In March of this year, the IRS began the Employment Tax National Research Program, the first comprehensive employment tax compliance study in 25 years. The IRS will randomly select 2,000 taxpayers each year for the next three years to conduct comprehensive audit examinations. Taxpayers selected for audit will receive notices describing the National Research Program process.
In these random audits, the IRS will focus on worker classification and fringe benefit policies. A fringe benefit is a form of compensation for the performance of services. However, a person who performs services for an employer for purposes of fringe benefit compensation does not have to be an employee. A person may perform services as an independent contractor, partner, or director. Furthermore, for fringe benefit purposes, a person who agrees not to perform services (such as under a covenant not to compete) is also considered to be performing services. An employer is considered the provider of a fringe benefit even if the benefit is actually provided by a client or customer of the employer. The key is that the benefit is provided to the employer’s employee, contractor, director, or partner for services performed for the employer. Similarly, the employee, contractor, director, or partner is still considered the recipient of the benefit even if it is actually provided to someone who did not perform the services for the employer, such as a family member. Again the key is that the benefit is provided for and because of services performed for the employer. Absent a specific exclusion, fringe benefits are taxable and must be included in the recipient’s pay, and therefore, creates an obligation on the employer to withhold, deposit and report employment taxes relative to fringe benefits.
Fringe benefits, though, are distinguishable from expense reimbursement plans. Generally an advance, reimbursement or other expense allowance received under an “accountable plan” is not income to an employee and does not create employment tax obligations on the employer. An advance reimbursement, or other expense allowance, is treated as made under an “accountable plan” if:
1. the employee receives the advance reimbursement or other expense allowance for a deductible business expense that the employee paid or incurred while performing services as an employee of the employer,
2. the employee adequately accounts to the employer for the expense within a reasonable period of time, and
3. the employee must return any excess reimbursement or allowance within a reasonable period of time.
If an advance, reimbursement or other expense allowance to an employee does not satisfy all three of these conditions, it is treated as paid under a nonaccountable plan. All advances, reimbursements or other expense allowances paid under a nonaccountable plan are taxed to the employee and create an obligation on the employer to withhold, deposit and report employment taxes relative to all such nonaccountable plan payments.
Similarly, improper classification of employees or independent contractors could have a significant impact on federal and state tax liabilities (including unemployment tax liability), health and welfare benefit obligations, Code-qualified benefit plan participation and funding, as well as IRS penalty exposure for an employer. Worker classification can be a complex area as each case requires careful analysis of the facts and circumstances in light of general common law principles and divergent IRS and case rulings. In very general terms, classification depends on the degree of control by the employer versus independence of the worker. Factors that provide evidence of the degree of control and independence generally fall into three categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how, when or where the worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship be ongoing? Is the work performed a key aspect of the business?
However, there is no “magic” factor or set number of factors that will tip the determination one way or the other. In fact, more likely than not, there will be some factors indicative of employee status, while other factors indicate that the worker is an independent contractor. Furthermore, factors which are relevant in one situation may not be relevant in another. An in depth discussion of this issue is beyond the scope of this article, but the general recommendation is to pay careful attention to worker classifications because, again, mis-classification can result in significant liabilities for an employer.
Even if not randomly audited as part of the current IRS study, employers should be on notice that the IRS is giving greater scrutiny to employer practices and will ultimately use the information gathered through this study to focus on particular types of employers and employment tax and benefits issues. As such, it is prudent for employers to review their fringe benefit and expense reimbursement policies and procedures as well their independent contractor relationships for correct classification. Identification and correction of any errors, omissions or inconsistencies relative to employment tax and benefits is much easier and less costly if done proactively as opposed to after coming under IRS scrutiny.
In the event you receive a notice of audit pursuant to the Employment Tax National Research Program or would otherwise like assistance with compliance review of your employment tax and benefits policies and procedures or employee classifications, the employment and tax attorneys at Wilke Fleury are happy to assist you.