Employment Tax Compliance: Reimbursed Business Expenses Investigated

In November 2009, the IRS began a new National Research Program Initiative (the Initiative): an industry wide detailed random audit of employment taxes for 6,000 employers during the course of the next three years. The purpose of the Initiative is dual fold: (1) assess systemic employment tax compliance; and (2) collect assessments from delinquent employers.

With diminishing tax revenues due to the depressed economy, the U.S. Treasury Department is stepping up efforts to decrease the tax gap between overall tax liabilities and taxes paid to the Internal Revenue Service. Auditing employment taxes is seen by the IRS as a necessary method of closing this 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 employer found to be in noncompliance could face stiff civil penalties and interest on unpaid taxes. These penalties could have a particularly severe impact on small business owners.

The IRS has prioritized 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.

It has been reported that the IRS has already commenced with the process of selecting entities for audit of their employment taxes now that the employment tax audit Initiative has begun. Severe consequences wait for employers who are in noncompliance with the employment tax laws. Businesses are highly encouraged to make sure procedures are set to adhere to the applicable tax laws. Doing so can thwart much headache, and the loss of money and productive office time in the event of an audit.

For example, the Internal Revenue Code requires a written reimbursement plan in order to take advantage of the tax benefits of legitimate business expenses. Employers should consider consulting with experienced counsel in preparation for the Initiative and in the event of an audit of their employment taxes.

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.