Income tax withholding is crucial to the general revenues of our federal government, but it turns out that employers have trouble complying with the rules, according to two payroll tax consultants speaking at the American Payroll Association’s 2021 Virtual Congress on July 15.
More than 70% of all the revenue collected by the federal government comes from income tax withholding, said Ken Fitzgerald, a tax manager at Deloitte Tax LLP.
Around 20 years ago, the Internal Revenue Service figured out that employment tax audits were more lucrative than corporate tax audits in closing the tax gap, said Jason Russell, a director at Deloitte Tax LLP. To enforce the withholding rules, the IRS focuses on three main areas in an employment tax audit: worker classification, equity deposit funding, and fringe benefits, Russell said.
“It’s odd to see worker classification apply to executives, but we do see it,” Russell said, noting it may be more common among companies planning to go public. These companies may have high performers who refuse to onboard as employees, he said. To secure their services, the company may agree to hire them as contractors. “This has always mystified me as a practitioner,” Russell said, “because the company should be in charge.”
Other companies hire contractors out of budgetary concerns. They may not have the budget to hire employees but do have the budget to hire contractors. This is especially problematic when contractors and employees are performing the same duties side by side, Russell said. The IRS does not care which budget funds their pay, he said.
The IRS will care how their pay is reported, though, said Fitzgerald. True contractors generally have an employer ID number. When looking at the Accounts Payable records, the IRS will scan for any Social Security numbers, which is often a red flag that the worker is an employee being paid as a contractor, he said.
Executives who leave the company only to return as a consultant are another common issue, Russell said. Generally, they are paid to answer questions during the transition to new leadership. Their pay is an extended severance payment and should be reported on a Form W-2, he said.
Equity compensation is noncash pay offered to employees, such as stock, that may be used to boost an otherwise below-market salary. The compliance issues all relate to the deadlines for reporting the payments and depositing the withheld taxes, and the penalties can run into the tens of millions of dollars, Russell said.
Often, companies do not realize that an equity transaction is a separate payroll event, Russell said. Most companies deposit their taxes according to a semiweekly schedule. However, when the liability reaches $100,000, the company becomes a next-day depositor. “You have to execute a same-day payroll,” he said. “If you rely on your regular deposit schedule, it will be late.”
The IRS can be hit-or-miss on fringe benefits, Russell said, but payroll should be aware simply due to the potential size of the penalties. “We’ve had some surprises where IRS imposed several hundred thousand dollars in fines and even several millions of dollars. So, this goes beyond the gift card program,” he said.
“Most of the things you give your employees tend to be taxable,” Russell said. During the pandemic, employer reimbursement for internet access in an employee’s home became a nontaxable fringe benefit. The IRS may revisit that when the pandemic ends, he said.
Free lunches are also coming under scrutiny. “The IRS doesn’t get free lunches,” Russell said, “and they don’t think you should either.”
Among executives, personal security is becoming more prevalent and may or may not be taxable depending on who is in charge. If the CEO can decide to have security and an armored car for the commute to and from work but not during evenings and weekends, that is taxable, Russell said. If a third party determines the threat risk and provides security accordingly, that would be nontaxable.
The IRS has various settlement programs that can help employers greatly reduce their penalty exposure, Russell said. For the maximum benefit, it is best for the employer to approach the IRS before the IRS has the employer in its sights.