IRS to Audit 6,000 Companies to Enforce Employment Tax Compliance

Alerts / November 10, 2009

In the next few months, the IRS will launch comprehensive tax examinations of approximately 6,000 random U.S. companies as part of its National Research Program on employment tax compliance. In addition to closing the tax gap, which is the difference between the amount of taxes collected and the amount owed, the IRS hopes the program will help it assess its own performance and generate income. This is one of the agency’s biggest audit campaigns in the area in more than 25 years.

Background on the National Research Program

Recently, the Government Accountability Office (GAO) has stated that the IRS should investigate the improper classification of workers by employers and use disciplinary measures such as penalties to enforce compliance and ensure employees receive adequate labor protection. In 2007, the GAO reported that states uncovered approximately 150,000 misclassified workers. Employees who are misclassified as independent contractors can be denied health benefits, overtime pay and unemployment insurance.

In response, the IRS will perform roughly 2,000 random audits per year over the next three years. Targeted companies will cover businesses of varying sizes, including both for profit and non-profit employers. Around 200 to 300 specially trained IRS agents will perform these audits, likely involving line-by-line reviews of employment tax returns and information returns filed. Most of these audits will be conducted face to face, but the IRS states it will try to make the process less burdensome by gathering information from the Internet and internal sources. However, those familiar with the methods imposed by the Taxpayer Compliance Measurement Program audits 20 years ago will realize that this will undoubtedly be a tedious and expensive process.

Subjects Covered By The IRS Employment Tax Audits

The IRS announcement noted that although these audits may target any reporting aspect of each tax return, the primary focus will be on worker classification (employee vs. independent contractor), executive compensation, fringe benefits, nonfilers and reimbursed expenses.

Improper worker classification is a primary concern because it affects the revenue state governments use to pay for unemployment benefits. The IRS will also scrutinize audits for non-conforming benefits which will be considered as wages subject to employment taxes. Common fringe benefits include personal use of company vehicles, employee discounts, employer provided housing and meals, accident and health benefits, educational assistance, and stock-based compensation. Reimbursed expenses, in order to be tax-free and deductible, must generally be reasonable, have a business connection, include reasonable accounting for the expenses, and all excess reimbursement should be repaid within a reasonable time. In addition, the IRS will look at the reasonableness of officer or owner compensation when such individuals receive both wages and dividends.

Concerns For Employers

Employers should be aware that although the audits will focus on tax returns for the calendar years 2007 and 2008, the IRS may expand the scope of these audits to years earlier or later. Because many company documents will be scrutinized during the process, employers should think carefully about protecting attorney-client privilege throughout the audit preparations. Employers may also consider referring to outside expertise as early as possible, compiling files necessary for audits, and proactively reviewing the company's current payroll procedures, specifically focusing on the targeted tax areas. Additionally, employers may want to consider designating a clear chain of command for responding to all IRS communications.

We hope you find this information helpful. If you have any questions please contact any member of Baker Hostetler’s Tax or Employment Teams or your regular Baker Hostetler contact.

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