Act Now to Prepare For IRS Employment Tax Audit Initiative

Kevin E. Packman is a Partner in our Miami office

A new IRS employment tax audit initiative heightens the need for employers to review their practices for classifying workers and structuring compensation, benefit, and reimbursement plans.

The Employment Tax Audit Initiative (the "Initiative"), in which the IRS will audit 2,000 U.S. companies annually, commenced in February 2010. The Initiative was originally announced in September 2009 and will provide data for the IRS' National Research Program (NRP) study of employment tax compliance. This will mark the first such study conducted by the IRS since 1984. Mary C. Gorman, assistant division counsel for prefiling, Office of Chief Counsel, SB/SE division, advised members of the American Bar Association Tax Section on 1/22/10 ("ABA Tax Section"), that this is in addition to the 60,000 employment tax audits that occur annually. The IRS is expected to focus during the audits initiated pursuant to the Initiative on the following five employment tax issues:

(1) Worker classification (employee vs. independent contractor).

(2) Fringe benefits.

(3) Officers' compensation.

(4) Reimbursed expenses.

(5) Non-filers.

The Initiative is intended to help reduce the size of the tax gap—i.e., the difference between the tax the IRS estimates is due and the amount actually paid by taxpayers. The gap reflects significant lost revenue. On 7/8/09, the IRS released "Update on Reducing the Federal Tax Gap and Improving Voluntary Compliance."1 The report, relying on data from a 2001 NRP, concluded that the IRS failed to collect an estimated $54 billion in employment taxes, which accounted for nearly 16% of the total tax gap in 2001. This figure was similarly reported in "A Comprehensive Strategy for Reducing the Tax Gap," issued on 9/26/06 by the U.S. Department of the Treasury, Office of Tax Policy.2 Yet, IRS SB/SE Division Deputy Commissioner Faris Fink told the New York State Bar Association's annual Tax Section meeting on 1/26/10 ("NY State Bar") that the employment tax gap was $15 billion.

What is an NRP?

An NRP is a specific type of IRS examination designed to take a snapshot of a given taxpayer population in order to determinate the compliance within that population. Make no mistake, however; it is an audit. According to the IRS, "the guiding principles for an NRP are: (i) minimize taxpayer burden as data are collected and (ii) ensure that the collected data will meet business objectives and are used as a corporate asset."3 The data extracted from an NRP includes the amounts reported by taxpayers on their tax returns as well as the deficiency, if any, determined by the IRS.

The IRS started NRPs in 2001 to measure the tax gap. The belief is that by examining a wide variety of returns for different types of taxpayers from different industries, the IRS will gather sufficient statistical sampling to estimate the tax gap.

Perhaps the most notable characteristic of an NRP audit is its comprehensive nature. NRP audits are similar to the Taxpayer Compliance Measurement Program Audits previously conducted by the IRS in that every line item on a return potentially can be examined to determine the proper reporting of each item of income and deduction. NRPs are not examinations triggered by classified issues on a tax return; rather they are random examinations of a variety of taxpayers to determine overall compliance. The IRS uses the data collected in an NRP audit to set specific examination goals (sometimes referred to as Tier 1 and Tier 2 audit issues) and areas of noncompliance that are then applied in choosing taxpayers for examination. By fine-tuning the taxpayers subject to examination, the IRS can avoid engaging in taxpayer audits that result in "no change" letters being issued, as this constitutes a waste of time and energy for both the IRS and the taxpayers.

Seasoned employment tax auditors, who will be conducting the audits, received special training for the Initiative. If an employer receives Letter 3850-B or a letter indicating that it is subject to a compliance research examination, then it is part of the Initiative. It is unclear if examiners will use traditional NRP audit techniques during the Initiative. Ms. Gorman indicated during the ABA Tax Section meeting, however, that any employment tax issue that presents itself during the course of the audit will be examined. Since the IRS has targeted specific issues in these examinations, the examiners may very well limit the actual audits to the above-referenced issues and not otherwise conduct an examination of non-employment-tax-related items.

Because the Initiative is an NRP, however, the selection of companies for audit will not be based on objective criteria. Rather, companies will be chosen as part of a random selection process, which should encapsulate companies of varying size and form. Notwithstanding, Mr. Fink told the NY State Bar meeting that while the 6,000 audits will be "full-blown" and cover a variety of taxpayers, the majority will be small businesses.

Worker classification

Section 4.23.2.2 of the Internal Revenue Manual reflects that the IRS is "committed to evaluating and improving the employment tax program." The IRS has three goals in the employment tax area, and they are reflected as ensuring that:

(1) All employers and workers are "in the system" (i.e., they are filing timely, accurate, and fully paid returns).

(2) Workers are properly classified as employees or independent contractors.

(3) All remuneration subject to employment tax is reported.4

The Bureau of Labor Statistics reported that 7.4% of the total labor pool in 2005 were independent workers. It is unclear how many of these...