Comprehensive Employment Tax
Examinations Are Here – Are You
Prepared?
April 12, 2010
Adam Cohen
Catherine Wilkinson
Moderator: Mark Silbiger
Overview


Summary of employment tax
national research project
Key issues




Worker classification
Fringe benefits
Employee reimbursements
Executive compensation
2
Overview




Managing an employment tax audit
Legislative update
Severance and FICA – Quality
Stores
Q&A
3
Summary of Employment Tax NRP

Background on the NRP





August 2009 GAO report
First comprehensive employment tax
study since 1984
Coincides with other Administration
efforts relating to worker classification
Attempt to measure tax gap caused by
worker classification issues – as much
as $50bn
Goal is to gather data, not raise
revenue
4
Summary of Employment Tax NRP

Scope of the NRP



Focus on worker classification, fringe
benefits, executive compensation,
employment tax reporting/deposits
Three years
6000 employers, including
approximately:
2000 total per year
 Reportedly, 500 EOs per year
 Reportedly, 30-50 of 500 EOs may be
government


Trained approximately 200 agents
5
Summary of Employment Tax NRP

Selection for NRP




Random selection, all types of
organizations
Reportedly includes 20% large
companies
3850-B letters expected to be sent in
March
If under CAP, not subject to NRP
6
Summary of Employment Tax NRP

Audit process




Focus on 941, but also corporate
returns and executive 1040s
Use of checksheets
Likely less flexibility over scope and
materiality for agents
Potential use of other IRS information
sources (e.g., SS-8’s)
7
Summary of Employment Tax NRP

Years covered


Start with 2008
If find issues, may go back to 2007,
forward to 2009
8
Key Issues – Worker Classification


Issue: Whether workers are properly
classified as employees or independent
contractors
Topics:
 Common Law Test
 Frequent Issues
 Non-tax Consequences of
Misclassification
 Tax Consequences of Misclassification
 Section 530 relief
9
Key Issues – Worker Classification

Common Law Test: All of the facts and
circumstances indicating the degree of
control and independence must be
considered. No one fact is determinative.

The D.C. Circuit refined the common law test
as follows:
 “[W]hile all the considerations at common law
remain in play, an important animating
principle by which to evaluate those factors in
cases where some factors cut one way and
some the other is whether the position
presents the opportunities and risks inherent
in entrepreneurialism.”
FedEx Home Delivery, Inc. v. National Labor
Relations Board, No. 07-1391 (D.C. Cir. Apr.
21, 2009) (emphasis added).
10
Key Issues – Worker Classification

IRS Analysis


Revenue Ruling 87-41 provides twenty
factors for determining a worker’s
proper employment classification.
The IRS has refined the twenty factors
to three categories:
 Behavioral Control
 Financial Control
 Type of Relationship
11
Key Issues – Worker Classification

Behavioral Control: Does the company
control, or have the right to control, what
the worker does and how the worker does
his or her work?

Factors:
 Does the business provide the worker with
instructions about when, where and how to do
work?
 Does the business provide the worker with
greatly detailed instructions?
 Does the business evaluate the worker on his
or her work performance or on the end result?
 Does the business provide the worker with
training on how to do the job?
12
Key Issues – Worker Classification

Financial Control: Are the business
aspects of the worker’s job controlled by
the business?

Factors:
 Does the worker have a significant investment
in the equipment used for the job?
 Does the worker have unreimbursed expenses
related to the job?
 Does the worker have the opportunity to
make a profit or loss with respect to the job?
 Is the worker generally free to seek out other
business opportunities in the relevant market?
 Is the worker guaranteed a regular, periodic
wage?
13
Key Issues – Worker Classification

Type of Relationship: How do the
worker and the business perceive
their relationship?

Factors:
Is there a written employment contract?
 Does the business grant the worker
employee benefits, such as insurance,
pension plans, paid vacations, sick days,
and disability insurance?
 Is the relationship expected to continue
indefinitely?
 Is the worker providing services that are
key aspects of the business?

14
Key Issues – Worker Classification

Frequent Issues



Executives rehired as consultants
Dual status employees
Employee leasing arrangements
15
Key Issues – Worker Classification

Non-tax Consequences of
Misclassification



Claims for entitlement to employee
benefits
Workers’ compensation and
unemployment liabilities
Subject to claims for violating state and
federal labor laws
16
Key Issues – Worker Classification

Tax Consequences of
Misclassification

If a business has no reasonable basis
for treating an employee as an
independent contractor, the business
may be held liable for back taxes and
penalties.
17
Key Issues – Worker Classification

Penalties if a 1099 was filed for an
improperly classified worker




100% of FICA employer should have
paid
20% of FICA employees should have
paid
1.5% of all wages paid misclassified
workers
100% of FUTA that should have been
paid
18
Key Issues – Worker Classification

Penalties if a 1099 was not filed for
an improperly classified worker and
no employment taxes were withheld




100% of FICA employer should have
paid
40% of FICA employee should have
paid
3% of all wages paid the misclassified
worker
100% of FUTA that should have been
paid
19
Key Issues – Worker Classification

Penalties for intentional disregard,
assessed when the business and
those associated with the business
“knew or should have known” the
proper classification of the worker




100% of FICA that should have paid
100% of FICA employees should have
paid
20% of all wages paid to the worker
100% of FUTA that should have been
paid
20
Key Issues – Worker Classification

Relief from Paying Employment Taxes for
Misclassified Employees: Section 530
Relief

A business that misclassifies a worker may not
owe employment taxes if it meets the following
three requirements of Section 530 of the 1978
Revenue Act:
 Reasonable Basis: The business reasonably
relied on judicial precedent, IRS rulings, a
past IRS audit, or a long-standing practice in
the relevant industry.
 Substantive Consistency: The business
consistently treated the worker, and similar
workers, as independent contractors.
 Reporting Consistency: The business filed all
required federal tax returns consistent with
the business’ treatment of the worker as an
21
independent contractor.
Key Issues – Worker Classification

Relief from Paying Employment Taxes for
Misclassified Employees: Classification
Settlement Program (CSP)



The CSP provides a standard settlement agreement
for instances in which the examiners determine that
certain workers are misclassified. The amount of
relief provided under the CSP depends on the
strength of the business' Section 530 argument.
In most cases, if a business has met the Section
530 reporting requirements and agrees to begin
treating the workers in question as employees
prospectively, a tax assessment is made for only
one year (rather than for all years of the
examination) based on the rates in IRC Section
3509.
If a business meets the Section 530 reporting
requirements and has a colorable argument that it
meets the other requirements of Section 530, the
tax will be reduced to 25%.
22
Key Issues – Fringe Benefits



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
Legal framework
Working condition –
travel/entertainment, cars, cell
phones, dues
De minimis – gifts, tickets, cafeteria
No additional cost
Other exclusions – parking, discount
Taxable fringes
Withholding on taxable fringes
23
Key Issues – Fringe Benefits

Legal framework



All fringes taxable at FMV under
Section 61 unless an exception applies
Exceptions are codified in Section 132
Key issues will be:
Are the requirements for exclusion under
Section 132 satisfied
 If taxable fringe, is the right value
assigned

24
Key Issues – Fringe Benefits

Section 132(a)(3) – Working condition
fringe

Must be an item that the employee could have
deducted
Fringe Taxable
Nontaxable
Travel
Business trip to a
different city
Commuting
Lodging Hotel in home city
Hotel in travel city
Meals
Meals on overnight
travel
Regularly provided
meals (not for
“employer
convenience”)
25
Key Issues – Fringe Benefits

Working condition fringe - company
car




Business use is non-taxable
Incidental personal use does not result
in tax, but narrow definition
Commuting is taxable
Several valuation rules available
26
Key Issues – Fringe Benefits

Other working condition fringes



Cell phone as working condition fringe
– Notice 2009-46 and subsequent IRS
statements
Outplacement is generally a nontaxable
working condition fringe
Professional dues are nontaxable
working condition fringes (but not club
dues even if occasional business use)
27
Key Issues – Fringe Benefits

Section 132(a)(4) - de minimis



No fixed dollar amount (various
amounts reflected in unpublished
rulings)
Value must be so small that accounting
is (i) impractical or (ii) unreasonable
Frequency is also relevant; more
frequent = less likely de minimis
28
Key Issues – Fringe Benefits

De minimis fringes

Regs list certain fringes as de minimis
Traditional holiday gifts
 Occasional event tickets
 Copy machine usage
 Occasional late night taxi and meals


Gift cards and cash reimbursements –
never de minimis
29
Key Issues – Fringe Benefits

De minimis fringes - qualified
company cafeteria




Revenue must equal or exceed direct
operating costs
Must be on or near employer premises
Must be operated by employer (or
contract with catering service)
Certain nondiscrimination requirements
apply
30
Key Issues – Fringe Benefits

Section 132(a)(1) - No additional
cost



Employer must not incur substantial
additional cost – including lost revenue
and cost of labor
Cannot take into account employee
payment of costs
Must be in employer’s line of business
31
Key Issues – Fringe Benefits

Other statutory or regulatory exclusions






Qualified transportation
Qualified parking
Employee discount
Qualified moving expenses
Section 74 employee achievement award
Taxable fringes – e.g., club dues



Valuation is a key issue
FMV, not value to employee
Employer cost generally not determinative
32
Key Issues – Fringe Benefits

Withholding on taxable fringes




Must withhold on other cash
compensation, even though the fringe
is non-cash
Under Ann. 85-113, can deem paid on
any day during calendar year or spread
throughout calendar year
When collect, must deposit promptly
Withhold at regular rates or
supplemental wage rate
33
Key Issues - Reimbursements


Generally, reimbursements of
business expenses are taxable and
subject to withholding
Reimbursements under an
“accountable plan” are not
taxable/subject to withholding
34
Key Issues - Reimbursements

Accountable plan requirements



Business connection and reasonable
expense
Reasonable accounting (unless below
federal per diem)
Excess reimbursements are repaid
35
Key Issues - Reimbursements

Potential issues



Reasonableness of expenses
Failure to repay excess advances
Adequate accounting
36
Key Issues – Executive Compensation








Corporate aircraft
Spouse travel
Security purpose – car and driver,
corporate aircraft
Common executive fringes
Loans
3121(v) – FICA timing
Section 162(m)
Section 409A/457A/457(f)
37
Key Issues – Executive Compensation

Corporate Aircraft

Taxable v. nontaxable
Key is whether the trip is primarily for
business or primarily personal
 Mixed purpose trips and multi-leg trips
present particular challenges

38
Key Issues – Executive Compensation

Corporate Aircraft

Valuation
FMV - charter cost
 SIFL value
 Special SIFL rules


Special situations
Spouses/guests
 Use for outside Board meetings
 50% occupied seat rule

39
Key Issues – Executive Compensation

Spousal travel


Spouse attendance may appear to be
business related, for example attending
conferences, client dinners, etc.
However, generally taxable unless
satisfy strict business purpose standard
40
Key Issues – Executive Compensation

Security exception for car and
driver, corporate aircraft



Lower SIFL rates, value of driver not
taxable
Requires comprehensive security OR
security study advising lesser security
measures
Driver training
41
Key Issues – Executive Compensation

Other common taxable fringes




Club dues
Financial planning
Tax advice
Annual physicals (though may be
excluded depending on facts)
42
Key Issues – Executive Compensation

Loans




Below market loans generally produce
taxable income equal to the interest
not charged
Exception for loans below $10,000
Loans that are forgiven by service or
paid with guaranteed bonuses equal to
loan installments may instead be
treated as up-front taxable income
For public companies, loans to officers
are not common due to SOX issues
43
Key Issues – Executive Compensation

Section 3121(v) – FICA timing



Generally, deferred compensation is
subject to FICA when no longer subject
to substantial risk of forfeiture, even
though not otherwise taxable until later
Exception for severance, not applicable
to restricted stock
Often an issue for traditional deferred
compensation, but also RSUs, SERPs,
etc.
44
Key Issues – Executive Compensation

Section 162(m)


For public company, $1MM
compensation deduction limit for CEO
and top 3 (other than CFO)
Very significant exception for
“performance-based compensation”
45
Key Issues – Executive Compensation

Section 162(m)

Most issues involve failing to comply
with performance-based compensation
rules
Stock plan approval and re-approval
 Performance goal establishment and
adjustments
 Outside director issues
 Target payment on involuntary
termination/retirement

46
Key Issues – Executive Compensation

Common Section 409A compliance
issues




Separation from service
Employment agreements
Severance pay
RSUs and other phantom equity
47
Key Issues – Executive Compensation

Section 457A



Targeted at offshore hedge fund
deferred compensation
Statutory language is actually much
broader
E.g., multinational expat with RSUs in
Hong Kong or Switzerland
48
Key Issues – Executive Compensation

Section 457(f)



Applies to deferred compensation of
tax-exempts and government entities
Substantial risk of forfeiture is common
issue
Potential regulatory changes
49
Key Issues – Executive Compensation


Audit will likely include request for
executives’ Form 1040s
Purpose is generally to ensure
matching employer and executive
reporting
50
Key Issues – Other




S-Corp compensation practices
TIN solicitation
Back-up withholding
Timeliness of deposit of withholding
on equity compensation
51
Managing the Examination




Conduct an internal “mock” audit
Review current practices – worker
classification, and tax treatment and
reporting for fringe benefits, executive
compensation and expense
reimbursements
Clean-up worker classifications
Review mitigation strategies, including



Section 530 Relief
Classification Settlement Program
Special mitigating tax rate
Early referral to Appeals
52
Managing the Examination

Taxpayer’s Goals





Limit scope of the examination – likely
not possible if selected for NRP
Facilitate expedited conclusion of the
examination
Document what the auditor has
reviewed
Develop and maintain a professional
rapport
However . . . limit verbal and
written responses to what was
requested
53
Managing the Examination

Initial meeting






Discuss scope of audit and initial IDR
Request that all future requests for records be
in writing and establish procedure for handling
requests
Identify the contact for the auditor – if outside
counsel, Power of Attorney will be required
Determine any special office needs – do not
provide access to copier!!
Locate auditor away from major centers of
employee activity
Make certain employees are aware of IRS
presence
54
Managing the Examination

Document preparation




Assemble requested files and records in
well-organized manner
Review all requested documents to spot
any potential issues
Remove all attorney-client privileged
documents or attorney work product
Keep a log of all documents reviewed
by auditor and any copies provided to
the auditor
55
Legislative Update

Topics






162(m)(3)
Limitation of Section 530 Relief
Worker Classification Initiatives
Fringe Benefit Initiatives
Corporate Information Reporting
Initiative
Payroll Tax Initiative
56
Legislative Update

162(m)(3)

Currently the IRS interprets “covered employee” as
any employee of the taxpayer if, as of the close of
the taxable year, such employee is


The principal executive officer, or an individual
acting in such a capacity, or
One of the three highest compensated officers for
the taxable year, other than the principal executive
officer or the principal financial officer, who is
required to be reported to shareholders under the
Exchange Act.
See Notice 2007-49.
The compensation limits of § 162(m) do not apply if
the compensation is performance-based
compensation that satisfies certain requirements.
57
Legislative Update

162(m)(3) Proposals

Eliminate the exception for the Chief
Financial Officer
Once a covered employee, always a
covered employee
58
Legislative Update

Limitation of Section 530 Relief

The Taxpayer Responsibility, Accountability,
and Consistency Act of 2009 (H.R. 3408,
7/30/09)
 Generally to qualify for relief, a business
would have to demonstrate Reasonable
Reliance and Substantive Consistency.
 The Act redefines “Reasonable Reliance” as
only reliance on a written determination or a
concluded examination.
 The Act would also increase penalties and
require the Secretary of the Treasury to issue
an annual report on worker misclassification.
59
Legislative Update

The Taxpayer Responsibility,
Accountability, and Consistency Act of
2009 (continued)
The Act was introduced by Rep. Jim
McDermott (D-WA). A related Senate bill
(S. 2882, 12/15/09) was introduced by
Sen. John Kerry (D-MA).
 The Act would apply prospectively to
services rendered more than one year
after the date the act is enacted.

60
Legislative Update

Worker Classification Initiatives

The President’s Proposed Budget for
2011 (issued 2/1/10)

Measures to Reduce the Tax Gap

The budget includes measures to help
reduce the tax gap, including clarified
standards for classification of workers as
employees or independent contractors and
clarifying when employee leasing companies
can be held liable for their clients' federal
employment taxes.
61
Legislative Update

The President’s Proposed Budget for 2011
(continued)
 Department of Labor Budget



The U.S. Department of Labor budget includes a
request of $10.96 million for the Employment and
Training Administration, and $12 million for the
Wage and Hour Division. These funds would
support a new multi-agency initiative to strengthen
and coordinate federal and state efforts to address
employer misclassification of workers.
The initiative includes increased information sharing,
targeted audits in high-risk industry sectors, the
addition of 100 new enforcement personnel, and
competitive grants to boost state incentives and
capacity to address this problem.
The Department of Labor initiatives are expected to
increase Treasury receipts by more than $7 billion
over 10 years.
62
Legislative Update

Fringe Benefit Initiatives

Bipartisan Tax Fairness & Simplification
Act of 2010 (S.3018, 2/23/2010)

The Act would repeal the exclusions for









Benefits under cafeteria plans
Employee awards
Premiums on group term life insurance,
accident and disability insurance
No-additional-cost service benefits
Qualified employee discount benefits
Working condition fringe benefits
De minimis fringe benefits
Qualified moving expense reimbursements
Qualified retirement planning services
Qualified military base realignment and
closure fringe benefits
63
Legislative Update

Bipartisan Tax Fairness & Simplification
Act of 2010 (continued)
The Act retains the exclusion of qualified
transportation fringe benefits from gross
income.
 The Act was introduced by Sens. Wyden
(D-OR) and Gregg (R-NH).

64
Legislative Update

Cell Phone Fringe Benefit

IRS Commissioner Douglas Shulman has
stated that he is “quite hopeful” Congress
will enact legislation in 2010 to exclude
personal use of employer-provided cell
phones from taxation.
65
Legislative Update

Corporate Information Reporting
Initiative

The President’s health care proposal,
released February 22, 2010, includes
provisions for expanding corporate
information reporting requirements.
66
Legislative Update

Payroll Tax Initiative

Hiring Incentives to Restore Employment
(HIRE) Act (Pub. L. 111-92)


The act includes a payroll tax exemption
for businesses from Social Security payroll
taxes through December for every worker
hired in 2010 who has been unemployed
for at least 60 days.
The act was signed into law March 18,
2010. The provision applies to wages
paid after March 18, 2010.
67
Severance and FICA



Section 3402(o) creates ambiguity
as to whether typical severance
payments are excluded from FICA
IRS position – severance pay
generally subject to FICA despite
section 3402(o) implications
Previously, Court of Claims ruled for
taxpayer, Federal Circuit overturned
and held for IRS
68
Severance and FICA



Quality Stores – MI District Court
concluded severance pay is
excluded from FICA
Employer can make protective
refund claim, but at some point
need to perfect by seeking
employee consent
Potential audit issue
69
Q&A
70
Speakers

Adam Cohen




Sutherland Asbill & Brennan LLP
adam.cohen@sutherland.com
202.383.0167
Catherine Wilkinson



Steptoe & Johnson LLP
cwilkinson@steptoe.com
202.429.6262
71