In recent years, the IRS has devoted more resources to employment tax matters. In addition to standard non-reporting and non-payment disputes, which will always be a high priority to the agency, the IRS continues to scrutinize worker classifications. Taxpayers embroiled in these standard employment tax disputes have options. Some of these are discussed more fully below.
Employment Tax Basics
Generally, federal employment tax laws impose two obligations on employers. First, employers must withhold and pay employment taxes to the IRS periodically throughout the tax year. Second, they must account for the employment taxes by filing employment tax returns.
On the payment side, employers must withhold and pay employment taxes under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA). Subject to an inflation-adjusted ceiling, FICA taxes are usually 15.3% of an employee’s wages. This 15.3% consists of a 7.65% withholding tax—deducted from the employee’s wages—and an additional 7.65% match paid by the employer out of its own pocket. FICA taxes fund Social Security and Medicare.
By comparison, FUTA taxes are much smaller. Under FUTA, employers must pay 6% of the first $7,000 of nonexempt wages paid to each employee. But in most cases this amount is reduced to account for payments employers must also make under state unemployment tax programs. FUTA funds certain federal unemployment benefits.
In addition to FICA and FUTA, employers must withhold income taxes from their employees’ wages. Through this withholding mechanism, employees receive an income tax credit (reflected on their IRS Form W-2, Wage and Tax Statement) on their tax returns.
Finally, employers must also file employment tax returns. They report the FICA taxes quarterly to the IRS on IRS Form 941, Employer’s QUARTERLY Federal Tax Return. And they report FUTA taxes annually to the IRS on IRS Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.
Adverse Consequences Of Employment Tax Disputes
Non-Reporting And Non-Payment
It is not uncommon for employers to fall behind on their employment tax reporting and payment obligations. For example, companies in financial distress may choose to pay third-party creditors over the IRS with the intention to make payment to the agency later when business picks up. In other instances, more nefarious reasons may come into play (e.g., pyramiding).
Whatever the reason, the IRS has the authority to assess penalties against the employer. These penalties include the standard failure-to-file and failure-to-pay penalties in addition to failure-to-deposit penalties. Significantly, the failure-to-deposit penalty alone can reach up to 15% of the amount of employment taxes that the employer should have deposited. Because all of these penalties may apply at once, the amounts at issue can be staggering.
But it can get worse, especially if the employer failed to pay the trust-fund portion of the employment taxes (i.e., the employee’s share of the FICA taxes and the income tax withholdings). In these instances, the IRS may seek trust fund recovery penalties against all of the individuals responsible for making payroll decision. Notably, the trust fund recovery penalty, once assessed, is not dischargeable in bankruptcy.
And, of course, in the more egregious cases, the IRS may seek criminal sanctions against employers and individuals who willfully failed to withhold and pay employment taxes to the agency.
Worker Classification
Because employers are required to pay employment taxes only on wages paid to employees, some attempt to circumvent the employment tax laws through improperly characterizing their workers as independent contractors. Unlike employees, independent contractors must pay their own taxes under the Self-Employed Contributions Act (SECA).
Recognizing this incentive, the IRS carefully scrutinizes worker classifications. If the agency disagrees with the classification of a worker, it can seek unpaid employment taxes and penalties against the taxpayer for prior years.
Employment Tax Defenses
There are numerous defenses and options available to taxpayers involved in an employment tax audit. These are discussed more fully below. However, a word of caution is necessary. Taxpayers who have criminal risks associated with their employment tax failures should immediately consult with a tax professional prior to using any of the strategies below. Circumstances that may lead to a criminal referral include repeated failures to pay employment taxes even after warnings from the IRS, paying workers in cash, and pyramiding, to name a few.
Non-Reporting And Non-Payment
Generally, the strategy for non-reporting and non-payment cases relates to regaining compliance, fighting the penalties, and entering into a collection alternative to the extent the employer cannot full pay. Regaining compliance means preparing and filing all necessary employment tax returns for prior years and continuing to file these returns and making proper payments moving forward.
After the prior year returns have been filed, the taxpayer can focus on payment options. Initially, the employer should try to pay all or a portion of the outstanding trust fund balances owed on the employment tax returns. Full payment of the trust fund portion eliminates any risks associated with a trust fund recovery penalty. If doable, the employer should take care to ensure that payments are designed properly. The failure to properly designate a payment can result in the IRS applying it in its best interests, which usually means it will not go to the trust fund portion.
Employers should also address any potential penalties by determining whether they have viable reasonable cause defenses. To show reasonable cause, the employer must demonstrate that it acted with ordinary business care and prudence but was nevertheless unable to comply with the reporting or payment obligation. In many employment tax penalty disputes, the IRS raises infirmities in the employer’s internal controls as a reason to deny reasonable cause. Therefore, employers should be ready to explain why their internal controls were sufficient and reasonable under the circumstances. A successful reasonable cause argument can substantially reduce the penalties, giving the employer a better shot at paying any remaining tax balances.
Finally, if the employer agrees with the amounts of tax owed but cannot make full payment, it should consider collection alternatives. These include an installment agreement, offer in compromise, and currently not collectible status. Employers should be aware that they may face additional hurdles in having a collection alternative accepted if the trust fund portion of the outstanding employment taxes have not been paid (another reason to full pay the trust fund portion, if possible).
Worker Classification
Before discussing defenses and options applicable to worker classification disputes, it is important to note that the IRS has programs in place to avoid these disputes altogether. For example, the Voluntary Classification Settlement Program (VCSP) allows employers to unilaterally recharacterize their independent contractors as employees on a prospective basis. The VCSP offers favorable terms for doing so, provided the employer voluntarily enters into the program prior to the initiation of an IRS employment tax audit.
If the taxpayer is already involved in an employment tax audit, it should raise “section 530 relief” early to potentially avoid penalties and additional employment tax assessments (although IRS guidance suggests that the agent must explore relief even if not raised). If the taxpayer qualifies for section 530 relief, it can avoid additional employment taxes and penalties that would otherwise occur due to an adverse classification determination.
In addition to section 530 relief, taxpayers should be mindful that they can challenge the agency’s determination of worker classification. Accordingly, these taxpayers should consult applicable IRS guidance associated with the factors the IRS will analyze in making the worker classification determination. Some of these factors can be found here. Taxpayers who lose at the administrative level can also challenge the determination in U.S. Tax Court.
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