Prudence Is the Best Way to Prevent an IRS Payroll Tax Audit

Prudence Is the Best Way to Prevent an IRS Payroll Tax Audit

The IRS has been refining its payroll tax targets and methodologies, including an intensive initiative to educate its agents on how to focus their audits. Stout’s Jerome M. Schwartzman and Joel Wukelic share how companies may deal with contractors to prevent a payroll tax audit.

September 15, 2022

The good news: You have finally completed an acquisition after an extended process, including a few bumps along the way, difficult representations and warranties insurance negotiations, and last-minute sales and purchase agreement hiccups. Now, the real work begins.

Among the diligence issues identified is the nagging question of how to deal with the company’s independent contractors. The tax due diligence report indicated a risk that the IRS may reclassify them as employees for payroll tax purposes, and the reps and warranties insurer would not cover the issue. As usual, you decided to deal with that issue post-closing. However, your financial model did not include variables for potential increased payroll costs related to the contractors.

Unfortunately, the contractors have adamantly refused to become employees but remain critical to the business. Being critical to the business is an indicative factor that the workers may be classified as employees under the extremely vague tax rules.

The IRS cares about worker classification to ensure proper collection of Social Security and Medicare (FICA) taxes, as well as unemployment taxes for the worker. On the other hand, contractors are responsible for their own self-employment taxes, and FICA and unemployment taxes do not apply. Proper classification is becoming even more critical to the IRS, as the Social Security fund is anticipated to run out of excess reserves in 2034. The IRS has even included this issue in its annual “Dirty Dozen” list of tax scams.

The best way to address the worker classification issue is to hire employment counsel, adopt formal policies, and follow the policies with all the appropriate bells and whistles. This would include having contractors sign written non-employment agreements, work for multiple companies, control their own work, assume risk of loss, and invoice the company for their work. Additionally, companies should be sure not to list contractors as employees on their websites or on LinkedIn. This includes being mindful of the various state rules regarding employee versus contractor issues. However, we recognize that may not be practical in many cases.

It may be possible to find other workers who perform the same services and are willing to be classified as employees, though this can disrupt the business and may upset management. Anecdotally, we find this is rarely a viable solution and may be even more difficult in this tight employment market.

Another solution is to find an employment agency that leases contractors in this line of business. Keep in mind this may be difficult in certain areas such as government contracting, where personnel are required to have security clearances.

Contractors can also form their own legal entities and contract with the company through these entities. This does not resolve the issue but merely masks it. Generally, the IRS does not look at 1099 forms that are issued to entities with employee identification numbers rather than to the contractor’s personal Social Security number. However, IRS scrutiny may be raised where an entity uses numerous contractors. We emphasize that this is not a real solution to the issue.

Of course, you can continue to treat your workers as contractors and assume the payroll tax risk. In this case, your CPA may require the company to post a reserve for payroll taxes in its audited financial statements. And on exit, the next buyer may be stricter in addressing the issue, including requiring an escrow to cover any potential historical exposure.

Unfortunately, there is no magic pill to solve the contractor classification dilemma, and buyers are faced with difficult decisions on how to address them post-close, even if fully indemnified for pre-close periods.

While audit risk has been low over the past decade, the IRS has been refining its payroll tax targets and methodologies, including an intensive payroll tax audit initiative to educate its agents on how to focus their audits and cooperating with the Department of Labor to address worker misclassification issues. In addition, the Inflation Reduction Act significantly increases the IRS budget, including for perceived widespread taxpayer issues such as worker misclassification. As such, prudence may be right path forward.

Originally published in Bloomberg Tax