The New IRS Employment Tax Audit Initiative Strategies to Prepare for Audits Given Anticipated Tax and Compensation Targets

Transcription

1 presents The New IRS Employment Tax Audit Initiative Strategies to Prepare for Audits Given Anticipated Tax and Compensation Targets A Live 110-Minute Teleconference/Webinar with Interactive Q&A Today's panel features: Anthony Arcidiacono, Senior Manager, National Tax Practice, Ernst & Young, Iselin, N.J. Edward Froelich, Of Counsel, Morrison & Foerster, Washington, D.C. James Merritt, Senior Counsel, Morrison & Foerster, Washington, D.C. Ira Mirsky, Partner, McDermott Will & Emery, Washington, D.C. Tuesday, June 1, 2010 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific You can access the audio portion of the conference on the telephone or by using your computer's speakers. Please refer to the dial in/ log in instructions ed to registrations.

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4 The New IRS Employment Tax Audit Initiative Webinar June 1, 2010 Edward Froelich, Morrison & Foerster James Merritt, Morrison & Foerster Anthony Arcidiacono, Ernst & Young Ira Mirsky, McDermott Will & Emery y imirsky@mwe.com

5 Today s Program Federal Employment Tax Oversight To Date Slides 6-22 (Edward Froelich, James Merritt and Anthony Arcidiacono) IRS 2010 Employment Tax Audit Initiative Slides (Ira Mirsky) Preparing For A Possible Federal Audit Slides (Anthony y Arcidiacono) ) 5

6 Federal Employment Tax Oversight htto Date Edward Froelich and James Merritt, Morrison & Foerster Anthony Arcidiacono, Ernst & Young

7 Prior Classification Audits Harsh and unpredictable results Taxes due if workers reclassified as employees could equal or exceed 40% of gross payroll. Retroactively applied for three or more years Applicable tests produced conflicting and unpredictable results. Example: Gypsy chasers (persons engaged to assist in the loading and unloading of moving vans). On essentially the same facts, two courts held they were employees, and two other courts held that they were independent contractors. This is MoFo. 7

8 Prior Classification Audits (Cont.) Results produced serious competitive advantages or disadvantages, having an unwarranted impact on business operations Increase in tax burden Other costs, if workers are reclassified as employees Vagaries of selection for audit Uncertain outcome of audit, appeals and litigation This is MoFo. 8

9 Prior Classification Audits (Cont.) Businesses and workers unable to obtain certainty by contractual agreement Contract helpful, but not determinative according to the IRS and courts Sound practice: Have a written contract with the workers (unless clear that they are independent contractors such as attorneys, accountants, contractors, etc.) that sets forth the agreement that they are independent contractors and which requires both parties to comply with tax reporting requirements. Note: These terms are required by Sect Other contract provisions are also helpful. This is MoFo. 9

10 Resolution Of Cases In Audit Fact based settlements in audit In audit, agree to treat some workers as independent contractors and others as employees. Subsequently, business could make certain that new workers meet terms for independent contractors. Penalties rarely asserted Practice Tip: It is a sound approach to a classification audit to develop all factors with a view to narrowing the field. In other words, point out the variations between groups of workers as to factors such as hours, place of work, payment of expenses, ownership of equipment, etc. This may reduce the size and scope of workers likely to be reclassified. This is MoFo. 10

11 IRS And Common Law 20-Factor Test The 20-factor test is set forth in Rev. Rul (see copy in background materials). These were established by the Social Security Administration in They obviously do not all apply to each situation; how they apply and weight given is highly subjective at best. National Research Project: In the current national research audit project, the factors are grouped into three categories: Behavior control Financial control Relationship of the worker to the business This is MoFo. 11

12 IRS And Common Law 20-Factor Factor Test (Cont.) In 1982, the Senate proposed a five-factor test: Control of hours worked Place of business Investment or income fluctuation Written contract and notice of tax responsibilities Filing of required returns This is MoFo. 12

13 IRS And Common Law 20-Factor Factor Test (Cont.) Practice Tip: In a classification audit, the agent will likely focus upon control and the factors relevant to that factor. The courts have held it is the right to control, not whether such control is exercised. The business will focus upon investments by the worker and hence the possibility of profit or loss and factors indicating independence such as engaging assistants, operating from another location, providing services to third parties or holding themselves out to do so, use of business cards, etc. as well as producing written contracts with the workers. The manner of payment is also important; for example, if the worker submits an invoice for payment upon completion of a project or at interim periods, it would indicate independent contractor status. Audit Issue: How to obtain interviews and information from the workers? This is MoFo. 13

14 Review Of Relief Provisions Sect. 530 Sect. 530, Revenue Act of 1978: Permits taxpayers to retain independent contractor status even if incorrect and prohibits IRS from issuing rulings Enacted as a temporary measure - anticipated i t that t Congress would provide new rules by 1980 No action until 1982, but still no new rules as Senate proposal was not adopted In 1982, further relief was provided in sections 3508 (real estate t agents and direct sellers) and 3509 (lower tax rates). This is MoFo. 14

15 Review Of Relief Provisions Sect. 530 (Cont.) Requirements of the safe harbor provided by Sect. 530 Consistent treatment of workers at issue and similarly situated workers as independent contractors. (Note: Similarly situated is interpreted to be with regard to the relationship of the worker to the business and not to the specific services performed.) Must file Forms 1099 reporting compensation Business must rely upon a reasonable basis for independent contractor status Legal authorities Cases, rulings, technical advice to taxpayer Prior audit by IRS Industry practice Other examples: Opinion or advice by attorney or accountant, consideration of the 20 factors, audit by state agency. Caution: IRS agents may contend that although there are supportive cases, etc., the business did not actually rely upon them at the time it first reported the workers as independent contractors. It is important to document the basis of reliance at the earliest moment possible, preferably at inception of the relationship. This is MoFo. 15

16 Review Of Relief Provisions i Sect Limited liability for employment taxes Sect Most favorable lower rates if Forms 1099 filed (1.5% and 20%) Applies even if Forms 1099 not filed but rates are doubled Does not apply if reporting due to intentional disregard of the rules nor to certain statutory employees (Note: Offset for taxes paid by independent contractors under sections 3402 and 6521 are not available if Sect applies.) Comment: Provisions of Sect and 1982 Senate proposal were based upon studies which showed that there was 97% compliance if Forms 1099 were issued, but only 83% where they were not issued. By comparison, compliance where W-2s are issued, is estimated at 99%. This is MoFo. 16

17 Review Of Other Relief Provisions Relief from interest under Sect Offset of taxes paid by workers under sections 3402(d) and 6521 Classification settlement program ( CSP ) (IRM (1999)) Considered by the IRS to be a settlement offer, which permits agents to offer a settlement even though they are not authorized to negotiate on a hazards of litigation basis. Does not apply if taxpayer protected by Sect. 530 safe harbor Applies if agent believes that workers are employees under 20-factor test Voluntary program that requires prospective treatment of workers as employees and a closing agreement, but which imposes reduced taxes for the audit year. One full year (using 3509 if applicable) if no basis for Sect. 530 relief. 25% of one year if colorable argument that qualifies for Section 530 relief Consistent reporting required (de minimis errors permitted) This is MoFo. 17

18 Public Law Section 530 Relief: To Meet The Test, You Must Have: Reasonable basis Such as reliance on a federal tax court case You were audited by the IRS before at a time when you treated similar workers as independent contractors, and IRS did not reclassify these workers as employees. A significant segment e of your industry treated ed similar workers as independent contractors. You relied on some other reasonable basis, such as the advice of an accountant or attorney who knew the facts of your business. Substantive consistency You must have treated the workers as independent contractors. If you instead treated similar workers as employees, relief is not available. Reporting consistency You must have filed all Forms 1099 Misc for each worker, unless the worker earned less than $600 during the year. Page 18 Presentation title

19 Some Historical Perspective Workplace environment has changed dramatically due to technological advances since the 20-factor test was devised and since the last studies of classification were conducted. Interpretation of Sect. 530 safe harbor restricts the choice of classification. For example, if a business that is protected by Sect. 530 engages a new category of workers, it is reluctant to treat them as employees, because if they are deemed to be similarly situated to its other workers it may lose the safe harbor for lack of consistent treatment. If Congress acts as a result of the National Research Project, it should consider all of the relief provisions i as well as the basic test, t to ensure fairness in classification and taxes imposed. This is MoFo. 19

20 The Tax Gap And The GAO Report The Financial Crisis of 2008 Reduced tax receipts Exacerbated the problem of the tax gap The August 2009 GAO Report, Employee Misclassification: Improved Coordination, Outreach, and Targeting Could Better Ensure Detection and Prevention Pointed to misclassification as contributory to the tax gap audits Noted limitations on the IRS to effectively conduct classification audits Noted that IRS officials blamed Sect. 530 for limiting their audit effectiveness Suggested narrowing longstanding industry practice prong of Sect. 530 protection, but warned against erosion of Sect. 530 protection generally Non-tax reasons, such as increasing the number of workers eligible for unionization or employment dependent benefits, may also underlie the current focus on classification of workers. This is MoFo. 20

21 IRS Action On Misclassification TIGTA February 2009 Report $1.6B of $345B tax gap attributable to misclassification according to 1984 data, but 2006 preliminary study indicates a much higher amount. Recommended developing an agency-wide employment tax program to address the classification issue, in order to improve coordination among the business divisions and improve compliance. Recommended conducting formal NRP study Increase enforcement efforts More intense audits leading up to implementation of NRP audit initiative Sect. 530 and 20-factor test Propose adjustments unless employer agrees to CSP (and agree to treat workers as employees going forward) Penalties Coordinate with Department of Justice Tax Division IRS expresses support for legislative attempts to narrow Sect. 530 relief TNT 81-2 (comments of R. Arnold, LMSB Territory Manager) This is MoFo. 21

22 Legislative Proposals Pending legislation On July 30, 2009, Rep. Jim McDermott introduced H.R. 3408, the Taxpayer Responsibility, Accountability, and Consistency Act of 2009 Would terminates Sect. 530 Only two grounds for reasonable basis : () (i) written determination and (ii) a concluded examination Numerous co-sponsors On Dec. 15, 2009, Sen. John F. Kerry introduced companion bill to H.R It has eight co-sponsors. White House FY 2011 budget proposal Eliminate Sect. 530 protection going forward, by allowing IRS to reclassify and remove prohibition on issuing general guidance. National taxpayer advocate proposal Replace Sect. 530 with a provision applicable to both employment and income taxes, and require the Secretary of the Treasury to issue associated guidance, including guidance with specific industry focus. This is MoFo. 22

23 IRS 2010 Employment Tax Audit Initiative Ira Mirsky, McDermott Will & Emery

24 Focus Of IRS Employment Tax NRP Exams The IRS NRP employment tax examinations will target 6,000 U.S. employers between 2010 and Audit selection process will be truly random, rather than specifically targeting employers for compliance issues. Stated objective is to collect data to help IRS understand recurring patterns of compliance/non- compliance to better focus examination and enforcement resources. Every employer is a potential target. Audit sample will draw from for-profit and tax-exempt employers, both large and small. Audit sample will also be drawn on geographic parameters. First 2,000 employers to be audited in 2010 already identified Among the 6,000 employers to be audited will be: 500 non-profit employers, 330 governmental entities, and 36 universities. 24

25 Focus Of IRS Employment Tax NRP Exams (Cont.) NRP audits will focus on five primary employment tax issues 1. Worker classification 2. Fringe benefits 3. Expense reimbursements 4. Officer compensation and 5. Other related payroll issues IRS wants to update findings from its last NRP employment tax examinations conducted in IRS then lacked the robust electronic audit tools that it has today. Future worker classification exam tools will very likely be drawn from NRP findings. IRS maintains that a significant objective to NRP exams is outreach/education. Still intend to work employment and other tax issues identified for exam/enforcement 25

26 NRP Exams Will Have Specific Focus On Worker Classification Issues Multiple stakeholders for enforcement of worker classification issues IRS, state and local tax authorities (where applicable) Employee wages generally subject to income tax withholding as and when paid. Both IRS /Treasury and Congress view this area as substantial gap to tax compliance. Employee wages also subject to Social Security and Medicare (FICA) taxes Two components to the FICA tax: (i) Employer s share of FICA; (ii) Employee s share of FICA U.S. Department of Labor= and related state employment authorities enforce: Unemployment insurance/tax liability, FLSA employee minimum wage and overtime rules, State workers compensation insurance, and Coverage under employee benefit plans. *White House FY 2011 budget proposal contained significant allocation of funds for DOL enforcement of worker classification issues. Proposal would also allow disclosure of information concerning IRS worker reclassification determinations to Department of Labor. 26

27 NRP Exams Will Have Specific Focus on Worker Classification Issues (Cont.) As part of its research, IRS will develop both Sect. 530 and common law analyses of worker classification position. IRS will start with Sect. 530 analysis. Will first evaluate consistent treatment of similarly-situated workers, and timely filing of IRS Forms 1099 and K-1 In NRP exams, IRS is trying to measure the revenue impact if the Sect. 530 safe harbor were eliminated. Legislation sponsored by Rep. McDermott and Sen. Kerry seeks to eliminate established industry practice as reasonable basis for Sect. 530 relief. Not simply the merits of employer s Sect. 530 position IRS will also analyze whether the worker should have been treated as an employee under the 20-factor common law test. Internal Revenue Manual (IRM) (Sect (5)) generally requires IRS agents to first determine whether the taxpayer qualifies for relief under Sect Once the Sect. 530 test is satisfied, the IRS can no longer make an assessment of liability based upon the 20-factor test. IRS worker interviews are likely to be the most invasive aspect of NRP exams. 27

28 Additional Areas Of Focus For NRP Exams Employee fringe benefits IRS has targeted information document requests (IDRs) created as part of 2003 IRS executive compensation audit initiative. Preliminary i inquiries i i will focus on written policies i and best practices. Very difficult conversation if written policies don t exist or are not followed Further inquiries to include employee interviews and some traditional exam/investigation procedures IRS will also utilize financial statements and public company filings to identify employee fringe benefits. IRS has added non-qualified deferred compensation (NQDC) to category. IRS may bring in specialists to develop NQDC issues under IRC sections 409A and 457A, once identified as part of NRP exam. 28

29 Additional Areas Of Focus For NRP Exams (Cont.) Expense reimbursements Preliminary inquiry will again focus on written policies and procedures Determination whether employer maintains an accountable reimbursement arrangement (Treas. Reg (c)(2)) Reimbursement of out-of-pocket expenses vs. allowance/advance Business meals and lodging reimbursed using per diems Application of IRC Sect. 274 expense deduction limitation rules 50% limitation on meals and incidental expenses Potential disallowance of entertainment expenses 29

30 Additional Areas Of Focus For NRP Exams (Cont.) Compensation of executives/owner-employees employees IRS already has highly-developed examination tools for executive compensation arrangements and perquisites. Enhanced SEC and financial accounting disclosure requirements provide valuable source of information for examining IRS agents. Particular interest in targeting abusive practices in connection with the compensation of owner-employees of closely-held businesses IRS has struggled to effectively audit this issue in the past. NRP exams will be significantly more invasive than previous audits of closely-held businesses. 30

31 Additional Areas Of Focus For NRP Exams (Cont.) Final area of focus on other payroll issues Preliminary indications IRS was looking to identify employers with poor compliance practices Assume that the IRS will subject filings of Forms 941, Employer s Quarterly Tax Return; Form 940 (FUTA tax returns); and Forms W-2; as well as the employer s IRS transcript to closer scrutiny. IRS will be looking for history of late deposits of withholding taxes, or delinquent filings of returns as indicia of poor compliance practices. Employers should also be prepared to discuss and substantiate internal practices and procedures to comply with employment tax information reporting and withholding obligations. 31

32 IRS Audit Approach For NRP Exams Because the objective is both to gather data and assess compliance, the IRS analysis will be extremely probing, both in depth and duration. Agents will go into greater detail to gather data surrounding issues. Agents may fully develop issues for research purposes without regard to whether they will yield the assessment of additional tax liability. IRS hopes to complete NRP audits in similar time frame as with conventional employment tax audits typically seven to eight months. 200 agents drawn from all three divisions of the IRS have been specially trained for conducting NRP examinations. Agents already experienced as IRS employment tax specialists IRS will assign agents with experience in either the Large/Midsize Business (LMSB), Small Business/Self-Employed (SBSE), or Tax-Exempt and Government Entities, as appropriate to the selected employer. 32

33 IRS Sharing Of Worker Classification Information With State Agencies The IRS already has established information-sharing practices with many of the states. Information gained in NRP exams is likely to be shared as well. Worker classification is a recurring federal and state employment tax examination issue. New coordination or worker classification issues between IRS, DOL and state employment authorities Formalized information-sharing agreements between the IRS and states established beginning in present count is 39 states Exams by either state employment/labor agencies or the IRS SS-8 Unit frequently initiated by disgruntled former worker(s) making claims for state unemployment benefits State-level e e ca claims may ayut ultimately ateygenerate eateirs worker cass classification cato exams. Don t assume that state unemployment/workers compensation claim for a single worker will just go away by paying the assessment. 33

34 State Worker Classification Examinations Questionable employment tax practice (QETP) initiative Provides centralized, uniform means for IRS and state employment authorities to exchange data/leverage resources for employment tax enforcement Collaborative effort between: U.S. DOL National Association of State Workforce Agencies (NASWA) Federation of Tax Administrators Initial participating workforce agencies from the states of California, Michigan, New Jersey, New York and North Carolina Emphasis on pursuing businesses/industries with recurring practices of misclassifying workers as independent contractors 34

35 State Worker Classification Examinations (Cont.) Many states have more demanding criteria than the federal 20 common law factors and/or Sect states and the District of Columbia follow a common law test, which emphasizes degree of control exercised over the worker. 31 states apply various forms of the ABC Test A. Direction and control B. Close integration of services with business of service recipient C. Worker customarily engaged in independent trade, profession or business in nature of services performed California is particularly aggressive in examination and enforcement of worker classification issues. Payments to independent contractors are separately reported to Employment Development Department (EDD). Process makes independent contractors far more transparent to California Franchise Tax Board (FTB). California generally requires state income tax withholding on payments to non-resident individuals or corporations that do not maintain a permanent place of business in California. Fundamentally different from federal rules, which do not require withholding on payments to independent contractors. 35

36 State Workplace Fraud Acts Numerous states have introduced legislation that makes it fraud for an employer to knowingly misclassify its workers in order to deprive them of the protection of: FLSA and state law prevailing wage and overtime pay rates, Federal and state unemployment insurance coverage, and State workers compensation insurance coverage. Under these Workplace Fraud Acts, employers face potential threat of: 1. Significantly increased recordkeeping requirements 2. Increased fines and/or administrative penalties 3. Stop work orders to rein-in violations Maryland legislation is one of few Workplace Fraud Acts that creates a private right of action for knowingly misclassified workers. Entitled to trebled (i.e., tripled) civil damages + attorney s fees Three-year statute of limitations to bring claims Also grants additional authority to for state Department of Labor, Licensing and Contracts to issue citations and fines to offending companies Several states are contemplating the creation of similar, explicit private right of action for misclassified workers. 36

37 Internal Revenue Manual Guidance For IRS Employment Tax Audits IRM sets out objectives for the IRS employment tax examination function. Among these objectives is the use of research to better understand the tax gap and assess possibilities for impacting taxpayer behavior. (IRM (1)(h).) NRP targets 4:6 identified areas of noncompliance (not exhaustive): (i) nonfilers (noncompliance); (ii) worker classification; (iii) officer compensation; and (iv) fringe benefits. (IRM (2)(a)-(d).) 2 2(2)(a)-(d) ) Objective is for coordination between the operating divisions on employment tax programs (IRM ) Objective is for coordination concerning appeals determinations on employment tax cases (IRM ) Authorization for federal/state exchanges (IRM ) 37

38 Internal Revenue Manual Guidance for IRS Employment Tax Audits (Cont.) IRM provides guidelines for the classification, selection and assignment of employment tax returns for examination. IRM (2) Selection of employment tax returns is based on classifying techniques targeting known or probable areas of non-compliance compliance. IRM discusses procedures for following up on CSP closing agreements to assure compliance. IRM provides further detail on CSP Compliance Follow-up. IRM and Exhibit discuss the referral of worker misclassification cases to the IRS TE/GE Employee Plans Division. IRM specifically discusses examination referrals of CSP cases to the IRS Employee Plans Division. 38

39 Preparing For A Possible Federal Audit Anthony Arcidiacono, Ernst & Young

40 Only One-Third Of IRS NRP Examination Notification Letters Have Been Mailed To Date IRS audit notification letters are Form # 3850N Agents case files will be received containing a tremendous amount of documentation, such as copies of related income tax returns, Forms W-2 and 1099, and Internet research of the business Agents examinations will include a thorough examination of the general ledger to uncover issues such as employee benefits, executive compensation, etc. Page 40 Presentation title

41 Audit Planning Update processes and procedures prior to exam Consider voluntary disclosures as applicable Verify payroll system taxability and tax rates Deploy appropriate audit defense and negotiation tactics Seek abatement of penalties Adjust employment tax returns upon discovery of errors Page 41 Presentation title

42 Re-examine Withholding Tax Compliance Classification of staff as employees or as independent contractors Look to behavioral controls, financial controls and relationship of parties Examine nature and frequency of payments Make certain all Forms 1099 were prepared correctly with the correct payee TIN number, amount, and name and address Page 42 Presentation title

43 IRC Sect Relief Internal Revenue Code Sect provides relief in the form of tax rates. This is mandatory rather than discretionary on the part of the agent; provides rate as follows: If Forms 1099 were issued to the workers: The income tax withholding rate is computed at the rate of 1.5%. The employer s FICA liability is computed at the rate of 20% of the employee s share plus the entire employer s share. If Forms 1099 were not issued: The income tax rate becomes 3%. The FICA rate is the employer s share plus 40% of the employee s share. Page 43 Presentation title

44 Review Permanent Employees And Independent Contractors (ICs) Be prepared to reflect legitimate differences between the two to support their respective classifications. Where possible, maintain open lines of communications with your workers. The IRS agent may want to interview them in order to verify certain facts. Examining the independent contractor classification: This is a very detailed-oriented d i t d process that t entails many facets. The agent will scrutinize IC contracts and files to gather facts. Investigation may lead to interview of independent contractors and of employees to determine their respective daily duties. The information document requests (IDRs) issued by the IRS agent will be very detailed. This is necessary to gather all facts. Page 44 Presentation title