Practical Tips for Accountants
G.J. Stillson MacDonnell and William Hays Weissman
APRIL 2008 - Employment
tax audits are a fact of life for many businesses, and accountants
often possess critical information and intimate knowledge that can
be crucial to the successful defense of such an audit. Knowing how
to and when to use such information can make a crucial difference
to the success of the audit. Here are some practical considerations
to keep in mind when handling employment tax audits.
payroll taxes come within the parameters of employment or payroll
unemployment insurance tax; and
income tax withholding.
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.
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.
Tax Audit Leads
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:
income tax audits, which usually include at least a cursory
review for employment tax audit potential;
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
determinations and tip-compliance checks.
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.
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.
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.
Issues Raised in Audits
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
- To ensure
that all remuneration subject to employment tax is reported.
correspond with the primary issues raised in federal employment
the employer is properly filing and reporting employment tax
returns and taxes;
the business is properly classifying workers as either employees
or independent contractors; and
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.
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.
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.
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.
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:
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
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
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.
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.
for Handling an Employment Tax Audit
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:
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.
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.
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.
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,
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.
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.
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.
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.
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.
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
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:
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.
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.
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.
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.
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.
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.
Stillson MacDonnell is a shareholder and chair of the employment
taxes practice group at Littler Mendelson, P.C., a national employment
and labor law firm.
William Hays Weissman is a shareholder in the employment
taxes practice group of Littler Mendelson, P.C. The authors can
be contacted at firstname.lastname@example.org