by: Jim M. McCarten and J. Allen Sullivan Jr.
An Introduction to the IRS’s Employment Tax National Research Project
In a 2009 report, the Government Accountability Office (the “GAO”) took the IRS to task regarding its supposed lackluster enforcement efforts in employment tax compliance. The so-called “tax gap” – the gap between taxes owed and those actually paid – was widening at this time, and employment tax issues, such as the misclassification of workers as independent contractors, were believed to play a significant part. Soon after the GAO report’s release, the IRS responded by announcing a “National Research Project” (“NRP”) – the first of its type since 1984 – to address many of the issues outlined in the report.
Referring to the NRP as a “research project” is somewhat disingenuous, however, because in reality it is more like a massive audit initiative. In the NRP, the IRS pledged to audit 6,000 U.S. companies. NRP audits have targeted, and continue to target, a broad cross-section of employers nationwide including corporations and pass-through entities, profitable entities and those in-the-red, and large and small operations. The more important issues included in NRP audits are worker classification, expense reimbursements, executive compensation (Section 409A) compliance, and fringe benefits such as company automobile usage. A sampling of these issues is addressed in this article.
Employers invited to participate in the NRP may also find the audits to be overly burdensome, especially in our current economic environment. Even careful employers deemed to be in complete compliance may find the audits exhausting because of the IRS’s additional research-related goal of collecting detailed data on employment tax compliance. Armed with this data the IRS is identifying noncompliance patterns and using this information to audit others.
Employers should prepare themselves by reviewing their own compliance procedures, and take the necessary steps to ensure that the right people are made aware of any contact from the IRS in a timely fashion. Time is especially of the essence in an audit, and a proper “chain of command” structure helps ensure that important notices, along with their more important deadlines, are not left unaddressed. Additionally, companies should have procedures in place that guarantee that outside advisors are notified upon receipt of an audit notice. Involving tax practitioners early in an audit may allow them to narrow the audit’s scope, and thereby reduce the costs of defending it.
Worker Misclassification – IRS and State Agency Enforcement Efforts
The misclassification of workers as independent contractors instead of employees is a major area addressed in NRP audits. The 2009 GAO report estimated that worker misclassification alone is responsible for $1.8 billion of the tax gap. The U.S. Department of Labor (“DOL”) estimated additional unemployment insurance revenue losses to be in the $400 million to $600 million range.
In response, the IRS has aggressively educated its revenue agents regarding worker classification and these matters are addressed in all NRP audits. An important factor in these audits is the degree of the company’s control over the impacted workers. Related Form 1099 reporting issues also arise in NRP audits. Here, companies may realize that they have committed a common error by failing to file Forms 1099 reporting payments to LLCs or partnerships. LLCs are often mistaken for corporations, payments to which often need not be reported in a Form 1099.
Not to be left out, a number of states have also enacted legislation designed to curb worker misclassification. For example, Pennsylvania passed a 2009 law imposing significant penalties on businesses improperly classifying workers as independent contractors rather than employees. Similar laws are now on the books in Colorado, Connecticut, Delaware, Illinois, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New Mexico, New York and Wisconsin. Notably, these laws usually apply to businesses in industries where misclassification is most prevalent; for example, construction, landscaping and sales.
Penalties under the state provisions may even be imposed whether or not the misclassification is seen as intentional. An increasing number of states have also executed Information Sharing agreements with the IRS and one another. So issues with state agencies regularly trigger IRS attention. Employers not yet under audit by the IRS, the DOL or a state agency may be able to take advantage of the IRS’s 2011 Voluntary Classification Settlement Program (the “VCSP”), the highlights of which are touched on in an insert to this article (see sidebar).
Reimbursement of Employee Expenses
Employee reimbursement issues also arise in NRP audits. IRS adjustments in this area often hinge on whether reimbursements are part of an “accountable plan.” Accountable plan reimbursements enjoy preferential tax treatment. The IRS aggressively attacks accountable plans because the plans are often seen as income tax subsidies used by highly compensated employees to fund their “lifestyle” choices. Of particular interest to contractors are IRS attacks on tool and equipment reimbursement plans. The IRS often does not view such plans as true reimbursement arrangements – likely because the tools can be used by employees to generate income away from the employer’s place of business.
Generally, tool reimbursement plans must have certain characteristics to qualify as accountable plans. Reimbursements must have a business connection to the business of the employer, and the expense must arise in connection with the employee’s employment. That is, expenses incurred prior to the employee’s employment do not qualify. Expenses must be properly substantiated, and reimbursements based on estimates or surveys are not acceptable. When addressing these issues and other related issues, contractors interested in tool and equipment accountable plans should enlist a tax practitioner’s help to write and execute the plan.
Section 409A and Executive Compensation
In addition to covering the employment tax issues above, NRP audits also involve executive compensation issues – primarily, deferred compensation plan compliance under Section 409A. Section 409A of the Internal Revenue Code was enacted in 2004 to cover the taxation of nonqualified deferred compensation plans. Deferred compensation is compensation earned in one taxable year, but which is or may be paid in a later year. Many different types of compensation are classified as deferred compensation including: elective deferrals of regular compensation, bonus plans, Supplemental Executive Retirement Plans (“SERPs”), certain stock option and stock appreciation plans, etc.
Section 409A’s requirements are beyond the scope of this article, but potential harsh penalties for failures to comply should be briefly addressed. Section 409A causes an inclusion in income in the year of deferral for amounts deferred under plans failing to meet Section 409A’s requirements, and the tax on such amounts is increased by 20 percent. Section 409A affects employers also by requiring that they include specific information related to deferred compensation plans on Forms W-2 or Forms 1099-MISC, as applicable, or face penalties themselves. With stakes this high, help from outside advisors is usually warranted.
The IRS, other federal agencies, and many state agencies are focused on employment tax-related compliance issues. Companies using independent contractors are particularly at risk of unwanted scrutiny, but all should find a review of their current procedures, worker contracts, expense plans, and related documents to be beneficial. Spending a little time and money now can save a lot of both later.
Jim M. McCarten is a Partner in the Burr & Forman Nashville office for the firm’s corporate, trusts & estate, and tax practice groups.
J. Allen Sullivan Jr. is an Associate in the Burr & Forman Birmingham office where his practice focuses on tax planning for entrepreneurs and their closely-held businesses.
The 2011 Voluntary Classification Settlement Program (“VCSP”)
- Not Under Audit for Worker Classification Issues, and
- Filed Forms 1099 for all Impacted Workers for prior 3 years.
Potential Benefits of Participation:
- Taxes Limited to 10% of Prior Year’s Liability,
- No Interest or Penalties, and
- No Audit for the 3 Taxable Years prior to Participation.
Note: This article appeared in the July 2012 issue of Dixie Contraxctor