Business owners have long understood the importance of income tax compliance. Companies that understand the tax law and apply it correctly can save money and reduce the risk of surprises in the event of an audit. But recent focus on employment taxes by the IRS has caught even savvy business owners off guard, and in some cases, out of compliance.
Smart Business spoke with Claudia Necke-Lazzarato, a tax manager at Sensiba San Filippo LLP, about changes in employment tax rules, increased IRS scrutiny, and what businesses should be doing to ensure compliance and limit their risk.
Why is employment tax compliance becoming more important?
Compliance has always been important. However, recently the IRS has shown an increased focus on employment taxes. With the economic slowdown, income tax revenue growth has slowed as well, and the IRS has increased its focus on employment taxes. These types of tax audits are definitely on the rise. This increase in IRS audits means an increase in risk for taxpayers. It is essential that business owners understand the importance of employment tax compliance. If it’s important to the IRS, it should be important to every business owner.
What are some common employment tax reporting mistakes?
Underreporting W-2 wages is the easiest way for businesses to fall out of compliance. Whether it’s wages that are improperly characterized as reimbursable expenses, or employees who are incorrectly designated as subcontractors, it is very common for a misunderstanding of tax law to lead to the underpayment of taxes.
Just this year, the IRS released a clarification on what qualifies as a reimbursable expense. This clarification created a requirement that employers have ‘accountable plans’ for reimbursement. The IRS also defined these ‘accountable plans’ for employee reimbursements, and according to the new ruling, they must meet the following three requirements:
• The reimbursed expense must be allowable as a deduction and must be paid or incurred in connection with performing services as an employee of the employer.
• Each reimbursed expense must be adequately accounted for to the employer with receipts or other proof of expense.
• Any amounts paid to employees in excess of expense must be returned within a reasonable period of time.
If all of these requirements are not met, reimbursements will not be treated as reimbursable expenses. Instead, these payments would be considered wages, and would be subject to withholding and employment taxes.
This means that flat value ‘expense allowances,’ which allow a set amount of funds to offset the costs of tools, automobiles and other business-related expenses, may now be reportable as W-2 income. To simplify internal reporting, many companies have historically provided fixed-value allowances for common expenses. Typically, these allowances would not meet the new requirements for ‘accountable plans.’
How do you determine if someone should be designated as an employee or a subcontractor?
Another very common mistake is mischaracterizing employees as subcontractors. If an employer incorrectly designates a worker as a subcontractor, it will fail to withhold tax for the employee and fail to pay the employer’s share of employment taxes. This can put both the employee and employer at significant financial risk.
To feel confident that they have correctly determined employment status, employers should know what questions to ask and who to speak with for clarification. Evaluate each contractor’s relationship with a few simple questions, then ask a CPA who is well versed in employment tax law if there is any ambiguity remaining. Look closely at who has behavioral and financial control in the relationship and answer the following questions:
• Is the work performed as part of a defined project?
• Who is supervising the work?
• Who provides the tools and supplies needed to complete the work?
• Who sets the schedule for the work?
If you still aren’t sure of the answer, find a CPA and ask for help. The IRS defaults to assuming an employee/employer relationship, so be certain you’re getting it right.
What are the consequences of underreporting employment tax?
Employment tax compliance isn’t just about having the right answer. There are real consequences for underpayment of taxes. The IRS has sharpened its focus on the reimbursement arrangement taxpayers have in place. In several instances, companies have a reimbursement arrangement that does not pass the requirements of accountability, from the IRS’s point of view. The IRS penalties can be very costly and time consuming to resolve, with companies having to pay all underpayments with interest, and in addition, pay an automatically assessed 20 percent penalty. Working with a CPA firm with IRS audit experience can help clients receive a negotiated reduced penalty and put a qualifying accountable plan in place.
How can business owners ensure compliance?
Understanding the importance of getting employment taxes correct is the first step. Rules and enforcement change frequently, so partnering with an experienced tax professional is a good idea.
A best practice to help remain compliant is to talk about the issue as much as possible and in a proactive manner, rather than taking the rearview mirror approach after an audit notice is received. When ongoing success is your primary objective, you need a tax professional who actively helps you to find opportunities and avoid potential problems.
Claudia Necke-Lazzarato is a tax manager at Sensiba San Filippo LLP, a regional CPA firm based in the San Francisco Bay area. Reach her at (925) 271-8700 or [email protected].
