Audit Risk Rising—What an Employer Can Do Before an Audit Happens

The IRS announced that it will begin conducting detailed employment tax audits on certain taxpayers as early as November of this year.  Employers will be selected for audit based on a statistical sampling method, and not necessarily on suspicious past tax returns.  One IRS representative speculated that there may be 6,000 of these employment tax audits over the next three years.  Among the employment tax items the IRS may scrutinize on an audit are: worker classification, fringe benefits, officers’ compensation, and expense reimbursements.  

Now is the time to review your policies and procedures to (1) be ready for any potential audit and (2) correct any errors that may have arisen before you are selected for an audit.  Among the steps an employer should consider taking are the following:   

• Consider whether you are properly treating individuals as independent contractors and talk to your employee benefit plan advisor.  Liabilities for misclassification don’t stop at employment taxes; misclassification can result in worker’s compensation liability, overtime pay claims, and claims for benefits under retirement and welfare plans.  Employers should discuss the preventative actions available to reduce potential liability from reclassification with their employee benefits advisor.  See the following articles by Louis Meyer for more information on the legal tests for determining independent contractor status: Independent Contractor or Employee? Recent Court Opinions Provide Guidance; and U.S. Department of Labor Sues Over Improper Classification of Workers as Independent Contractors. 
   
• Review all benefits provided to employees and ensure that you have adequate documentation to support all pre-tax benefits and reimbursements.  Generally, any benefit provided to an employee must be included in the employee’s income.  Only certain benefits and expense reimbursements may be provided on a pre-tax basis.  The employer is responsible for retaining documentation that supports the pre-tax treatment of these items.  You should review all benefits with your benefits advisor and ensure that you are retaining the necessary documentation.

In addition, if you are an employer that has outsourced its payroll functions to a third-party, it is important to remember that the employer remains liable to the IRS for any employment tax violations.  To identify and prevent issues you should:  

• Receive regular documentation from your payroll vendor that shows how payroll taxes are being determined and paid.
   
• Periodically reconcile statements received from your payroll vendor to ensure employment tax amounts are being calculated and submitted correctly.

Given these impending audits, it is also important to remember that other agencies and states, including North Carolina, routinely share information with the IRS, including information regarding tax avoidance schemes and questionable tax practices.  This information sharing could lead to additional investigations from other agencies and the state.