Surviving An Employment Tax Audit

In recent years the IRS has examined closely the status of workers classified as independent contractors and whether they should instead be considered employees. The results of these examinations: Hundreds of thousands of workers were reclassified as employees and their employers were assessed hundreds of millions of additional tax dollars in the form of back taxes and penalties. Although such examinations are time-consuming, detailed and costly, taxpayers (and their accountants) can take steps to prepare for, and lessen the impact of, these audits.

UNDERSTANDING THE FACTS AND RELEVANT ISSUES
An IRS employment tax audit takes one of two forms: a “compliance check” (a perusal of a company’s federal employment tax forms and a brief interview centering on the factors the service deems important) or a full audit (an extensive and detailed examination of corporate books and records). When a company receives the IRS notification about the audit, it should in turn notify its CPA firm, which must obtain a clear understanding of the facts and issues relevant to the client’s situation.

The CPA first should examine the nature of the relationships of the workers employed by the client and then (1) prepare a list of workers, outside vendors and other entities used as contractors and (2) review all 1099 and W-2 forms the client issued.

In addition, the CPA should (1) interview management; the human resources, payroll and legal departments; and the workers themselves (if necessary) to ensure the work relationships support the company’s classifications and (2) review all documents and relevant filings between the workers and the company to determine whether the workers were classified consistently from year to year. Standard employment contracts and other retained agreements between the company and all contractors also should be examined.

PREAUDIT ANALYSIS
After compiling the list of workers, the CPA should review all job responsibilities and each individual’s relationship with the company. If several workers perform the same job, reviewing the job category or position may suffice.

Once the CPA determines which workers (if any) may be reclassified, he or she should analyze the potential tax exposure associated with them. This should include a summary of amounts paid, federal (and, if applicable, state) withholding, Medicare and Social Security taxes withheld and any penalties and interest that may be assessed; other payroll issues, such as fringe benefits or cafeteria plans, also should be examined.

COMPLIANCE-CHECK STAGE
Proper compliance and cooperation at the compliance-check stage—typically the first level of the agent’s review—may help avoid a full-scale audit. Responses to requests for information should be timely; arguments and documentation supporting a position and establishing the reasonableness of the client’s classifications should be well organized and presented clearly and concisely.

RESOLUTION OF ISSUES AND SETTLEMENTS
The IRS has established several programs that act as incentives to encourage taxpayers to resolve classification issues as early in the administrative process as possible, including (1) early referral of certain unresolved issues to the IRS Appeals Division, (2) limits on liability for the employee’s share of federal withholding (assuming the failure was not due to intentional disregard of the requirement to deduct and withhold taxes) and (3) the use of closing agreements limiting the amount owed based on certain reporting and substantive consistency requirements. Taking part in such programs (and the point, if any, in the negotiation and settlement process at which to consider them) depends on whether the client qualifies for their use and whether it would be administratively advantageous to settle the client’s specific situation.

For discussion and guidance on the many issues involved in reclassification examinations, see “How to Survive an Employment Tax Audit,” by Aureon Herron, Jerri Langer and David Eft, in the May 1998 issue of The Tax Adviser .

Nicholas Fiore, editor
The Tax Adviser