Transcript Audit Pitfalls - California Payroll Conference

IRS Audit Pitfalls
Matthew Pover
Deloitte Tax LLP
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Agenda
• Setting the Stage for an IRS Examination
• Federal Issues
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Non-Cash Items-fringe benefits
Worker Classification
Payroll Tax Deposit Timing & Rate
Severance FICA Refunds – Quality Stores
DOMA
• State Issues
– Worker Classification
– CA’s position for UI on Expats
– Mobile Workforce Taxation
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Fringe benefits
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Fringe Benefits
• There was an update regarding company-provided mobile
devices in IRS Notice 2011-72
– De minimis personal use is non taxable if there are business reasons for
providing the device
– Examples cite to after-hours client/supervisor calls
– Taxable if providing device for goodwill of the employee or recruiting tool
• Reimbursement of personal service does not have the same
outcome, although IRS may be evolving here
– Business use is Ok to reimburse; guidance says expectation is not 100%
of total bill
• Consider taxable allowance as non-threatening HR position
and minimal expense burden
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Fringe Benefits
These taxable items are of IRS concern:
Awards and prizes
Award trips
Sports Tickets
Company cafeteria
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• Gift cards
• Tablets, raffle prizes
• “President’s Club, Diamond Club,
Century Club”
• Spousal accompaniment
• Occasional tickets are considered di
minimis
• Subsidy is OK; free is not
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Fringe Benefits
These taxable items are of IRS concern:
Wellness programs
Relocation
Company cars
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• Subsidized gym dues are taxable
• House hunting trips are taxable
• Commuting is taxable, even if done via
flight
• Personal use
• Gas cards
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Worker Classification
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Worker Classification
• Employers must withhold income taxes, withhold and pay
Social Security and Medicare taxes, and pay unemployment
tax on wages paid to an employee
• Employers do not generally have to withhold or pay any taxes
on payments to independent contractors
• Reclassification by the IRS could result in an assessment
against the business for back taxes, substantial penalties, and
interest
• Employers generally have the burden of proof in disputes
with the IRS
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Worker Classification
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Former employees cannot usually be a contractor
Form 1099 & Form W-2
Form 1099 — Multiple years
Industry focus
No perpetual contracts
Leads
– IRS internal database
– Contractor originated compliant
– State info sharing
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Worker Classification
Common misconceptions of worker classification:
• Project workers are not employees
• Temporary workers are not employees
• Former executives returning as “consultants” are
independent contractors
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Worker Classification
Why is worker classification important?
Increased audit focus
• IRS Employment Tax Research Study (began Feb 2010)
• The IRS has entered into data sharing agreements with various state
agencies and the Department of Labor to increase its compliance
efforts around worker misclassification
• California, New York, and Massachusetts have begun to provide
referrals to the IRS regarding worker misclassification cases
New Voluntary Classification Settlement Program (VCSP) launched
• Great opportunity to resolve past worker classification issues at a
reduced cost by voluntarily reclassifying workers
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Worker Classification
Worker
Payor’s withholding obligations
Independent contractors
None
Common law employees
Federal income tax, Social Security,
Medicare, and state tax (if any)
Statutory employees*
Social Security and Medicare
Statutory nonemployees**
None
*Statutory employees
• Independent contractors under the common law rules, but may nevertheless be treated as employees
by statute for FICA purposes
• Who are they? Full-time traveling or city salespersons, full-time life insurance agents, agent-drivers
engaged in distributing certain food, home workers performing work on material or goods furnished by
the employer
**Statutory Nonemployees
• Treated as self-employed for all Federal tax purposes, including income and employment taxes
• Who are they? Direct sellers and licensed real estate agents
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Worker Classification
FIT definition of employee
• An “employee” is any individual who performs services for
another if the relationship between the worker and the
person for whom he is performing such service has the
legal relationship of employer and employee
• An “employer-employee” relationship exists if the person
for whom the services are performed has the right to
control and direct the individual performing the services
• However, if the individual is only subject to the direction
and control of another as to the result of the work and not
as to the means and methods for accomplishing that result,
then the individual may possibly be characterized as an
independent contractor
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Worker Classification
FICA, FUTA definition of employee
The definition of an “employee” includes four groups of workers:
• Officers of a corporation
• Individuals satisfying the common law definition of employee
• Statutory employees
• Any individual performing services included in an agreement
entered into pursuant to Section 218 of the Social Security Act
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Worker Classification
Rev. Rul. 87-41 — Twenty common law factors
1.
Instructions
11. Oral, written report
2.
Training
12. Hour, week, month pay
3.
Integration
13. Business expense pay
4.
Personal services
14. Furnish tools and materials
5.
Hire, pay assistants
15. Significant investment
6.
Continuing relations
16. Realize profit, loss
7.
Set work hours
17. More than one employer
8.
Full time required
18. Services available to public
9.
Employer’s premises
19. Right to discharge
10. Order, sequence set
20. Right to terminate
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Worker Classification
IRS audit manual on worker classification
• Created 3 categories of evidence:
– Behavioral control
– Financial control
– Relationship of the parties
• IRS Focus:
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Profit/Loss motive
Whether similar services are performed for others
Whether services are required full time
Whether the worker receives benefits, training
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Worker Classification
State unemployment ABC test
• Many states adopt the “ABC test” for state unemployment
tax purposes.
A. Is the worker free from control and direction in the performance of
the work
B. Are the services outside the usual course of the business for which
such service is performed
C. Is the worker engaged in an independently established trade,
occupation, profession, or business
• The ABC test is considered much more inclusive than the
IRS test
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“Section 530 Relief”
• Section 530 of the Revenue Act of 1978
• If the business misclassified an employee as an
independent contractor but:
– Filed Form 1099 MISC,
– Did not treat the worker or any similar worker as an employee after
1978, and
– Has a reasonable basis
• Then the business may continue to treat the employee as
an independent contractor
– Retroactively and prospectively
– Employment tax purposes only
– Benefit plans have been drafted to exclude these workers
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“Section 530 Relief” (cont.)
• Reasonable basis:
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Judicial precedent
Past IRS audit
Industry practice
Other reasonable basis
• Not available to businesses that provide the following
categories of workers to clients:
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Engineer
Designer
Drafter
Computer programmer
Systems analyst
Similarly skilled workers
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Paying for misclassification
• § 3509 applies where Section 530 Relief is not available and gives
reduced rates for income tax withholding and the employee's share of
FICA
• If failed to deduct and withhold any tax with respect to any employee by
reason of misclassification, the amount of the employer’s liability for:
– FIT will be equal to 1.5% of wages paid to such employee; and
– The employee portion of FICA will be determined as if the taxes imposed
were 20% of the amount that should have been withheld.
– The employer portion must also be paid, as well as FUTA and State
Unemployment taxes
– Amounts are double if no reporting has occurred
• Courts have ruled that reclassified individuals are eligible for employee
benefits, such as stock options, deferred compensation and health
coverage
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Classification settlement program
• Available only to businesses facing an IRS audit
• Procedure for CSP
– If entitled to section 530 relief, then no assessment
– If not entitled, then auditors determine eligibility for CSP settlement offers
(auditors generally take their cases to IRS Appeals at this stage)
• Eligibility for CSP
– If the business meets the section 530 reporting consistency but clearly does
not meet either substantive consistency or reasonable basis test, then the
CSP offer will be a full employment tax assessment for the one taxable year
under examination computed using section 3509.
– If the business meets the section 530 reporting consistency, but has a
colorable argument that it meets the substantive consistency requirement and
the reasonable basis test, the offer will be an assessment of 25 percent of the
employment tax liability for the audit year computed using section 3509
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CSP analysis chart
1099 timely field?
Substantive consistency or
reasonable basis met?
No
N/A
None; all open years
will be examined
Yes
No
1 Yr Tax
Yes
Maybe
25% Tax
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Type of CSP offer
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Voluntary worker classification settlement
program
• A new IRS program that allows employers to resolve past
worker classification issues at a reduced cost by voluntarily
reclassifying their workers
• Available to businesses, tax-exempt organizations and
government entities that currently erroneously treat their
workers as independent contractors, and would like to
correctly treat them as employees in the future
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Eligibility for Voluntary Program
• To be eligible, an applicant must:
i.
ii.
iii.
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Consistently have treated the workers in the past as nonemployees
Have filed all required Forms 1099 for the workers for the previous
three years
Not currently be under audit by the IRS, and not currently be under
audit by the DOL or a state agency concerning the classification of
these workers
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VCSP agreements
• Reduced cost
– Just over one percent of the wages paid to the reclassified workers for
the past year (10% of the employment tax liability determined under
the reduced rates of section 3509(a)),
• No interest or penalties
• No audit on payroll taxes related to these workers for prior
years
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How to apply?
• File Form 8952, Application for Voluntary Classification
Settlement Program, at least 60 days before beginning
treating the workers as employees.
• Special 6-year statute of limitation
– For the three years beginning after the date the taxpayer has agreed
under the VCSP closing agreement
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Other issues
• Reclassification may raise many issues beyond the
increased liability for federal employment taxes
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Minimum wage rules
overtime pay
workman’s compensation
employee benefit plans
insurance policies
employment discrimination
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Tax rate comparison
E.g. Tax Year 2010
3509(a) Rate
3509 (b) Rate
ER Share of FICA
7.65%
7.65%
EE Share of FICA
1.53% (20% of 7.65%) 3.06% (40% of 7.65%)
Total FICA
9.18%
10.71%
ITW
1.50%
3.00%
Total
10.68%
13.71%
Tax Rate
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No Relief
Section
CSP 1 YR CSP 25%
530 Relief
VCSP 10%
13.71% +
Penalties
and
interest
N/A
1.07%
10.68%
2.67%
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Procedures for proper classification
• Evaluation process
– Review contractors by applying either the ABC or 20 Factor test
• Required documentation
– Maintain sufficient documentation to substantiate relationship
– W-9, business cards, advertisements, invoices, web page
• Written contract
– Preferable drafted by the vendor
• Common misconceptions
– Project workers are not employees
– Temporary workers are not employees
– Former executives returning as “consultants” are independent
contractors
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Payroll Tax Deposit Timing
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What is the payroll deposit date?
• Typically, the date the compensation becomes taxable, will trigger the
employment tax liability. The deposit date for that liability, will be based
on the employer’s payroll deposit filing status.
– Monthly deposit schedule — deposit due by the 15th day of the following
month.
– Semi-weekly deposit schedule
• If the payday falls on a Wednesday, Thursday, and/or Friday, then deposit taxes
by the following Wednesday.
• If the payday falls on a Saturday, Sunday, Monday and/or Tuesday, then deposit
taxes by the following Friday
– Deposits are due on business days, if a due date falls on a Saturday,
Sunday, or legal holiday, the deposit is considered timely if it is made on the
following business day.
– There is a next day deposit requirement once the accrued payroll tax liability
exceeds $100,000 (“one day deposit rule”)
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Typical liability dates
NQSOs:
SARs:
RS:
RSUs:
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• Exercise date (T+3)
• Exercise date
• Vesting date (or transfer date
if 83(b) election is made)
• Vesting for FICA and stock
delivery for FIT
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Field audit memorandum
• On March 14, 2003, a Memorandum was issued by the IRS to audit examiners
to provide guidelines surrounding assessment of employment tax penalties for
NQSOs.
– “It has been argued that the shares (or the value of the shares) are not available to
the exerciser of the options until settlement date, and therefore no actual or
constructive payment of wages takes place until that time.
– There is generally only a three day delay between time of exercise and time of
settlement resulting from such exercise. In fact, under 17 C.F.R. Sec. 240.15c6-1(a),
the SEC generally established a maximum three day settlement period for brokerdealer trades. There is presently no specific published guidance relative to whether
the date of exercise or date of settlement is the appropriate date for considering
assertion of the penalty for failure to deposit employment taxes attributable to the
exercise of nonqualified stock options.”
• Under this Field Directive, auditors “should not challenge the timeliness of
deposits required under Treas. Reg. § 31.6302-1(c), if such deposits are made
within one day of the settlement date, as long as such settlement date does not
fall more than three days from date of exercise.”
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Penalties
• Underpayment penalty
– 2% — One to five days late;
– 5% — Six to 15 days late; and
– 10% for more that 16 days late
• Weekends and holidays are included
when calculating penalties
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Penalties
• The IRS uses a First In First Out system to assign deposits, and will attribute
a deposit to the most recent tax liability, even if a deposit was missed and the
deposit actually relates to a later-dated liability. Unfortunately, this can cause a
cascading penalty.
• Taxpayers can designate to which tax period they want a specific deposit
applied within 90-days of receipt of a notice of penalty.
• The IRS does allow a “safe-harbor” shortfall if the shortfall is no more then the
greater of $100 or 2% of the amount due, so long as the original deposit is
made timely, and the shortfall is made up by the ‘make-up date.’
– Example: A is required to make a deposit of $1,000 on June 15 and is a semiweekly depositor. A makes a deposit of $900 on June 15 and would be required to
make the additional $100 deposit by the first Wednesday or Friday occurring on our
after July 15th. Because the shortfall is $100 and they have made up the deposit by
the make-up date, no penalties are assessed.
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Withholding for executives and exempts
• Executives
– 39.6% supplemental withholding applies once the individual
exceeds $1M in supplemental wages for the year
– W-4 withholding is not available for supplemental wages at
that point
• Exempts
– It is possible for an employee to submit a W-4 claiming
exemption from income tax withholding
– Must be renewed each calendar year
– Does not suppress FICA
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U.S. Domestic business
travelers
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U.S. Domestic business travelers
What are the concerns with domestic travel?
• Many states have not established a
de minimus reporting threshold,
which creates administrative
challenges to achieving full
compliance.
• Many states define the employer
withholding obligations as an
approximation of what the employee
is anticipated to owe in taxes.
• Standard deductions and/or personal
exemptions may provide a de
minimus limit for determining when a
tax filing obligation arises.
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U.S. Domestic business travelers (cont.)
California
Connecticut
No De Minimis
threshold
Very aggressive regarding non-resident wage withholding
and tax remittances
Illinois
December 2, 2009 CT issued Announcement 2009(9)
requiring employer wage reporting and tax withholding for
non-residents working 14 or more days in CT throughout
the year
New York
No De Minimis threshold
Has quite ‘favorable’ non-resident guidelines — Especially
if firm is not located anywhere in IL
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De Minimis threshold
14 days
De Minimis threshold
14 days
Uses an informal calendar year de minimis threshold for
state tax withholding for a non-resident working in New
York as reported in its state Field Audit Guidelines issued
July 1, 2004 and TSB-M-12(5)I issued on July 5, 2012
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U.S. Domestic Travelers: Suggested Employer
Practices
Withholding for active employees should be in location(s)
where work is or was performed (because the Company likely
has nexus there).
• Even if this is a temporary work location.
• Even if it’s a jurisdiction in which the employee is a nonresident.
• Even if it requires looking back to prior periods for sourcing
(bonus/equity)
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U.S. Domestic Travelers: Suggested Employer
Practices
Assuming the Company has nexus there, withholding for
active employees should be in location(s) where employee is
a resident:
• If there is no tax assessed in the actual work state.
• If there’s a higher tax rate assessed in the residence state
than in the work state, then often the difference in work
state and residence state should be withheld in the
residence state.
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U.S. Domestic Travelers: Suggested Employer
Practices
Find an owner of the process
• Tax or Finance are the likely candidates
Bring relevant team members
• Tax, Payroll, Stock Admin, Legal
Don’t limit the analysis to payroll
• Nexus: Corporate income, sales, and use taxes
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U.S. Domestic Travelers: Suggested Refinements
for 2014
Find travelers
• Trip reports from corporate travel desk
• Accounts payable expense reports
• Administrative assistant calendars
• Hint: Start at top of executive hierarchy and work down
from there; include sales teams
• Watch “move-ins” and “move-outs”
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U.S. Domestic Travelers: Suggested
Refinements for 2014
Analyze Exposure: Consider elements
• All compensation (cash, equity, taxable fringe, etc.)
• Estimate state penalty of 10% for failure to withhold
Permanent v. Temporary Transfer
• Taxable living expenses if paid for permanent or long-term
assignment
Gross-Up/Tax Preparation Assistance
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Other federal issues
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DOMA impact: Rev. Rul. 2013-17
• IRS clarified that for federal purposes, a same-sex
marriage valid in a U.S. state, District of Columbia, U.S.
territory, or a foreign country will be recognized for U.S.
federal tax purposes.
• Applies regardless of current state of residence.
• Applies to all federal tax provisions where marriage is a
factor.
• Amended tax returns may be filed for open statute of
limitations year(s)—generally 2010 and later.
• 2010 statutes expired on April 15, 2014
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DOMA impact: Notice 2013-61 - Prior Year
Refund
• File Form 941-X for the 4thQ of each open year
• Write “WINDSOR” on the top of Page 1
• Correct applicable Social Security and Medicare wages/tax
• No refund of FIT
• W-2c’s are required
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Severance is subject to FICA Supreme Court decided in favor of IRS
• Severance is subject to FICA
• Supplemental unemployment benefit (SUB) plans can be
exempt from FICA, but they are distinguishable from
severance.
• Continue to withhold FICA on severance payments.
• No action item on previously filed refund claims.
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Contact information
Matthew Pover
Manager
Deloitte Tax LLP
+1 415.783.4455
[email protected]
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This presentation contains general information only and Deloitte is not, by means
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decision or action that may affect your business. Before making any decision or
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any person who relies on this presentation.
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