In an effort to lessen the "tax gap" (the difference between the amount of income reported by taxpayers and the amount the IRS believes is due) the IRS has increased the amount of random employment tax audits. What does this mean for your business and what will the IRS be focusing on?

The tax audit will focus on the following:

1. Worker Classification. Are your workers classified as employees or independent contractors? If you have a number of workers classified as independent contractors you may face increased scrutiny. There is a twenty factor test that the IRS uses in determining whether employees are properly classified. Our attorneys can assist you in determining how best to classify your workers.
2. Fringe Benefits. Do you provide nontaxable fringe benefits to your employees? If your workers are considered independent contractors rather than employees, fringe benefits cannot be provided on a tax free basis.
3. Officer's Compensation. How are your key officers compensated? Are they paid a salary or percentage of profits from the business? Depending on how your business is organized (C Corporation, S Corporation, LLC, etc.) there may be tax benefits to paying a higher salary to a key officer or a lower salary with profit distributions to a business owner. The IRS will be reviewing these payment structures to determine whether the compensation being paid is reasonable.
4. Reimbursed Expenses. Do you reimburse business expenses for your employees? Do you have a written policy in place that complies with the Internal Revenue Code for such reimbursements? If not, these reimbursements should be categorized as additional income to the employee. This additional income must be reported and is subject to additional income and employment tax.

How do you protect yourself from these audits? Unfortunately, because the audit process is random, there are no proactive steps you can take to prevent an audit of your business. However, you can ensure that your policies and procedures are in compliance with the Internal Revenue Code and IRS rules as they relate to the proper classification of employees, reasonableness of compensation and proper internal policies.

While your firm may stand ready to assist you throughout the audit process, waiting until an audit is initiated to review your policies and procedures may be a costly mistake as taxes, interest and penalties may be unavoidable.