Upon hearing the word “audit,” most people automatically think of an examination of 1040 tax returns. While these IRS investigations inspire a certain amount of fear, they are somewhat familiar and relatively straightforward. Payroll tax audits, however, are less well-known and may be a complete mystery to business owners when they first discover they’ll be going through the process.
As they soon learn, these audits are often more complex than income tax audits. Besides the multiple employees, tax rates, and paychecks to review, there’s the time factor: an error in one year can impact multiple tax years, making resolution of the problem a complicated task indeed.
The audit includes an examination of forms W2, 941, 940, 1099, 1096 and specific general ledger accounts to determine hours worked and taxes withheld for each employee. Did the company withhold the correct amount of FICA and income tax, and were these funds deposited to the proper accounts in a timely manner? Were contractors correctly classified, or should they have been treated as employees instead? What about annual filing responsibilities – did you submit all required 1099s and W-2s, and are they correct?
If the IRS identifies a problem, that’s when things get really complicated. Here are some of the most common questions that arise:
- Which years will be affected by the change? If the IRS discovers an error during an audit of a prior tax year, say 2016, how does that impact what you owed in 2017 and 2018 to date? In some cases, the IRS will simply request payment for the 2016 mistake and let 2017 stand, with the expectation that you adhere to the code correctly in 2018 and future years. If they believe the error was intentional, they’re more likely to involve subsequent years as well.
- How does the IRS calculate the tax you owe? Figuring out what you owe can be extremely difficult. Each payroll tax audit is evaluated on a case by case basis where situational details are taken into account. For example, an employee originally set up incorrectly and consistently treated in the wrong employment capacity will likely be assessed differently than one who was switched between a W2 and 1099 mid-employment for an unwarranted reason. In addition to any unpaid taxes, the IRS may assess penalties and interest that can significantly increase the amount you owe. Adjustments to FICA taxes are assessed in a range from 1.74%-12.4% and adjustments to federal taxes are assessed in a range from 1.5%-25%.
- Do you qualify for relief? Section 530 is a safe harbor provision under the tax code that may allow you to escape past taxes, penalties, and interest if you misclassified employees as contractors. This relief is available only in cases where the employer can prove a good faith effort to comply with the law, indicating that the mistake was genuinely unintentional. To qualify, you must show your mistake was both reasonable and consistent across the company, and that your tax reporting was also consistent.
- How does the change affect employees? What are an employee’s responsibilities after a payroll tax audit has resulted in a change to their status? While employees are not required to file an amended tax return for the relevant year or years, they may choose to do so. It may be beneficial to retroactively change their status and file an amended return in situations where the difference results in a larger refund or affects other financial matters, such as financial aid for a college-age dependent. Those who were treated incorrectly as a contractor also have some recourse regarding social security and Medicare taxes that should have been paid by the employer. Use Form 8919 and its instructions to get that process started.
It’s never simple to resolve issues like these, nor is it good news for business owners when the IRS finds a mistake through a payroll tax audit. Once you are aware of a problem, being proactive with researching Section 530 and gathering the needed evidence for your particular situation is your best bet, and will show that you are doing your part to reach a resolution. One bright spot is that the agency will negotiate the amount due, in some cases, so if that first figure strikes fear into your heart it’s worth trying to discuss a more workable number.
Also worth mentioning: under the new tax reform act (TCJA), salaries come into play for the 20% qualified business income deduction while contractor pay does not.
If you’re unsure on anything related to payroll or employees, always contact a qualified tax professional to get the answers you need. It’s well worth the effort to handle payroll taxes, employee classification, and annual filings correctly to begin with, avoiding unpleasant surprises in an audit.