How to survive an employment tax audit.

• Author: Herron, Aureon A.

Once a clients has been selected for an employment tax audit examining whether its independent contractors should be reclassified as employees, what happens next? This article provides a blueprint to the Federal employment tax audit process and also offers guidance on correlative state tax audits.

The IRS estimates that more than one-half of the roughly five million Americans now working as independent contractors should be reclassified as employees.(1) Since establishing the Employment Tax Examination Program in 1988, the Service has assessed more than $670 million in penalties and back taxes and has forced businesses to reclassify over 430,000 independent contractors as employees.(2) Although tax advisers do not typically plan for or look forward to any type of tax audit, in particular, employment tax audits can become time-consuming, detailed and costly; however, preventive measures and steps can be taken to ensure adequate preparation.

This article prepares readers for employment tax examinations and highlights recent developments in this area. Employment tax audits may be successfully handled by:

* Obtaining a clear understanding of the facts and circumstances.

* Performing a "pre-audit" analysis.

* Knowing the areas of interest to the agent.

* Making a strong case at the compliance-check stage of the audit.

* Setting the stage for Revenue Act of 1978 Section 530 (RA '78 Section 530) relief.

* Resolving issues and negotiating a settlement early in the audit Process.

Understand the Facts and Circumstances

For employment tax review purposes, the Service may conduct a "compliance check" (i.e., a perusal of the client's Federal employment tax forms and a brief interview centering around the 20 factors in Rev. Rul. 87-41(3)) or a full-scale audit (i.e., an extensive and detailed examination of the client's books and records). On receiving notification from the Service that a client has been targeted for an employment tax audit or for a compliance check, it is imperative to begin to prepare a case by obtaining a clear understanding of the facts and issues relevant to the audit or compliance check.

The preliminary fact-gathering process is essential to the tax advisers understanding of relationships with workers, sheds light on the company's strengths and weaknesses and limits the possibility of surprises. Most importantly, however, the fact-gathering process prepares the adviser for the detailed questions that the IRS examiner will ask during the audit or compliance check. In today's high-technology world, agents have access to much of the information the client has reported in the past and usually have an idea or strategy in place at the outset. Obviously, the practitioner should know the filing base better than the agent before the first meeting; this will be critical to a successful outcome.

The agent may raise concerns regarding independent contractors. The practitioner will need to establish a listing of all workers, outside vendors and other entities used as contractors. A review of all Forms 1099 issued, as well as Forms W-2, should assist the practitioner in compiling this list. In addition, interviews with management, members of the human resources, payroll and legal departments, and with the workers should be conducted if necessary to determine whether the facts surrounding the work relationship support the company's classification scheme.(4)

All documents and filings relevant to the relationship between the worker and the company should be reviewed to determine whether the worker has been consistently classified from year to year.(5) Standard employment contracts and other retainer agreements between the company and all contractors should be scrutinized.(6) Any formal written policies, training materials, and other company literature relating to its worker classification policies should also be reviewed.

At the conclusion of the fact-gathering and investigative process, the tax adviser should have a clear understanding of the client's payroll positions and exposure points, and be armed with documentation and substantiation supporting these relationships.

Perform a Pre-Audit Analysis

Once an exhaustive list of all workers at issue has been compiled, a detailed review of each individual worker's job function and his relationship with the employer should be conducted. For employers with several workers performing the same function, a review of each job category or position will suffice.

The determination of whether a worker is an employee or an independent contractor is governed by guidelines set forth in Secs. 3121(d)(2) and Regs. Secs. 31.3121(d)-1(c),31.3401(c)-1 and 31.3306(i)-1. These regulations provide that an employer-employee relationship generally exists when the person for whom the services are performed has the "right" to direct and control the individual who performs die, services as to the result to be accomplished, and also as to the details and means by which the result is accomplished. It is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.

To assist in determining the proper classification of workers, the Service has identified 20 common-law factors in Rev. Rul. 87-41 that serve as guides for establishing whether sufficient control exists for validating the employer-employee relationship.(7) These 20 factors were developed based on an examination of case law and rulings. The client and the tax adviser must attack the fact-gathering process armed with these factors, which the IRS will consider in evaluating the client's classification schemes.

Once it has been determined which workers (if any) may potentially be reclassified, an extensive analysis of the potential tax exposure...