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5 Business Audits: What to Know Before You Go. BY: MICHAEL MARCH

6 Types of Business Audits Employment Classification Audits Sales and Use Tax Audits Trust Fund Audits Fraudulent Tax Preparers Tax Evasion

7 Employment Classification Audit What is it? IRS and/or state governments will analyze the relationship between the company and its workers to determine if they are independent contractors or employees. Worker classification is important as it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes, and unemployment tax on wages paid to an employee. Alternatively, businesses do not have to withhold or pay any taxes on payment to independent contractors. However, the earnings of an independent contractor are subject to self employment tax. The general rule is that an individual is an independent contractor if the employer has the right to control or direct only the result of the work, not what will be done and how it will be done. Highly factual analysis.

8 Employment Classification Audit Influential factors when determining status of worker Generally, determining whether a worker is an employee or an independent contractor comes down to an analysis of: Behavioral Control: a worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Consider the degree of instructions given to worker, who provides the tools, who purchases the supplies, and training of the workers. The level of skill required to complete the job is highly influential. Financial Control: Can the worker incur a loss, if the workers takes on more tasks can they increase their income, are workers free to seek out additional business opportunities that do not affect their current employer, method of payment (is it regularly wages, paid per job, or a commission). Relationship: Are there written contracts (if so what do they say), does the worker receive employee benefits including health insurance, retirement plans, or vacation or sick pay. What is the permanency of the relationship (if working indefinitely this is indicative of an employee employer relationship). Finally, are the services provided which are a key activity in the business.

9 Employment Classification Audit Section 530 Safe Harbor: to qualify you must meet all three of the following requirements: Reporting Consistency You must have timely filed all required federal tax returns (including informational returns) which were consistent with your treatment of each worker as an independent contractor. Substantive Consistency You must treat similar workers as independent contractors. Reasonable Basis this is where the IRS likes to litigate. To establish reasonable basis you can use the following items: Court case about federal taxes or a ruling issued to you by the IRS (Private Letter Ruling) Prior IRS Audit which did not reclassify the workers as employees You treated the workers as independent contractors because you knew, and you can substantiate, that was how a significant segment of your industry treated similar workers. Often you will see this factor in case analysis through expert witness testimony. You relied on some other reasonable basis. For example, a tax attorney, CPA, or consultant who knew the facts about your business. Forum Shopping: U.S. Tax Court vs. Federal District Court

10 Employment Classification Audit Voluntary Classification Settlement Program Classification Settlement Program The Voluntary Classification Settlement Program (VCSP) is a voluntary program that provides an opportunity for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes. Occurs before an audit is initiated or before contesting the audit in Court.. File IRS Form Taxpayer pays 10% of employment tax liability for the most recent tax year. Taxpayer is not liable for interest or penalties. Allows taxpayers and tax examiners to resolve worker classification cases as early in the administrative process as possible thereby reducing taxpayer burden. A CSP offer is mandatory if all Form 1099s were timely filed. If all Form 1099s were not filed CSP is not available. Taxpayer must reclassify independent contractors as employees moving forward. Acceptance may provider for reduction of Employment taxes through same factors in Section 530 relief (Reasonability).

11 Sales and Use Tax Audit What is it? A state auditor reviews records of a business to determine whether state taxes on the purchase and sales of goods were properly collected and paid. Use tax refers to the tax on goods purchased out of the state. Every time you purchase taxable tangibles goods from businesses outside of Maryland, whether in person, over the phone, or on the internet, the purchase is subject to Maryland s 6% or 9% sales tax, if you use the merchandise in Maryland. Note: Every state law is different. Policy is to protect Maryland businesses from unfair competition as Maryland businesses would be at a competitive disadvantage if consumers were entitled to a 6 or 9 percent discount on items purchased from out of state businesses. In Maryland Sales and Use Tax is 6% or 9% on alcoholic beverages. South Dakota v. Wayfair: South Dakota was losing million annually due to the physical presence test (See Quill). As a result, South Dakota Required out of state sellers to collect and remit sales taxes if above transactions exceeded $100,000 annually or 200 transactions per year. Result: Quill and Bella Hess is overruled no physical presence is required. Split 5:4 decision.

12 Sales and Use Tax Audit How the auditor proves income was not reported 1. Testing Gross Receipts (POS sales). Cash register sales. Alternatively, what if the business purposefully does not use their cash register? 2. Bank Account Analysis. 3. Business Ratio Analysis. Horizontal Analysis: Analysis of changes over time. Compare current year tax return to previous tax returns. Vertical Analysis: Analysis of Taxpayer s business and industry standards for a given year. 4. Economic Approach Analyzes changes in net worth by examining assets including houses, cars, and bank accounts.

13 Trust Fund Recovery Penalties What is it? Tax assessed against those who said they were going to send money to the IRS on behalf of others but never did. Examples include: Withholding Taxes Employment Taxes Social Security Taxes Railroad Retirement Taxes Excise Taxes excise taxes are paid when purchases are made on a specific good, such as gasoline, wagering, highway usage by trucks. Called trust fund taxes because you actually hold the employee s money in trust until you make a federal tax deposit in that amount.

14 Trust Fund Recovery Penalties Who can be held liable? A Responsible Person: Definition of a responsible person: one who has the duty to perform or the power to direct the act of collection, accounting for, or paying over trust fund taxes. See IRM Generally it is the individuals with control or signatory authority over the company s bank account. Can the worker exercise independent judgment with respect to the financial affairs of the company. The Reasonable Person must have done so willfully: Willfully means voluntarily, consciously, and intentionally. Must have been, or should have been, aware of the outstanding taxes and Either intentionally disregarded the law or was plainly indifferent to its requirements (no evil intent or bad motive is required). Using available funds to pay other creditors when the business is unable to pay the employment taxes is an indication of willfulness.

15 Trust Fund Recovery Penalties Results of the Audit: IRS can impose the penalties against more than one person. Generally IRS will hold interviews to see who is liable. Interview focuses on the individuals role in the business. Individually can be held personally liable for a penalty equal to the full amount of the unpaid trust fund tax, plus interest. The amount of the penalty is equal to the unpaid balance of the trust fund tax. The penalty is computed based on: The unpaid income taxes withheld plus The employee s portion of the withheld FICA taxes. For collected taxes, the penalty is based on the unpaid amount of collected excise taxes.

16 Fraudulent Tax Preparers What is it? Filing of State or Federal Tax Returns with gross inaccuracies, fictitious businesses, inaccurate and/or overstated dependents.

17 Fraudulent Tax Preparers What it looks like: Inaccuracies on Schedule A including: overstated medical expenses, charitable contributions, other itemized deductions (employee expenses). Fictitious Schedule C including: unprofitable businesses, overstated business expenses, or manipulation of inventory. Fictitious Schedule E including: overstated expenses, or manipulation of depreciable assets. Generally, the IRS or Comptroller s Office will notice large whole numbers, lack of business profits for multiple years, or mathematical inconsistencies. Percentage analysis of income to expenses. Sampling of returns filed over a certain period. Is the income from tax preparation actually reported on the preparer s return

18 Fraudulent Tax Preparers Results Choosing the crime you are convicted of : Theft (misdemeanor) vs. Preparation of fraudulent tax returns (fraud). Both are considered crimes of moral turpitude. Sentencing: MD: Willful fraudulent preparation of state income tax return = 5 year maximum and/or $5,000 Federal: Average Sentencing is 17 months. Suspended Sentence: Successfully complete a period of probation and sentence will be eliminated. Restitution payments: Percentage of profits the State or Federal Government lost and any income that the preparer failed to report. Probation (Supervised vs. Unsupervised) Supervised probation includes monthly check ins with probation officer, travel restrictions, fees, and other requirements Judge deems appropriate. Unsupervised probation does not include monthly check ins. Do not get in trouble! Always ask for a sentencing modification once the restitution has been paid. This can change your sentence from supervised to unsupervised probation. Ask the prosecutor if they would object to an expungement or a modification of sentence.

19 Tax Evasion vs. Tax Avoidance What is it? Tax Avoidance: Minimization of paying taxes. Using legitimate tax deductions, setting up tax deferral plans, and taking tax credits. Tax planning Tax Evasion: Not paying taxes. Not reporting income, inflating expenses, not paying taxes owed, understating the amount of taxes owed, not filing tax returns at all. Generally, the statute of limitations is three years after the due date of the return or 3 years after the date the return was actually filed, whichever is later. Statute of limitations can extend to six years for 25% or more under reporting of gross income. Substantial omission. No statute of limitations if there is fraud. Fraud is the willful and intentional falsification of information in order to limit tax liability. Popular Tax Cases: Martha Stewart: Forced to pay back taxes of $220,000 to the State of New York. Sentenced to prison for insider trading. Wesley Snipes: Owed the federal government 17 million in back taxes. 3 years in prison. Convicted of failure to file a tax return. Willie Nelson: Owed the federal government 16 million in back taxes. Results of an erroneous tax shelter. Mike the Situation Sorrentino: Failed to pay taxes on over 9 million in earnings. Filed falsified tax returns. Sentenced to 8 months in federal prison. Two years of supervised release. Gregg Mark, Sorrentino s accountant also admitted to filing the fraudulent returns.

20 Contact Information Michael March Attorney at Rosenberg Martin Greenberg, LLC Tax Controversy Group Phone: