Employers Spooked by IRS Initiative on Employment Taxes

Though Halloween is now behind us, employers find themselves spooked by reports that the Internal Revenue Service (IRS) has commenced a wide-reaching initiative to determine the extent to which U.S. employers are dodging employment tax liabilities. Even more haunting to employers are the whispers of a joint effort between the Department of Labor (DOL) and IRS to combat the misclassification of employees as independent contractors (ICs).

Unfortunately for employers, these reports are more than mere ghost stories. In February of 2010, the IRS will begin to audit approximately 6,000 randomly-selected U.S. companies. According to one report, the IRS will audit 2,000 companies a year in each of the next three years. The audits are part of a study that seeks to accumulate data on how non-compliance with employment-tax liabilities contributes to the overall "tax gap," or the difference between the amount of taxes owed and the amount paid on time. Companies of all sizes and corporate forms are potential targets of these audits, even tax-exempt companies. The audits will zero-in on employment tax issues, including IC status, compensation of corporate officers, fringe benefits, and payroll taxes.

The IRS's confirmation of its study comes shortly after the publication of a government report on the misclassification of employees as independent contractors. In addition to discussing the potential contribution of misclassification to the tax gap, the government expressed concerns over the possibility that misclassified workers may not receive labor protections they are entitled to, such as unemployment insurance, workers' compensation, minimum wage, and overtime. The report recommended, among other things, that the DOL and IRS work together to address misclassification of employees as independent contractors. In doing so, the agencies (and the courts that interpret the laws) likely will apply multi-factor tests, with the crux of the analysis being the extent to which the employer maintains a right to control the worker. Importantly, any collaboration between the IRS and DOL will mean increased scrutiny of employers and their payroll-related practices.

While there is no way to avoid a random audit, employers should take steps to prepare for the possibility. Recommendations include a review of current payroll practices and an internal audit of recent tax returns, with a focus on the issues identified by the IRS as areas of particular interest. In particular, employers should review the status of workers designated as independent contractors. Additionally, in light of the GAO's report, now is the time for employers to make sure that their wage and hour practices are compliant, as a collaboration between the DOL and IRS is likely to lead to increased scrutiny of worker classification across the board, as well as minimum wage and overtime issues.

If selected employers should understand that the examination will likely be very comprehensive and detailed. To minimize the disruption employers should:

• Have the requested documents organized and available.
• Have a single or coordinated point of contact.
• Make certain that employees interacting with the IRS understand the issues and how to interact with the IRS.

For questions on the issues raised in this article, please contact a member of Ice Miller's Labor and Employment or Tax Practice Groups.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.