Employment Tax Audits

CPA Journal, The, Apr 2008 by MacDonnell, G J Stillson, Weissman, William Hays

Practical Tips for Accountants

Employment tax audits are a fact of life for many businesses, and accountants often possess critical information and intimate knowledge that can be crucial to the successful defense of such an audit. Knowing how to and when to use such information can make a crucial difference to the success of the audit. Here are some practical considerations to keep in mind when handling employment tax audits.

Four federal payroll taxes come within the parameters of employment or payroll taxes:

* Social Security tax;

* Medicare tax;

* Federal unemployment insurance tax; and

* Personal income tax withholding.

Social Security and Medicare taxes, collectively known as FICA, are paid one-half by the employer and one-half by the employee. Federal unemployment taxes, known by FUTA, are paid entirely by the employer. Personal income tax is paid entirely by the employee, but the employer is obligated to withhold and remit such tax to the IRS.

In addition, all states have some kind of state unemployment insurance (UI) tax. Most states have income taxes, while only some states have some form of disability insurance or paid family leave, which may be payable by the employer, the employee, or both.

Employment Tax Audit Leads

Although dedicated employment tax audits at the federal level have been relatively rare in recent years, the IRS has recently threatened to increase its activity in this area, and beginning in Fall 2007 has been entering into agreements (called MOUs) with the state agencies administering unemployment insurance to provide for active exchange of information about audit results, as well as potentially coordinated auditing by the IRS and state agency. Pending the activation of these agreements, the primary sources for federal tax audits are as follows:

* Corporate income tax audits, which usually include at least a cursory review for employment tax audit potential;

* Combined annual wage reports, which are used to determine whether the amounts reported on W-2s match the employment tax returns (IRS Forms 940 and 941); and

* SS-8 determinations and tip-compliance checks.

Other sources for federal employment tax audits include leads from competitors, customers, and disgruntled employees. Employers that habitually file late returns or returns without payments are more likely to get audited. Annual exchanges between the IRS and the states that compare the unemployment wage base can result in an automatic proposed FUTA assessment.

Employment tax audits are most common at the state level. They are most often triggered by "obstructed claims," which are claims for unemployment benefits filed by an individual whom the business has not reported as an employee. States are generally required to attempt to recoup the unemployment insurance benefits they pay, and to do so they turn to audits of employers of all employment taxes. Under a pact with the federal government, a secondary source of audit leads is complaints.

Certain businesses are singled out for special scrutiny. Such businesses traditionally have a high use of independent contractors, such as the agriculture, landscaping, construction, and hospitality sectors. Businesses that believe a competitor is gaining an unfair advantage by improperly reporting workers are a common source of complaints to state taxing authorities, as are workers who feel they should be treated as employees. In addition, 1099 information reported to the states by the IRS can be a frequent source for audits.

Primary Issues Raised in Audits

There are three basic purposes for federal employment tax audits:

* To ensure that all employers and workers are "in the system," that is, they are filing timely, accurate, and fully paid returns;

* To ensure that workers are properly classified as employees or independent contractors, and

* To ensure that all remuneration subject to employment tax is reported.

These purposes correspond with the primary issues raised in federal employment tax audits:

* Whether the employer is properly filing and reporting employment tax returns and taxes;

* Whether the business is properly classifying workers as either employees or independent contractors; and

* Whether the employer is properly reporting all taxable wages.

By far, of greatest interest is ascertaining the status of workers and ensuring that all taxable payments to employees are properly reported. A strict audit of payroll tax returns is unusual for an employer that uses a payroll service.

Worker classification audits are the most common kind of state employment tax audit. A recent federal law requires states to amend laws to discourage what has become known as "SUTA dumping," which is loosely defined as activity where an employer forms a new company and transfers some employees to the new company with lower tax rates for the purpose of avoiding unemployment taxes.

In August 2004 President Bush signed the SUTA Dumping Prevention Act of 2004. This federal law required each state to enact laws to prevent SUTA dumping. As a result, states enacted laws that meet the federal requirements regarding the transfer of reserve accounts. Most laws are effective either January 1, 2005, or January 1, 2006. States vary in how aggressively they audit SUTA dumping issues.