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Home » Employee Benefits: Library » Newsbriefs

IRS Mounts Audit Initiative Targeting Misclassification, Fringe Benefits

Date Posted: October 20, 2009

Authors:

David R. Fuller

David R. Fuller, Esq.
Morgan Lewis & Bockius LLP
Washington, D.C.


Jerry E. Holmes

Jerry E. Holmes, Esq.
Morgan Lewis & Bockius LLP
Washington, D.C.


The IRS has quietly revealed its most significant audit initiative in decades — an announcement made with little fanfare and designed to attract as little attention as possible, even though the IRS has promised to examine the returns of 6,000 businesses. In the next few months, the IRS will commence an audit initiative intended to study compliance in the areas of payroll taxes, independent contractor (IC) status, and fringe benefits/executive compensation arrangements. One of the goals is to reduce (1) the tax gap by increasing tax compliance and (2) the number of "misclassified" ICs. A likely secondary objective, and one urged by the Government Accountability Office (GAO), is to ensure benefits coverage and "labor protection" associated with employee status.

While the IRS has said it intends these audits to be as little burdensome as possible on businesses, most taxpayers can appreciate that the use of the words "little burdensome" and "audit" in the same sentence is an oxymoron. This is certainly true here since the sheer numbers (6,000 companies) and the methodology (taxpayer compliance reviews) suggest precisely the opposite. This initiative comes on the heels of renewed congressional scrutiny of IC issues and the GAO's own report urging the IRS to focus its "efforts to probe the improper classification of workers" as independent contractors and, perhaps most disturbing, to use penalties to deter misclassification. The audits have parallels with the Taxpayer Compliance Measurement Program (TCMP) audits last conducted more than 20 years ago. Practitioners with any experience in these types of examinations and TCMP audits realize that, in fact, this will likely be a very painful process requiring the allocation of financial and administrative resources even if an audit ultimately reveals no adjustments are warranted.

What the IRS Is Examining

The audits will focus on traditional payroll tax issues but with special emphasis on (1) worker classification, (2) fringe benefits, (3) executive/officer perks and benefits, and (4) nonfilers. The first phase of the initiative will target 6,000 taxpayers (compare this to the initial 24 taxpayers the IRS targeted in its executive compensation audits before it expanded the program in the ensuing years) to determine the level of noncompliance. The initiative will provide the IRS a foundation to further hone and refine its future examinations in what is sure to bring sweeping changes not only in audit techniques but also in the breadth, depth and scope of future examinations after the initial 6,000 audits are completed.

The IRS indicates that it has already developed the infrastructure to conduct broader inquiries using its existing experienced agents combined with some additional training from the IRS National Office in the areas of worker classification, fringe benefits and payroll taxes. While the IRS has been surprisingly quiet about this initiative, what we do know is that the audits will initially include the following four subject matters before possibly being expanded:

  • Worker Classification. We have already seen an upward trend in the scrutiny of worker classification issues in the past two years. While our IRS backgrounds and experience have almost always obtained favorable results for clients, even a successful outcome in one of these audits can be mind-numbing for companies. This renewed emphasis combined with current legislative initiatives before Congress addressing worker classification issues will undoubtedly create additional legal expenses for many companies and may pressure others to convert otherwise valid ICs into employees in an effort to avoid both (1) future IRS scrutiny, and (2) increased penalties being urged by the GAO and actively considered by Congress. The focus will undoubtedly include traditional IC relationships, as well as three-party relationships, W-2 vendors and processors, and failure to satisfy certain relief provisions.

  • Officers' Compensation. The scrutiny of officers' compensation is a natural offshoot of the IRS' much more restrained research initiative five years ago when the audits started with a mere 28 taxpayers (see June, 2005 newsletter). In those audits, the IRS initially identified eight issues, but subsequently refined its focus to remove some issues and add others. Based upon that earlier initiative, we anticipate the IRS will look at all issues, but will likely devote special attention to employer provided housing (see ¶490 of the Guide), employer aircraft (see ¶900), loans, executive travel, and other executive compensation such as nonqualified deferred compensation, retirement contracts, stock based compensation, the million dollar compensation cap, and golden parachutes. Noncash fringes such as housing and corporate aircraft provided to officers (including the validity of security studies) are likely examples of "low-hanging fruit" that the IRS will almost certainly pursue.

  • Fringe benefits. The IRS is looking at a number of executive fringe benefits associated with officer compensation (including whether the executives properly included the amounts in gross income). Since the IRS indicated that it found widespread noncompliance in its earlier executive compensation audit initiative, it quickly expanded its review to encompass other traditional and nontraditional cash and noncash fringes. As indicated above, these benefits will certainly be a focal point in these audits. However, the fact that fringe benefits are separately mentioned indicates the likelihood of an expansion into other cash and noncash fringes provided to a broader spectrum of employees.

  • Nonfilers. In its executive compensation audits, the IRS pulled and/or demanded that companies provide the executives' individual income tax returns to confirm that the amounts being paid as both cash and noncash benefits were being reported by the executives on their individual tax returns. It is anticipated that the IRS will also review individual returns in these examinations to ensure that both ICs and officers are actually reporting the compensatory payments on their individual federal income tax returns. The statistics from the 1980s indicate that there is a drop-off in compliance if Forms 1099 are issued rather than Forms W-2 and that the drop-off becomes a steep cliff when no Forms 1099 are filed, thereby heightening the IRS concern with IC treatment. This will undoubtedly be a focus of these upcoming TCMP-type audits.

What the IRS Expects to Find

In the comparatively mild executive compensation initiative, IRS officials identified "wide-spread noncompliance" such as failing to report compensation and deficient corporate governance practices including incentive payments, non-qualified deferred compensation, golden parachutes and executive perks. The IRS had noted that in many cases, failures resulted from a lack of sufficient internal procedures, notwithstanding the existence of plan documents that complied with applicable tax law. The IRS expects to find much of the same this time, particularly with the focus on ICs. As we warned several years ago, the IRS will use the information that it extracts from these research audits and incorporate it into all future employment tax examinations and, perhaps all audits in general.

What Employers Should Do

This IRS development strongly suggests immediate action by companies to evaluate their level of audit readiness on both traditional and more nontraditional payroll tax issues. Improper treatment of workers, executive perks, compensation reporting, and other payroll tax issues may adversely impact corporate finances, as well as the reputations of the responsible corporate departments, especially where the audits trigger executive compensation and Sarbanes-Oxley concerns.

Compliance Reviews

Given this renewed IRS focus on payroll taxes, IC and fringe benefit issues, it is incumbent upon companies, their executive and their advisors to respond pro-actively to this looming tax and corporate governance concern. Perhaps the best way to address this issue and the method the IRS has actually recommended in the past is for a company to conduct its own compliance review. Conducting an internal compliance review allows a company to review the targeted audit issues on its own terms, rather than waiting for the IRS to raise the issues after it is too late to address them or to otherwise come into voluntary compliance. We concur with past IRS statements that being proactive offers companies "a good opportunity ... to go back and take a look at their arrangements and make sure that the rules are being complied with themselves ... as there are certainly opportunities to make fixes before the IRS comes in."

Purpose and Benefits

Given the likely concentration on penalty issues as urged by the GAO, a company's advisors should be able to assist it to become "audit ready" and to neutralize any penalty issues by providing a list of specific questions and document requests gleaned from prior IRS audits and training materials. To protect the mutual interests of the corporation, executives, shareholders and even the ICs (remembering that many if not the majority of ICs wish to remain as ICs), companies should implement cost-effective compliance reviews to proactively respond to this new and very real IRS threat.

Becoming "audit ready" includes assessing current compliance, quantifying the likelihood of an adverse audit outcome and seeking to satisfy available tax relief provisions, all while ensuring the necessary attorney-client privilege. These compliance reviews are comparatively inexpensive. Statutory and administrative relief provisions can reduce or eliminate the risk of an adverse result and the related tax exposure for a company and its directors, officers and executives — especially if the IRS follows through on the penalty-related aspects of these audits. Given the threat of IRS penalties, these compliance reviews are an excellent way to assist corporate directors as they oversee their companies.

Outside Advisors

The corporate governance, penalties and Sarbanes-Oxley considerations underscore the importance of seeking review by outside counsel to more readily preserve the confidential nature of the review process. The role and backgrounds of outside advisors are important considerations, particularly because executive compensation reviews entail both tax considerations and corporate governance considerations. Protecting attorney-client privilege is critically important and every effort should be made to protect the confidentiality of the compliance review and preparations to become audit-ready. Reliance on counsel can also alleviate or eliminate payroll tax penalties, especially since the IRS has suggested such compliance reviews and these reviews often sustain reliance on statutory and administrative relief provisions.

This does not mean that a nonlegal advisor such as an accountant cannot or should not be involved; in fact, they can greatly enhance the process since they may understand many of the policies being targeted by the IRS. Nonetheless outside legal advisors should be the lead or consolidator in the review process, including having attorney-advisors retain the accountants to seek to protect their advice. Of course, any written material that relates to the compliance review should be clearly marked to more readily protect it from IRS discovery.

Conclusion

When the IRS targeted executive compensation and executive fringes five years ago, it initially started with only 24 companies and a handful of auditors. These ended up being high-profile examinations in which the IRS audited the tax returns of many corporate officers and finding widespread noncompliance. Many believe that this first audit initiative is what has led to the current exempt organization audits that focus on many of these same issues. By contrast to these other relatively small, but high-profile audits, the IRS has already indicated that it will start off with 6,000 taxpayers in this initiative.

Where it will ultimately lead and the level of expansion is unknown at this stage. Hopefully, the past will not be prologue. In an effort to successfully write its own ending to the IRS' impending initiative, a company should conduct its own compliance review making every effort to ensure that it asks the same questions and reviews the same documents that the IRS will seek. A compliance review not based on these prior audits and training materials may be destined for failure for any company that is unlucky enough to be one of the initial 6,000 or one of the future audits when the IRS widens its net.

For more information on IRS enforcement, see Thompson Publishing Group's Employer's Guide to Fringe Benefit Rules.


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