Employment Tax Compliance: Compensation of Owners Investigated

The IRS initiated a new National Research Program Initiative in November 2009 simply known as the Initiative: an industry wide detailed audit of employment taxes for 6,000 randomly selected businesses for the duration of the next three years. The intent of the Initiative has two aspects: ONE: assess systemic employment tax compliance; and TWO: collect assessments from delinquent employers.

With tax revenues dwindling from the recession, the U.S. Treasury Department is stepping up efforts to close the tax gap the difference between overall tax liabilities and taxes paid to the IRS. Auditing employment taxes is seen by the IRS as a crucial means of closing the tax gap. For tax year 2001 for example, the gross tax gap was estimated by the IRS at around $345 billion, with underreporting of employment taxes accounting for around 17% of the tax gap.

The IRS will audit businesses to ensure that Federal withholding taxes are deducted and paid over to the government from employees wages for Social Security and Medicare as well as Federal Unemployment taxes. An business owner found to be in noncompliance could face harsh civil penalties and interest on unpaid taxes. These penalties could have a particularly severe impact on small business owners.

The IRS has identified four areas to focus their auditing efforts under the Initiative, including:

Worker Classification: i.e. whether an employer properly classifies an employee as an employee or independent contractor for tax purposes. Determining which depends on the behavioral, financial and type of relationship the company has with the person performing the work.

Employee Fringe Benefits: A fringe benefit is a form of pay for the performance of services. i.e. benefits such as insurance coverage, company car or child care, etc. that are provided by employers tax free to employees but not to independent contractors.

Reimbursed Business Expenses: e.g. reimbursement for taking a client to lunch, purchasing office supplies: which requires a written business expense plan. I.E. You must have paid or incurred expenses that are deductible while performing services as an employee. You must adequately account to your employer for these expenses within a reasonable time period, and you must return any excess reimbursement or allowance within a reasonable time period.

Compensation of Owners: who are also employees of the company, whereby unpaid taxes may result in personal liability for the employer.

Harsh penalties can occur for employers that are in noncompliance with employment tax law…and now that the employment tax audit Initiative is upon us the IRS has been reported to have already begun the process of selecting businesses for audit of their employment taxes. In order to ensure that these procedures are in compliance with applicable tax law is critical and can save time, money and heartache in the event of an audit.

For example, the Internal Revenue Code has specific requirements for taxing the Compensation of Owners depending on business structure set forth in its operating agreement and what classification the owner has elected. Employers should consider consulting with experienced counsel in preparation for the Initiative and in the event of an audit of their compensation methods to its owners is in question.

For more information on Employment Tax Compliance, please contact Mary Beth Rinladi at the Thorn Law Group in Washington, D.C.

Mary Beth Rinaldi is an experienced attorney who represents clients in civil and criminal tax litigation and in tax disputes before the Internal Revenue Service, the Department of Justice, state taxing authorities, and in federal court.