Getting a notice that the IRS wants to examine your payroll taxes can be unsettling for any business owner. You may immediately wonder: What are they looking for? How far back are they going? Did my payroll company make a mistake? Are they going to question my independent contractors? And could I personally be responsible if something is wrong?

An IRS payroll tax audit – more formally called an employment tax examination – can be much more than a review of whether the numbers on your payroll tax returns add up. The IRS may examine how workers were paid, whether workers were properly classified as employees or independent contractors, whether all compensation was reported, whether required Forms W-2 and 1099 were filed, and whether employment taxes were properly withheld and deposited.

When payroll taxes have been withheld from employees but not paid to the IRS, the consequences can potentially reach beyond the business itself.

What Is an IRS Payroll Tax Audit?

Employers generally have obligations involving federal income tax withholding, Social Security and Medicare taxes, federal unemployment taxes, and employment tax reporting. During an employment tax examination, the IRS may examine wages, tips, compensation, credits, deposits, information returns, and the classification of workers.

• Employees who may have been improperly treated as independent contractors
• Cash wages or other compensation that was not reported through payroll
• Missing or incorrect Forms W-2 or Forms 1099
• Payments to corporate officers
• Taxable fringe benefits
• Tips and tip reporting
• Reimbursements or other payments to employees
• Failure to properly withhold employment taxes
• Failure to make required federal tax deposits

How Does an IRS Payroll Audit Begin?

Usually, the business receives written notice identifying the employment tax returns and periods being examined. The IRS may request an initial meeting and issue an Information Document Request seeking records. Before simply turning over everything requested, it is important to understand what the records show and where the potential problems may be.

What Records Will the IRS Ask For?

• Payroll registers and payroll reports
• Forms 941 and other employment tax returns
• Forms W-2 and W-3
• Forms 1099 and related contractor records
• General ledgers and trial balances
• Bank statements and canceled checks
• Employment and independent contractor agreements
• Corporate records and officer information
• Federal income tax returns and other records showing how workers and service providers were paid

The IRS Will Look Beyond the Payroll Reports

One of the biggest mistakes a business owner can make is assuming, “My payroll company handled everything, so I should be fine.” A payroll company’s reports are only part of the picture. The examiner may compare payroll records against the company’s books, bank records, tax returns, and information returns.

If the general ledger shows $600,000 in labor expenses but only $350,000 went through payroll, an obvious question follows: Where did the other $250,000 go? Perhaps those payments were legitimate payments to independent contractors. Perhaps they were properly reported on Forms 1099. Or perhaps the records reveal a larger employment tax problem. That is why we want to understand the company’s records before the IRS examiner starts asking those questions.

Cash Payments Can Turn Into a Very Expensive Problem

Cash-intensive businesses require particular care. Restaurants, bars, construction companies, trucking businesses, and other businesses may legitimately pay independent contractors or other service providers outside of traditional payroll. But paying someone in cash does not determine whether that person is an employee or independent contractor – and failing to maintain records or file required information returns can create serious problems during an audit.

• Who received the money?
• What work did they perform?
• Were they employees or independent contractors?
• Were Forms 1099 required?
• Were Forms 1099 actually filed?
• Should employment taxes have been withheld?
• Can the business prove who received the money?

Hector’s $1 Million Payroll Tax Problem

We represented a business owner we will call Hector who paid workers in cash. The IRS examination turned into a nightmare. The IRS assessed more than $1 million after asserting penalties relating to the failure to file Forms 1099 and also treating the payments as wages subject to payroll taxes.

We challenged the assessment. One of our arguments was straightforward: the IRS could not have it both ways. If the government was going to characterize the workers and payments one way for purposes of imposing information-return penalties, it could not simply characterize the same payments inconsistently when doing so produced another tax assessment. We were ultimately able to substantially reduce Hector’s liability.

Hector’s case illustrates an important point: the number on an IRS examination report is not necessarily the amount the business ultimately owes. The examiner’s factual assumptions, legal conclusions, and calculations need to be examined individually.

Employee or Independent Contractor?

Worker classification can become one of the most expensive issues in an employment tax examination. Calling someone an independent contractor does not necessarily make that person an independent contractor. The IRS can examine the actual relationship between the business and the worker, including behavioral control, financial control, and the nature of the relationship.

If workers treated as independent contractors are determined to have been employees, the business may face additional employment taxes and potentially penalties and interest. But that does not mean every worker-classification dispute automatically results in the employer owing the full proposed tax.

For example, Section 530 relief may protect an employer from federal employment tax liability for certain workers when its requirements are satisfied, including reporting consistency, substantive consistency, and a reasonable basis for the classification. This is an issue that should be identified early in the examination.

The IRS May Interview the Business Owner

An employment tax examination is not necessarily limited to exchanging documents. The examiner may ask how workers are hired, supervised, scheduled, and paid. Questions about who signs checks, who decides which bills get paid, and who controls company finances can also become important if unpaid trust fund taxes are involved.

Business owners should understand the purpose of an IRS interview and the issues involved before answering substantive questions. A taxpayer also has representation rights. With proper authorization, an attorney, CPA, or enrolled agent may represent the taxpayer during an examination.

The Most Dangerous Part: The Business Debt Can Become Your Personal Debt

When a business withholds federal income taxes and the employee share of Social Security and Medicare taxes, it is holding that money in trust for the United States. If those trust fund taxes are not paid, the IRS can investigate individuals connected with the business to determine whether they should be personally assessed with the Trust Fund Recovery Penalty, or TFRP.

The IRS looks at responsibility and willfulness. Potential responsibility is not necessarily limited to the person whose name appears on the tax return. The IRS may investigate owners, officers, employees, bookkeepers, or others with sufficient authority over company finances. Paying other creditors while knowing payroll taxes remain unpaid can become important evidence in the willfulness analysis.

Once the Trust Fund Recovery Penalty is assessed, the IRS can pursue the responsible individual personally for the unpaid trust fund portion. That can put personal assets at risk.

‘I’ll Just Close the Company’ Does Not Solve the Problem

Closing the corporation or LLC does not necessarily make the payroll tax problem disappear. The IRS can assess the trust fund portion of unpaid employment taxes personally against a responsible person who meets the legal requirements for the Trust Fund Recovery Penalty. Once assessed, it is a liability of that individual.

That means closing the company, dissolving the corporation or LLC, or simply walking away from the business does not necessarily protect the owner or other responsible individuals. The business may be gone. The tax problem may not be.

‘Then I’ll File Bankruptcy’ Can Be an Even More Dangerous Assumption

Business owners sometimes assume that if everything goes wrong, bankruptcy will wipe out the payroll taxes. Trust fund taxes receive special treatment under the Bankruptcy Code. The portion of employment taxes withheld from employees – and a Trust Fund Recovery Penalty based upon those trust fund taxes – generally is not dischargeable in bankruptcy.

A business owner could close the company, file bankruptcy and discharge substantial amounts of other debt, and still emerge facing personal liability for trust fund taxes. That is why the time to address a payroll tax problem is before the business collapses whenever possible.

And Your Payroll Company Does Not Automatically Protect You

Another statement we frequently hear is, “But my payroll company was supposed to take care of this.” Using a payroll service does not automatically relieve the employer of responsibility for making sure employment tax returns are filed and taxes are deposited. Business owners should periodically verify that deposits are actually being made rather than simply assuming everything is being handled.

What Happens If the IRS Finds a Problem?

The examiner may propose additional employment taxes, penalties, and interest. But a proposed assessment is not necessarily the end of the case. The taxpayer should examine the factual findings, worker classifications, calculations, potential Section 530 relief, characterization of payments, penalty defenses, reasonable-cause arguments, and administrative appeal rights before simply accepting the proposed assessment.

What Should You Do When You Receive an IRS Payroll Audit Notice?

1. Do not ignore the notice. Identify the tax periods and returns being examined and calendar every response deadline.

2. Do not start “fixing” the records before someone reviews the problem. First determine what happened, what should have been reported, and what the legal consequences are. Then decide what needs to be corrected and how.

3. Do not create Forms 1099 retroactively without understanding the consequences. Worker reporting and consistency can matter to potential defenses. Do not accidentally damage a defense while trying to clean up the problem.

4. Review the records before giving them to the IRS. This does not mean hiding records. It means knowing what your own records say before the examiner reads them and being prepared to explain legitimate discrepancies.

5. Be careful about informal conversations with the examiner. Questions that sound routine can have legal significance for worker classification or potential personal liability.

6. Do not assume your accountant or payroll company can answer every legal issue. Employment tax examinations can move beyond accounting into worker classification, Section 530 relief, penalty defenses, appeals, and Trust Fund Recovery Penalty issues.

7. Find out whether anyone is personally at risk. If employment taxes were withheld but not paid, determine who controlled the accounts, signed checks, selected creditors for payment, knew the taxes were unpaid, and had authority to act.

The Most Important Thing to Remember

An IRS payroll tax audit may begin with a letter asking for records. It can end with a substantial assessment against the business – and, in some cases, an attempt to collect trust fund taxes from an owner or other responsible person individually.

The goal at the beginning of the examination should not simply be, “Let’s give the IRS what they asked for and get this over with.” The better questions are: What is the IRS investigating? Where is our exposure? What do our records actually prove? What defenses do we have? And how do we keep a business tax audit from unnecessarily becoming a personal tax problem?

Hector’s case is a good example. An assessment exceeding $1 million looked devastating when it was first presented. But the government’s conclusions and calculations still had to withstand scrutiny. An IRS assessment is not automatically correct simply because the IRS calculated it.

Facing an IRS Payroll Tax Audit in New Jersey?

If your New Jersey business has received an IRS employment tax examination notice, the time to evaluate the potential exposure is before records are produced and positions are taken.

Tomes Law Firm PC represents New Jersey businesses in IRS payroll tax audits, worker-classification disputes, employment tax controversies, Trust Fund Recovery Penalty matters, and IRS appeals. Call us today for a free confidential consultation at 732-333-0681 or 833-4IRS-TAX or visit us at tomeslaw.com