(Initial Focus on Employment Tax Compliance)
When the Internal Revenue Service (IRS) released its five-year strategic plan last year it promised a flurry of new attacks on the public in a variety of areas. Referred to by the IRS as “enforcement initiatives,” these attacks constitute the key areas the agency will target for increased audit attention in the years to come. What was a mere promise last fall of more audit activity is now a reality. The IRS just recently launched the first wave of audit attacks.
In reviewing the IRS’s strategic plan it came as no surprise to me that the lion’s share of this new audit attention would be focused on small businesses. What did surprise me is the level of aggressiveness with which the IRS intends to carry out the attack. The agency identified four specific areas that it will focus on. I reveal them here.
1. The misclassification of workers as independent contractors (ICs). Employment taxes represent a staggering cost to businesses, both in terms of money and time. For this reason, many businesses look for ways to trim costs by reducing employees. One strategy is to use independent contractors (ICs) rather than employees to perform services for the business. But there is a right way and a wrong way to use ICs. If you go about it the wrong way you open yourself up to substantial tax assessments with penalties and interest.
Because employment taxes are such an important revenue source, the IRS is determined to audit as many businesses as possible to ferret out those that use ICs. The Government Accountability Office (GAO) recently reported that in 2007, various audits by state revenue departments found that more than 150,000 workers were misclassified as ICs. This report prompted the IRS to undertake its own study. So beginning immediately, the IRS will launch at least 6,000 random audits of small businesses. The announcement came on April 22 and was issued by Robin Arnold, a senior IRS program manager and field specialist.
Of course, the random audits are just the beginning. Once the IRS has the audit program fully developed and refined it will let loose its agents upon businesses on a much wider scale. The agency is training 200 revenue agents right now to conduct these audits. Moreover, it’s in the process of hiring nearly 2,000 more agents this year to help carry the load. Even worse, the results of the audits will be shared with the states so they can get in line behind the IRS to pick the bones clean.
And while it’s certainly not illegal to use ICs, you must be sure the workers are legitimate ICs and not merely employees masquerading as ICs. This is just one reason my IRS Problem Solver Series is so important and valuable for small businesses. This issue is just one of the many I discuss in great detail in that package.
2. Employment tax return non-filers. The Treasury Inspector General for Tax Administration recently called on the IRS to step up enforcement against businesses that don’t file employment tax returns or pay employment taxes on time. The IRS treats this issue very seriously since employment tax money is largely withheld from the paychecks of employees. The employer is then responsible to pay it to the IRS. When the employer fails to do that he is treated as violating a “trust” relationship and becomes personally liable for the unpaid withholding taxes.
The IRS is now expanding its audits to randomly probe businesses for employment tax compliance. And because these audits are entirely random, there’s really no way a business can avoid such an audit. The best you can do is to make sure your business is in compliance.
3. Payment of fringe benefits to employees. Unless specifically excluded by law, the payment of money, property or services of any kind as compensation for services is taxable income. If a person receives goods in exchange for services, those goods are taxed at their fair market value.
On the other hand, the tax code does exclude from taxation certain fringe benefits paid by companies to their employees. But the exclusions are limited and are expressly defined. To the extent that any benefits exceed those limits, they are taxable.
To illustrate how desperate for revenue the Federal government now is, the random audit program targeted at small businesses will also focus on the payment of fringe benefits to employees. Look for the IRS to work on taxing every possible benefit that’s paid to employees. And of course, it intends to squeeze that money out of your pocket.
4. Payment of compensation to corporate officers. One of the most common mistakes made by small corporations is the failure to pay corporate officers (usually the owners) a “reasonable salary.” The tax code provides that corporate officers who provide services to a corporation must be compensated by the corporation commensurate with the fair market value of those services.
But many corporate officers do not draw a salary. Rather, they take their entire compensation in the form of a “dividend.” The difference is that the dividend is generally not subject to social security tax while the salary is. This is an issue of growing concern, but most small business owners will not see it coming. Too many tax return preparation professionals just do not understand the nuances of determining reasonable compensation or even that the IRS will challenge the compensation package of a small business owner. I expect many business owners to be blindsided by this issue. It could cost you a fortune.
—Daniel J. Pilla