HR Solutions That Become Tax Problems: How to Minimize Risk

As organizations increasingly rely on HR-led solutions and third-party vendors to manage benefits, payroll, and compensation to improve efficiency, these solutions often carry hidden tax liabilities that cannot be outsourced and can trigger audits, penalties, and remediation costs. This article highlights the most common pressure points where HR solutions can inadvertently create tax problems, and offers practical strategies for managing risk through improved cross-functional coordination. By understanding these challenges and implementing proactive measures, companies can more effectively navigate the complex landscape of HR and tax compliance.

Why These Issues Are Emerging Now

The legal framework governing benefits and payroll sits at the juncture of tax, employee benefits, executive compensation, and corporate governance. Plan sponsors must consider: (a) what the law requires; (b) what the law permits; (c) what the plan requires; and (d) what the plan allows. As administration grows more complex—and as more companies outsource more core HR functions—gaps in process, plan compliance, and interdepartmental communication frequently come to light through IRS or state audits, attest findings, penalty notices, internal self-audits, or M&A diligence. Early, structured collaboration between HR and tax is proving essential to avoid costly errors.

Health and Welfare: ACA Reporting, Life Events, and Nondiscrimination Testing

Affordable Care Act information reporting remains a high-penalty exposure area. Failure to file IRS Form 1095-B with the IRS or furnish IRS Form 1095-C to employees can generate penalties under Code §6721 and §6722, with higher amounts for intentional disregard and abatement available only for reasonable cause. Penalties for late or missed filings escalate quickly, with tiered per-return amounts and employer-size caps.

Operational errors in cafeteria plan administration are also high impact. Allowing mid-year election changes that are not qualifying life events, are inconsistent with plan terms, or violate the consistency rule can jeopardize plan qualification. Separately, failure to perform required nondiscrimination testing for key cafeteria plan benefits—such as group-term life insurance under Code §79(d), self-insured medical reimbursement plans under Code §105(h), dependent care assistance programs under Code §129(d), and adoption assistance under Code §137—can result in taxable benefits to highly compensated employees. Unreported non-cash fringe benefits, including unrestricted company car usage for top executives and certain wellness benefits provided only to some employees, frequently necessitate Form W-2 corrections and penalties for employers, as well as amended income tax returns for employees.

Payroll: Deposit Timing, Equity Events, ERTC, PEOs, and Worker Classification

Payroll tax deposit failures under Code §6656 remain a pervasive risk. Penalties range from 2% to 15% based on lateness, with next-day deposit rules triggered when accumulated taxes reach $100,000 or more. A common pitfall arises when employees exercise nonqualified stock options without a company’s payroll provider receiving timely notice, causing late or insufficient deposits. While a reasonable cause abatement is possible, reliance on employees or third-party vendors generally does not qualify.

Employee Retention Tax Credit positions remain under intense scrutiny. The credit amounts—up to $5,000 per eligible employee in 2020 and up to $7,000 per eligible employee per quarter for the first three quarters of 2021—drove a wave of aggressive filings, prompting the IRS to include ERTC on its “Dirty Dozen” list. Legislative activity would disallow late-filed claims after Jan. 31, 2024, and extend the IRS assessment period to the later of key return dates and the claim date, with potential successor liability in M&A transactions, including asset deals.

The One Big, Beautiful Bill Act introduced new enforcement provisions affecting the ERTC. Section 70605(d) of the OBBBA prevents the IRS from allowing or refunding ERTCs after July 4, 2025, for the third and fourth quarters of 2021 if those claims were filed after Jan. 31, 2024. The OBBBA also extended the statute of limitations on assessment for the ERTC to six years from the latest of (1) the original quarterly return due date; (2) the original return filing date; or (3) the date on which the taxpayer filed the ERTC claim.

Outsourcing payroll and benefits to Professional Employer Organizations introduces distinct risk profiles. A non-certified PEO remains the employer of record for certain administrative purposes, but the client company typically retains ultimate liability for employment tax deposits if the PEO fails to remit. By contrast, certified PEOs are IRS-certified and assume sole liability for employment taxes, an important distinction for risk allocation and contract terms.

Worker classification (as independent contractors, as opposed to employees) continues to be a core compliance risk, with the IRS focusing on behavioral control, financial control, and relationship factors. State standards may differ, particularly for unemployment insurance. Misclassification can lead to back taxes, penalties, and interest.

401(k) Plans: Operational Failures and EPCRS Corrections

The most common 401(k) plan failures are operational: not following plan terms, excluding eligible participants, failing to remit required contributions, and loan administration errors. The IRS’s Employee Plans Compliance Resolution System offers three remediation paths depending on timing, significance, and audit posture: (1) self-correction for eligible failures; (2) voluntary correction with IRS approval and a fee; and (3) Audit Closing Agreement Program for failures identified during an IRS examination. Certain errors also require Department of Labor correction procedures. Coordinated HR–tax oversight is critical to identify issues early and choose the right correction path.

Equity Compensation: Partnership and Deferred Compensation Traps

Grants labeled as “phantom” equity can carry unexpected tax classifications. Profits interests in partnerships converts recipients to partners for tax purposes, shifting recipients to Schedule K-1 reporting, subjecting them to self-employment tax, and impacting their eligibility for employee benefit programs. Phantom stock and restricted stock units generally constitute nonqualified deferred compensation and can trigger FICA and Federal Unemployment Tax Act taxation upon vesting or accrual under Code §3121(v)and §3306(r)(2), well before cash payout. These timing and classification nuances require tight coordination across tax, HR, and payroll.

Remote and Itinerant Work: Multi-Jurisdictional Tax, Nexus, and PE Exposure

Remote, hybrid, and traveling workforces have created pervasive multistate and cross-border tax challenges. Undisclosed or fluid work locations can trigger city, county, and municipal tax obligations, create nexus through mobile employee activities, and drive a surge in questionnaires and local enforcement. States may retroactively identify pandemic-era nexus, increasing exposure and administrative burden. International travel and remote presence can elevate permanent establishment risk, while changed travel patterns and market volatility create downstream tax and benefits complexities. If a company’s business plans include or permit remote or hybrid work, expatriate assignments to foreign locations, or employees whose work locations change frequently, such businesses should seek advice from a tax professional regarding the tax consequences of those decisions before finalizing them.

Governance and Collaboration: Preventive Measures That Work

The recurring theme across these issues is that liability for the tax consequences of HR, benefits and payroll issues often cannot be delegated to outside vendors, and gaps typically arise from siloed decision-making. Organizations can materially reduce risk by conducting proactive self-audits, ideally under Kovel agreements with counsel designed to prevent waiver of attorney-client privilege, and by involving tax advisors earlier in HR plan and policy design, vendor selection, and contract negotiations. Cross-functional teams that bring together HR, tax, accounting, and legal can tighten control frameworks, improve plan and payroll design and administration, and ensure non-discrimination testing and information reporting are performed on time and in line with plan documents and tax law.

Key Takeaways

HR-led solutions frequently carry embedded tax obligations, and failure points often surface at scale through audits and diligence. Timely filing and furnishing of ACA information returns, rigorous nondiscrimination testing, disciplined payroll deposit procedures (especially around the grant, vesting, or exercise of equity compensation), sound worker classification, and vigilant 401(k) operational compliance are foundational. For remote and itinerant workers, location mapping and withholding alignment are now essential controls. Companies should involve their in-house tax function and/or outside tax advisors in decisions regarding HR and benefits design, administration, and outsourcing. In addition, it is vital for a company’s HR and tax departments to communicate regularly to improve compliance and avoid subjecting both the company and its employees to unforeseen taxes and penalties.

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

Author Information

Julie M. Bradlow is the Chair of DarrowEverett’s Tax Practice Group, and a Practice Leader for its Government Investigations Practice Group.

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