Advise client companies to review payroll practices.

• Author: Bailor, Bernard S.

The IRS has launched an initiative to conduct payroll tax audits for 6,000 randomly selected companies.

February 2010 marked the start of a new IRS initiative on employment taxes. The IRS will select at random approximately 6,000 companies nationwide for a payroll tax audit. The audits will focus on whether companies are paying all of their required employment taxes that fund Social Security and Medicare. The IRS wants to know how many companies are misclassifying employees as independent contractors and failing to pay taxes on fringe benefits. This initiative is expected to last for three years.

The IRS will likely find many companies in violation of IRS regulations concerning how workers are to be classified for payroll tax purposes. Companies have a clear incentive to classify employees as independent contractors. Companies are required to pay half of their employees' 12.4% Social Security and 2.9% Medicare taxes. The recent economic recession will most likely increase the pressure on companies to avoid paying these payroll taxes. However, if a company classifies an employee as an independent contractor, it does not pay these taxes. Based on 1984 data, the IRS estimates that companies underpay approximately $14 billion annually by misclassifying employees as independent contractors.

Company Liability and Penalties

Employers who misclassify employees as independent contractors are liable for a variety of penalties, as well as the unpaid tax liability plus interest. When a company fails to pay, a penalty is commonly assessed in these situations. The penalty can be up to 25% of the unpaid tax liability.

Some companies that are experiencing financial distress might withhold income, Social Security, and Medicare taxes from their employees but may fail to pay these taxes to the IRS. This situation is very serious. Both the company and responsible company officers are subject to severe civil and criminal penalties. The Internal Revenue Code (IRC) imposes a penalty equal to the total amount of withheld taxes on any person who is required to collect and pay these taxes and willfully fails to do so. This penalty, commonly called the trust fund penalty, is in addition to other penalties. Individual officers, as well as the company, may be subject to the trust fund penalty. Additional penalties may be imposed for failing to file returns, to pay taxes when due, or to make timely deposits of payroll taxes.

In addition to imposing civil penalties, if...