This month, the Internal Revenue Service (IRS) is expected to begin comprehensive employment tax compliance audits targeting approximately 2,000 randomly selected employers per year over a three-year period. The employers audited under this initiative are expected to constitute a representative sample of all employers, including large and small businesses, as well as tax-exempt organizations. One of the stated goals of this audit initiative is to enable the IRS to better compute the "tax gap," which is the difference between the amount of taxes owed and the amount actually collected. Another stated goal is to enable the IRS to better focus on the most noncompliant employment tax areas. This significant audit initiative almost certainly signals enhanced IRS enforcement in the employment tax area with consequences extending far beyond the approximately 6,000 employers initially selected for audit over the next three years.

It appears that the IRS will focus on at least four general areas:

• Worker classification. Whether a worker is an employee or independent contractor (and, if he or she is an employee, in some cases, such as "professional employer organization" (PEO) or leased employee arrangements, who is the employee's employer?) has significant employment tax and labor law implications, including, among other things, the following:
  • Employers are required to withhold and promptly remit income tax, withhold and promptly remit the employer's and employee's shares of Social Security and Medicare contributions (FICA) and pay federal unemployment taxes (FUTA) on wages paid to employees.
  • Employers are required to timely report employment taxes to the government and furnish information returns to employees concerning their wages, employment tax withholdings and other information.
  • Employees may be eligible for benefits under whatever employee benefit plans the employer maintains.
  • Proper testing of an employer's tax-qualified retirement plans for compliance with nondiscrimination and other qualification rules under the tax code requires that the employer's employee group be accurately identified.
  • Employers must comply with minimum wage and overtime laws, laws prohibiting discrimination in employment and unemployment insurance and workers' compensation laws.

Worker classification determinations can require a surprisingly complicated and fact-intensive analysis. Although courts and governmental agencies apply multifactor tests, and there is no universal test for all legal purposes (e.g., a different test may be applied for employment tax purposes than that for minimum wage and overtime law purposes), the classification of each worker generally depends on the extent to which the employer/service recipient reserves the right to direct and control the details and means by which the worker accomplishes the results of his or her work.

The significance of the IRS audit program is reinforced by a recent General Accountability Office (GAO) report recommending, among other things, that the IRS, US Department of Labor, other federal agencies and state agencies enhance their coordination and information sharing in addressing worker misclassification issues. The IRS will certainly give close scrutiny to all the facts and circumstances relevant to an employer's classification of workers as employees or independent contractors.

• Fringe benefits. Fringe benefits are property or services provided to an employee in lieu of or in addition to cash wages, (e.g., life insurance or use of a company car or aircraft). Fringe benefits are generally taxable income for an employee unless they meet the requirements of a specific exclusion under the tax code. Where an employer treats a fringe benefit as nontaxable, IRS agents conducting these audits can be expected to verify whether the applicable tax code requirements have been satisfied.
• Employee business expense reimbursements. Payments made by an employer to reimburse employees for business expenses are not considered wages subject to employment taxes if they are made under an "accountable plan". An accountable plan generally requires that: (1) such expenses have a business connection to the employer, (2) the employee submits to the employer evidence substantiating such expenses and (3) any reimbursements that exceed such substantiated expenses are returned to the employer within a reasonable time. IRS agents conducting these audits can be expected to confirm that these requirements have been satisfied for payments to employees that an employer treats as nontaxable business expense reimbursements.
• Compensation of owner-employees and executive compensation generally. Another area on which the IRS may focus is the reasonableness of compensation paid to employees who are also owners of closely-held corporations. There are no precise standards for reasonableness of compensation paid to owner-employees, which are taxed as wages and subject to employment taxes, and dividends or distributions paid to such owner-employees, which may be taxed at a lower rate and are not subject to employment taxes. Additionally, especially in light of the IRS's more limited executive compensation compliance audit initiative five years ago, as well as changes in executive compensation-related tax laws since then, the IRS can be expected to look at executive compensation tax compliance generally (to the extent not already covered by the areas of focus identified above, and whether or not involving owner-employees), including nonqualified deferred compensation, stock-based compensation, the US$1 million deductible compensation cap for public companies and golden parachutes.

In addition to these areas of focus, employers should also expect IRS agents to conduct a general review of the completeness and accuracy of the employer's Forms W-2, calculation of withholdings, compliance with backup withholding requirements for payments to independent contractors reported on Form 1099 without a corresponding taxpayer identification number and timeliness of tax deposits and reports.

The IRS's employment tax audit initiative certainly signals greater scrutiny on employment tax compliance not only for those employers selected for audit under the initiative but also for all other employers in the future. All employers should consider reviewing their current employment tax (both federal and state, including unemployment insurance and workers compensation) compliance procedures and practices, modifying those procedures and practices to the extent appropriate going forward and taking any necessary corrective action—before they hear from the IRS or other agencies. Employers selected for the IRS audit initiative should also designate a person or group internally to manage and coordinate the employer's audit preparation and response, analyze their current compliance status (including a review of recent years' employment tax returns), review and organize relevant records and documents and engage the assistance of outside counsel and other expertise as early as possible in the process.

If you have any questions or require more information or assistance concerning this IRS audit initiative, or worker classification or employment tax compliance in general, please contact us.