Employment Tax Audits Are Coming, So Businesses Must Prepare

Thousands of auditors are being hired and trained as part of the Inflation Reduction Act’s $80 billion in funding for modernizing the IRS. We anticipate a significant increase in audit activity will focus on executive compensation, fringe benefits, and employment tax compliance.

To prepare for potential audits, employers should review their payroll and employment tax administration practices. Internal audits can identify compliance risks, address them before penalties are assessed, and demonstrate good-faith efforts in the event of a subsequent audit by the IRS or state taxing authority.

Employment Tax Audit Issues

It’s impossible to predict everything the IRS examiners may focus on, but past experience foretells that they’ll “follow the money.” In particular, auditors will scrutinize billions of dollars in employee retention credit refunds. Issues targeted in an IRS employment tax audit vary based on company size and industry.

Fringe benefits and perquisites. If a benefit is provided, and the amount is not excludable from taxation, the employer is liable for federal income tax withholding and FICA taxes that should have been withheld, plus the employer share of FICA and federal unemployment taxes. Late deposit penalties and information reporting penalties could also apply.

Travel reimbursements and per diems. The tax treatment of travel reimbursements and per diems is often the subject of IRS scrutiny. IRS auditors first focus on the location of the employee’s tax home (or the possibility the employee doesn’t have a tax home) and whether travel has a sufficient business purpose or involves personal aspects.

Longer-term travel or location reassignments can raise unique issues, such as whether the assignment is expected to last one year or less and what happens if expectations change. Per diems that aren’t properly substantiated can be subject to recharacterization as taxable wages.

Deferred compensation. Most employers have compensation arrangements that implicate Internal Revenue Code Section 409A, such as severance arrangements and long-term incentive plans, and many offer traditional deferred compensation or excess plans. Section 409A failures—either in design or operation—result in accelerated income taxation, 20% additional tax, and underpayment penalty interest.

For excess or similar plans that pay out upon termination of employment, employers should be prepared to demonstrate that they properly identify when “separations from service” occur and apply the required six-month delay when applicable.

Worker classification. A standard IRS Information Document Request seeks a list of workers who have received both a W-2 and 1099 during the audit period. The IRS strictly scrutinizes retired or former employees who have been reclassified as independent contractors.

Remote work. Remote work arrangements can trigger several tax compliance concerns. There can be questions about the location of the remote worker’s tax home and treatment of transportation reimbursements, housing benefits, and employer-provided home office equipment. State taxing authorities also have a vested interest in scrutinizing remote workers, particularly in states such as New York that seek to tax individuals working outside the state under its “convenience of the employer” standard.

Internal Audits Can Help

An internal employment tax audit can help employers identify and correct employment tax, tax information reporting, fringe benefit, and executive compensation issues. Identifying and correcting issues before an IRS audit can significantly reduce potential employment tax assessment and penalties.

IRS guidance specifically recognizes that conduct designed to correct a failure may justify the abatement of a penalty. Based on our experience representing companies under examination, and conducting comprehensive and targeted internal audits before and after IRS examination, several issues are worth considering when planning and conducting an internal audit.

Identifying and aligning relevant internal stakeholders. Employment tax issues touch multiple departments, and oversight often doesn’t fall directly under tax or human resources. We have found that employers benefit from having structured meetings across these departments (including HR, payroll, tax, and legal department) to discuss common issues and identify areas for improvement and better coordination.

Conduct internally or hire external help. Although employment tax audits can be conducted internally, outside advisers and experts routinely conduct audits or can provide helpful advice in designing them or addressing any issues that arise. If an accounting or consulting firm is engaged, it is valuable to consider engaging them through counsel to maintain a stronger claim to attorney-client privilege.

Determining scope. Although the list of potential issues can be daunting—with the issues above comprising just a small selection—it typically is unnecessary to turn over every rock. We recommend identifying key areas of focus where the review is most likely to uncover and mitigate potential risk.

Handling negative findings. Once issues are identified, the employer should prepare action items to adjust procedures and practices to improve compliance. There may be no perfect solution for employment tax problems, but there typically are steps an employer can take to significantly mitigate exposure. Specific self-correction procedures may be available, such as under the IRS Section 409A corrections guidance. There also are instances where approaching the IRS is the best course of action to correct a past issue or develop a plan for future compliance.

Time and preparation before an IRS audit can substantially reduce an employer’s potential liability. First, corrective actions can reduce an employer’s potential employment tax exposure going forward. Corrective actions can also reduce an employer’s potential penalty exposure. Acting now, before the IRS comes knocking, can pay significant dividends later.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tom Cryan and Spencer Walters are partners at the tax and benefits law firm Ivins, Phillips & Barker, Chtd. in Washington, D.C.

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