Internal Revenue Service audits are not limited to just income taxes. The IRS also audits companies for non-payment of payroll taxes on payments to employees considered to be wages. Two of the most common issues that occur are when (1) business owners take distributions in lieu of wages; and (2) when companies utilize “independent contractors” but IRS would define them as “employees.” This article will discuss these two issues and how to avoid them occurring in your organization.

Background

      Employers are required to pay FICA (Social Security and Medicare) and FUTA (federal unemployment) taxes on wages paid to all their employees. States, in turn, rely on the reported IRS-based wages to assess other taxes including SUTA (state unemployment). Issues for companies arise when payments have been wrongly classified as something other than wages (i.e. distributions, independent contractor payments).

Distribution vs. Wages

      The IRS Tax Court case Sean McAlary Ltd Inc. is representative of recent cases in which the IRS successfully challenged the under- reporting of business owner wages and the associated payroll taxes.

      This S corporation reported net income of $231,454 and transferred $240,000 to the sole shareholder. The sole shareholder reported no wages. The IRS determined a reasonable hourly wage for the work performed and applied it to the hours worked during the tax year. The IRS concluded that $100,755 represented reasonable wage- based compensation. As a result, the IRS sought $21,360 in back payroll taxes, penalties and interest.

      Business owners should carefully consider the mix of compensation and distribution they expect to take in any given year. Reporting zero wages and taking all distributions is not an option. You should speak with your tax accountant to find the proper mix for your particular situation.

Employee characteristics

      When determining whether an individual is an employee or an independent contractor, the IRS advises a 20-factor test as defined in Revenue Ruling 87-41.

      These are the primary 16 characteristics of an employee:

1. Workers must comply with instructions on when, where and how to work.
2. Workers receive ongoing training from the employer.
3. Workers are important and integrated into the business.
4. Services are rendered by the worker and not assigned to others.
5. The employer hires, supervises and pays the subordinates.
6. A continuing relationship between worker and employer exists.
7. There are set hours of work established by the employer.
8. Workers normally work full-time for the employer.
9. Work is done on the employer premises.
10. Workers perform services in the sequence set by the employer.
11. Workers submit regular reports to the employer.
12. Compensation is by the hour, week or month.
13. The employer pays business travel expenses for the worker.
14. Employer furnishes significant materials, tools and equipment.
15. Employer has the right to discharge the worker.
16. The worker can quit work at any time without incurring a liability.

Contractor characteristics

      These are the four primary characteristics of an independent contractor:

1. The worker has a significant investment in the facilities where the worker works.
2. The worker can make a profit or loss.
3. The worker performs services for multiple unrelated companies.
4. Worker makes his or her services available to the general public.

Other factors

      The above are guidelines established by the IRS and not an absolute set of standards. The basic evaluation criteria is if the business has the right to direct or control how the work is done through instructions, training or other means, then the worker is most likely an employee. If the business controls only the result of the work done and not the means, then the workers are likely independent contractors.

      Other heavily weighted evaluation criteria include whether a written contract exists, whether the worker receives benefits, the permanency of the position and the extent to which the services performed by the worker are a key aspect of the regular business of the company.

Amnesty

      The IRS Voluntary Classification Settlement Program (VCSP) allows for voluntarily converting independent contractors to employees going forward. See IRS IR-2013-23. To be eligible for the VCSP, an employer must:

• Currently treat workers as independent contractors.
• Have been consistent in the treatment of workers including issuing 1099’s.
• Not currently under an IRS audit on payroll tax issues.
• Not under a Department of Labor or state agency audit regarding worker classifications.
• Not contesting the classifications of the workers in court.

Summary

      The above discussion is an overview of the most common types of payroll tax issues that companies face. The under payment of payroll taxes by business owners and employees treated as independent contractors can result in an IRS audit where back payroll taxes, penalties and interest are assessed.

Wayne Clark is a CPA with Federal Strategies Group LLC.