Originally published January 2010
The IRS Tax Exempt and Government Entities Division (TE/GE Division) announced that it will be conducting random employment tax audits in 2010. The audits will be conducted as part of an agency-wide effort of the IRS to track compliance with employment tax regulations among all filers of employment tax reports. The TE/GE Division reported that for the first time, the project—known as the Employment Tax National Research Project— will include audits of exempt organizations. According to the TE/GE Division Commissioner, some 500 audits of exempt organizations can be expected.
The IRS explained that underreporting of employment taxes is a large part of the tax gap— employment tax misreporting totals about $54 billion a year—and accordingly this is a target issue for the IRS. Members of Congress are also concerned about misclassification of workers. Pending legislation, introduced in December 2009, if adopted, would require employers to file additional information with the IRS when claiming independent contractor status for their workers.
Audits To Focus On Worker Classification
As a starting point, the IRS has stated that it will determine whether audited organizations have correctly classified workers as employees or as independent contractors. Failure to properly classify a worker as an employee—and to accordingly withhold, report and pay over income and Federal Insurance Contribution Act (FICA) taxes—could give rise to significant tax and legal implications. For example, an organization may be held liable for failure to withhold income and FICA taxes, plus interest and penalties, if an independent contractor is reclassified as an employee. Misclassified workers may also be entitled to retroactive participation in qualified pension plans (e.g., 401(k) plans, pension plans, and profit-sharing plans) and welfare benefit plans (e.g., cafeteria plans, group health insurance plans, and group life insurance plans), which can be costly for an organization.
Additional Risks For Exempt Organizations
For exempt organizations, employment audits could present additional risks as IRS agents may consider other employment-related tax issues that arise in the exempt sector. For example, on watch for excess benefit transactions, agents may examine reasonableness of compensation and adherence to expense reimbursement policies.
Economic benefits (which include payments of wages as well as deferred compensation, provision of living accommodations or services, use of property, royalties, foregone interest on loans, etc.) that are intended to be treated as compensation can give rise to excess benefit transactions if they are unreasonable in the aggregate. Additionally, if an organization reimburses a worker's expenses but does not do so in accordance with an accountable plan, and there is no contemporaneous written evidence that the parties intended to treat the benefits as compensation, the benefits may give rise to automatic excess benefits (regardless of whether the benefits were reasonable).
Generally, workers must repay to the organization any excess benefits, and they could be liable for penalties and interest on the amount of the excess benefits received. Additionally, any benefits that were treated incorrectly for tax purposes could result in additional income tax to the worker and corresponding tax obligations for the organization. In certain circumstances, the IRS may also assess organization managers with penalties, and in the most extreme situations, the IRS may revoke exempt status of an organization that engages in excess benefit transactions.
How Can Legal Counsel Help?
Legal counsel can provide an overview of how workers are classified for federal income tax purposes, and offer guidance and "best practices" on structuring relationships with individual consultants who are intended to be independent contractors. Counsel can also review or assist with the development of expense reimbursement policies and procedures to ensure that an organization's reimbursement and allowance arrangements qualify as accountable plans. Finally, counsel can review qualified plans and welfare benefit plans to ensure that the plans are properly drafted to address any later reclassification of service providers.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.