IRS Employment Exam--Will Your Construction Company Pass the Test??
by Josh Weiss, Lutz & Company CPA
(Editor Note: This is a reprint of article Josh wrote for June 2012. In honor of spring tax season—it seemed fitting to reprint.)
The IRS continues to utilize an audit program that focuses on employment tax issues. As part of a National Research Project (NRP), the IRS will randomly select approximately 6,000 employers over the next three years for detailed employment tax examinations.
The program is designed to gauge compliance with employment tax law and related reporting requirements, and to gather information that will help the IRS select and audit future returns with the greatest compliance risk. On your 2011 corporate tax returns, a box asked whether 1099 forms were sent to independent contractors. The goal of this is for the IRS to identify not only was your company in compliance with the 1099 rules, but also to find independent contractors that may have avoided paying tax. The IRS offers few details about the specific issues it plans to probe, but it’s a safe bet that auditors will be scrutinizing areas that led to audit adjustments in the past.
For construction companies, the Service’s Construction Industry Audit Technique Guide (ATG) provides clues to what auditors will be looking for. Here are some of the main employment tax issues NRP audits will target:
Worker classification. The employee vs. independent contractor issue is a significant one in the construction industry. The ATG warns agents that “the use of subcontractors is common within the construction industry. Many taxpayers treat employees as subcontractors to avoid paying employment taxes. The agent may need to seek guidance from an employment tax specialist when confronted with potential employment tax issues.”
On your 2011 corporate tax returns, a box asked whether 1099 forms were sent to independent contractors. The goal of this is for the IRS to identify not only was your company in compliance with the 1099 rules, but also to find independent contractors that may have avoided paying tax.
It seems unlikely that many contractors deliberately misclassify employees as independent contractors to avoid employment taxes. But even inadvertent misclassification can have serious consequences, including back taxes, penalties and interest; additional employee benefit obligations; and liability for overtime pay. To avoid these costs and ensure you can support your tax position; review your employment practices and procedures, relationships with independent contractors, and written contracts.
Officer compensation. The IRS will likely focus on two issues involving owner-employees: 1) C corporations that pay unreasonably high salaries, which are really disguised dividends, and 2) S corporation shareholders who receive unreasonably low compensation to reduce employment taxes. To avoid unpleasant tax surprises, be sure to maintain documentation that supports the reasonableness of owner salaries.
Reimbursed expenses. Agents will be looking for employee expense reimbursements that aren’t paid through an “accountable plan” and, therefore, should be included in income and subject to employment taxes. Payments under a nonaccountable plan, while they may be deductible by the employer, are usually taxable income to the employee. Your plan is accountable if it’s in writing and requires:
1. Reimbursed expenses to have a business connection,
2. Employees to adequately substantiate expenses in writing within a reasonable time, and
3. Employees to return any excess reimbursements or advances within a reasonable time.
Keep in mind that reimbursement of employees through an accountable plan won’t convert otherwise nondeductible expenses into deductible ones.
The chances of being selected for an NRP audit may be slim, but the same issues are likely to be raised in ordinary audits, too. In light of continued IRS interest in employment tax issues, work with your attorney and CPA to review your employment practices, procedures and records to be sure they meet the agency’s standards.