exchange of information about audit results, as well as potentially coordinated auditing by the IRS and state agency. Pending the activation of these agreements, the primary sources for federal tax audits are as follows:

• Corporate income tax audits, which usually include at least a cursory review for employment tax audit potential;
• Combined annual wage reports, which are used to determine whether the amounts reported on W-2s match the employment tax returns (IRS Forms 940 and 941); and
• SS-8 determinations and tip-compliance checks.

Other sources for federal employment tax audits include leads from competitors, customers, and disgruntled employees. Employers that habitually file late returns or returns without payments are more likely to get audited. Annual exchanges between the IRS and the states that compare the unemployment wage base can result in an automatic proposed FUTA assessment.

Employment tax audits are most common at the state level. They are most often triggered by “obstructed claims,” which are claims for unemployment benefits filed by an individual whom the business has not reported as an employee. States are generally required to attempt to recoup the unemployment insurance benefits they pay, and to do so they turn to audits of employers of all employment taxes. Under a pact with the federal government, a secondary source of audit leads is complaints.

Certain businesses are singled out for special scrutiny. Such businesses traditionally have a high use of independent contractors, such as the agriculture, landscaping, construction, and hospitality sectors. Businesses that believe a competitor is gaining an unfair advantage by improperly reporting workers are a common source of complaints to state taxing authorities, as are workers who feel they should be treated as employees. In addition, 1099 information reported to the states by the IRS can be a frequent source for audits.

Primary Issues Raised in Audits

There are three basic purposes for federal employment tax audits:

• To ensure that all employers and workers are “in the system,” that is, they are filing timely, accurate, and fully paid returns;
• To ensure that workers are properly classified as employees or independent contractors, and
• To ensure that all remuneration subject to employment tax is reported.

These purposes correspond with the primary issues raised in federal employment tax audits:

• Whether the employer is properly filing and reporting employment tax returns and taxes;
• Whether the business is properly classifying workers as either employees or independent contractors; and
• Whether the employer is properly reporting all taxable wages.

By far, of greatest interest is ascertaining the status of workers and ensuring that all taxable payments to employees are properly reported. A strict audit of payroll tax returns is unusual for an employer that uses a payroll service.

Worker classification audits are the most common kind of state employment tax audit. A recent federal law requires states to amend laws to discourage what has become known as “SUTA dumping,” which is loosely defined as activity where an employer forms a new company and transfers some employees to the new company with lower tax rates for the purpose of avoiding unemployment taxes.

In August 2004 President Bush signed the SUTA Dumping Prevention Act of 2004. This federal law required each state to enact laws to prevent SUTA dumping. As a result, states enacted laws that meet the federal requirements regarding the transfer of reserve accounts. Most laws are effective either January 1, 2005, or January 1, 2006. States vary in how aggressively they audit SUTA dumping issues.

In addition, there is a tension between federal and state reporting requirements. The IRS allows federal consolidated reporting, meaning that several legal entities may share the same federal employer identification number (FEIN). Some states, however, do not allow consolidation, or otherwise require each employing unit to have its own employer account number. This can cause mismatches in reporting between the IRS and the states, which sometimes results in the state reporting to the IRS that no wages were reported by a particular entity, or that wages were underreported by a particular entity. In such cases the IRS will routinely send a notice of underreported FUTA liability. This is often illusory because the difference is really in account numbers rather than true underreporting.

Typical Audit Requests

The type of information that auditors request varies in part depending upon the kind of audit being conducted and its scope. Nonetheless, auditors routinely ask for certain basic information, both at the federal and the state level:

• Type of business and officers, directors, shareholders, or owners. Generally, the auditor must verify the kind of business at issue. It also wants information about persons that could be deemed “responsible persons” if the business fails to pay its obligations.
• 1099s. While the auditor may seek to do a test check on acknowledged employees, this is usually not a major concern, because such wages are already being reported and taxes presumably paid. Thus, auditors will typically look at whether persons being paid as independent contractors are properly classified. Auditors typically start with a review of 1099 information and corresponding invoices. Certain 1099s and invoices can usually be quickly ruled out as being misclassified, such as obvious businesses with FEINs. Auditors tend to focus on businesses using DBAs or a Social Security number rather than a FEIN. For such categories of vendors, auditors may seek additional information as discussed below.
• Evidence of separately established businesses. In a worker classification audit, auditors typically will look for evidence of a separately established business for potentially misclassified workers. The typical documentation sought may include business cards, yellow page advertisements or other advertising and marketing materials, website addresses and sample pages, sample invoices, and contracts. While such information is usually acquired and reviewed at the time of the initial engagement, if it was not, then any helpful information should be added to the vendor file before audit review.
• Corporate books and records and tax returns. Auditors typically cross-check Form 1099 information against the accounts payable, professional services, or similar entries in the general ledger and on the balance sheet. They may also cross-check these items with the income tax returns.

Suggestions for Handling an Employment Tax Audit

The strategy a taxpayer should use in an employment tax audit depends upon a variety of factors, including the size of the business, its level of compliance, and the scope of the audit, among others. Nonetheless, certain strategies work in most employment tax audits:

• Conduct a factual and legal analysis before providing any information. Before providing any information in response to an audit, it is very important to conduct a factual and legal analysis of the issues, the taxpayer’s obligations, and the potential liabilities. Doing so allows for an honest assessment of the potential results of the audit, and a greater focus on the issues with the most financial impact.
• Conduct a review of all relevant documents. While it generally goes without saying that it is necessary to review all the relevant documents, it is important to do so with an eye toward their reasonableness and what they mean in the context of the audit. For example, a letter may contain a somewhat ambiguous statement that, if taken out of context, could appear harmful to an employer. One should assume the auditor will decide any ambiguities against the taxpayer. Thus, it is important to recognize such items and be able to explain them, either to minimize their impact, if truly negative, or clarify them, if truly supportive.
• Know who the players are. It is important to know who within an organization has possession of necessary documents and information. It is also important to ensure that such persons do not inadvertently communicate with the auditor and provide information without the accountant’s knowledge.
• Get legal counsel involved as needed. When necessary, legal counsel should undertake an analysis of the legal implications of the audit. This may also be necessary to protect certain information under the attorney work product or attorney-client privileges. Audits should be a collaborative process between the client and their advisors, including accountants, attorneys, and consultants.
• Use a power of attorney to respond directly on behalf of clients. As the business’s representative, accountants should generally control the flow of information between the client and the government. Businesses often have terminology that can be misconstrued by an auditor.
• Avoid meeting at the place of business. Accountants should gather all materials and meet with the auditor in the accountant’s office. This avoids the possibility of the auditor seeing or hearing something at the client’s office that could be misconstrued. Helpful but unknowledgeable employees quizzed by an auditor can waste both the auditor’s and the company’s resources. It is true that one never has an opportunity to make another first impression. Meeting in the accountant’s office prevents the auditor from asking to speak to employees who might not be prepared to address questions.
• Concede items that are clearly wrong or extremely weak. Quickly conceding issues early that are clearly wrong usually generates credibility with auditors, and also limits the areas of inquiry to those that are strongest for the taxpayer. Doing so also helps steer the audit in a direction that is generally beneficial. Furthermore, conceding issues that may be extremely weak, especially if they do not result in significant additional taxes, may allow for better focus on the primary issues in dispute, particularly if the matter moves to higher levels in the administrative process following the audit.
• Use low-value issues as bargaining chips. Sometimes the taxpayer will have a solid position on an issue that has little financial impact. In some cases, such issues can be used as bargaining chips, to be given up to narrow the scope of the audit or to deflect attention from other issues that are either weaker or have a much greater financial impact.
• Narrow information requests, and focus on a test year. It is often possible to narrow what information is needed by negotiating with the auditor or getting the auditor to explain what is really needed. Sometimes an offer to put together a position for the auditor on a particular issue will allow an accountant to tailor the information that is most favorable to the client. In addition, try to use a test period, either certain taxable quarters or a single taxable year, as a way to limit the amount of information that needs to be provided. This helps save resources and can make the audit more efficient. It is best to do this up front before either party has invested significant time into the matter.
• Know the audit periods at issue. Accountants must know what taxable periods are at issue. This can vary not only by jurisdiction, but by the kind of issue (e.g., normal assessment versus fraud). Auditors often request documents well in excess of the open statute period, and broad inquiries can be wasteful and time-consuming.

In addition to these basic strategies, it is also important to tailor responses to the particular kind of audit. For example, consider the following strategies with respect to worker classification audits:

• Organize a separate file for each worker. For each worker at issue, organize a separate file with all information. For example, if the worker had invoices, a written contract, business cards, business licenses, Yellow Pages advertisements, or a website, place copies of such documents in the file. When the auditor questions the employee’s status, these documents can be shown as evidence of independent contractor status by demonstrating that the worker had a separately established business. In addition, this may also help determine if any workers were improperly classified and should be conceded during the audit.
• Review the statutory definitions for employees. The IRS and many states use common law to determine the employer-employee relationship. Other states use other statutory tests. It is important to know the differences and the applicable definitions. One must also consider whether the workers at issue qualify as statutorily exempt workers. For example, a worker may qualify as a “direct seller” under IRC section 3508, and thus qualify as a statutorily exempt employee (meaning the worker’s wages are not subject to employment taxes) for federal employment tax purposes. Many states also have a direct-seller exemption. However, Arkansas, Connecticut, the District of Columbia, Georgia, Idaho, Indiana, Kentucky, Massachusetts, Mississippi, New Mexico, New York, North Carolina, North Dakota, South Carolina, South Dakota, Vermont, West Virginia, and Wyoming do not recognize the direct-seller exemption, potentially making a workers’ earnings subject to employment taxes in those states.
• Understand the relationship between the workers and the business. Understanding the relationship between a worker and a business is critical in a worker classification review and allows a representative to persuasively discuss the taxpayer’s position with the auditor. For example, it is important to know what types of restrictions the client placed on the time and place that services were performed, whether there is a written contract, whether the client monitored or evaluated the employees, and so on.
• Contest state benefits cases. Because many state employment tax audits result from obstructed claims, it can sometimes be important to contest a worker’s claim for benefits. A finding by an agency that a worker is not an employee can sometimes prevent or derail an audit of worker classification issues for the business generally, or can at least provide the business with a strong defense.
• Evaluate the use of IRC section 530 whenever possible for federal worker classification audits. IRC section 530 (created by the Revenue Act of 1978) is a safe harbor provision that prevents the IRS from retroactively reclassifying workers. It can relieve an employer of liability for federal employment taxes, penalties, and interest associated with a misclassification under common law. In any federal worker classification audit, IRC section 530 should be the starting point of the review. The requirements for meeting section 530 are explained in detail in the IRS publication “Independent Contractor or Employer? Training Materials” [Training 3320-102 (October 30, 1996)], available on the IRS website (www.irs.gov). If an employer has a strong position under IRC section 530, this may quickly resolve any status audit.

Be Prepared

The key to success in any unemployment tax audit is preparation. Accountants should know the details so that you can persuasively explain them to the IRS auditor. While the auditor may be friendly, he is not the taxpayer’s friend. Care should be taken when providing any information to the IRS. While no single strategy can work in every audit, the strategies outlined above provide a good framework for handling any employment tax audit.

©2009 The New York State Society of CPAs. Legal Notices