Employment Tax Gap Needs Some Trimming, Says IRS

There’s a gap between the amount companies and employees pay in employment taxes, and the amount they should be paying. And guess what? The Internal Revenue Service (IRS) is determined to narrow that gap. Much like going on a diet, the way they plan to shrink it will probably be uncomfortable for many American companies.
Jeffrey Davine, an attorney with the tax controversy group at Mitchell Silberberg & Knupp, is recommending to his clients that they pay close attention to the IRS’s announcement about the Employment Tax National Research Project. While the name sounds a little like a cable television special, it is actually much more serious (and much less entertaining). Davine spent 4 years as an IRS attorney; he knows what his clients are facing.
“Supposedly the ‘employment tax gap’—which is basically the difference between the amount of employment taxes collected and the amount owed—is estimated to be more than $200 billion a year,” Davine says. “The IRS is trying to focus on this area and narrow that gap.”
How? They are selecting approximately 6,000 companies to undergo an extensive employment tax audit. “They try to manage the selection so that it is done statistically, representing a cross-section of employers. Then they can take the information they get and apply it to everyone,” explains Davine.
‘Audit from Hell’
The IRS has conducted similar audits in the past, Davine says, and those earned a reputation as leaving the audit subjects reeking of fire and brimstone. The audits were known as Taxpayer Compliance Measurement Program audits. “They went through literally every line on your return. If you were married, for example, you had to produce a copy of your marriage certificate; it’s that level of scrutiny and detail. The Employment Tax National Research Project is expected to be that kind of audit.”
One of the issues in the audit is the proper classification of employees, Davine explains: “In other words, employee versus independent contractor status. This has been a very hot area for both the IRS and for state governments. So much so that in California, for example, the IRS has entered into an information sharing arrangement with the [state] agency that examines proper employment status classification. If the state agency audits an employer and finds they have misclassified employees, they’re going to share the information with the IRS. The employer might think they’re fine because they’ve resolved the state audit. But a short time later, the IRS is going to contact them. And typically, the federal taxes are going to be more significant than the state taxes.”
Plan Ahead to Reduce Exposure
Are you worried yet? Davine has some recommendations that could minimize the impact if you find yourself a little uncomfortable thinking about how an audit of your employees might turn out. The first thing to do, he says, is to act conservatively with regard to employment classification.
“It’s always a good idea to plan, and to do what you can to reduce your exposure,” he says. “Take a look at your records and make sure that, if you have people classified as independent contractors, that you’re treating all of those who are doing the same work the same way.
So for example, if you have people who make deliveries, make sure you classify all of those people one way or the other, not half of them as employees and half of them as independent contractors. Make sure you’ve issued them all 1099s (if they are classified as contractors) and make sure you have policies in place that lay out how you made the decision.
“To create your policy, you can refer to a laundry list of factors the IRS and state governments have published to help you make the determination. For example, if the company supplies the tools of the trade, that’s a factor that tends to show a person is more likely to be an employee than a contractor. Another factor is how people are paid. Are they paid by the hour? By the job?
“Typically, if you have someone working for you, say selling shoes, you’re going to pay them a salary or an hourly wage, maybe in addition to commission. But if you hire a plumber to fix some pipes, he will tell you it will cost $1,000. No matter how long it takes to fix the pipes, it will cost $1,000. The person in the shoe store will make an hourly wage, for every hour worked, whether or not he sells any shoes.”
Written Agreements for Independent Contractors
“One thing that sounds very simple that a lot of companies fail to do is to have a written independent contractor agreement that says ‘Independent Contractor Agreement’ across the top,” Davine says. “In and of itself, a written agreement isn’t going to make a person an independent contractor, but it is good evidence of what the parties intended, and that’s important. The government will often try to ignore it. They’ll say it doesn’t really matter what you and the contractor agreed to. But if you don’t have an agreement, they’ll say, ‘Aha! You don’t even have an independent contractor agreement!’”
What If You Made Mistakes?
Scanning through your files may make you feel better about your risk of exposure if the IRS comes to your doors. But if instead it makes you feel worse because you notice some inconsistencies, Davine has some advice. You’ll need to make some decisions, though, and the decisions won’t be easy.
“If you decide that you screwed up, that you should have treated some people as employees rather than independent contractors, you’ll have to decide whether to prospectively change their classification back to employee. If you do, and the government comes in for an audit, that will be an ‘Aha! Moment’ for them.
“On the other hand, it could show good faith if the government does come in and you tell them you’ve reevaluated things and made a determination that you made a mistake. Sometimes you can get a bit of a break from the examiner if you come clean. But that approach can be risky, because you’ve basically made the IRS’s case for them,” he says.
“Another approach is to go back and refile everything for the people improperly classified as contractors, changing them to employees. It’s going to get very expensive, because you’re going to have to be responsible for all the money you should have withheld. If you have a lot of employees, that can be very expensive,” Davine cautions.
If you do find you’ve made a classification mistake, speak with your legal counsel. He or she “will help you look at your potential exposure for each of your options.”
As usual, planning ahead is much simpler—and less costly—in the long run. “If you’re deciding whether or not to classify someone as a contractor, you have to know your risks,” Davine says.
“For example, if there is a 50/50 chance, you may be willing to accept the risk of misclassification. But understand that if the government comes in, and it concludes that the person should have been an employee, then at least you’re going into it with your eyes open. But if it’s clear and obvious, don’t misclassify someone. You don’t want to play the audit lottery. If you lose, and your return is selected for examination, you’re going to be in deep trouble.”