The Internal Revenue Service recently published an update to Publication 5146, Employment Tax Returns: Examinations and Appeal Rights, explaining the procedures IRS auditors use to conduct employment tax examinations and an employer’s rights and responsibilities during and after the examination process.

While there were no significant changes in the latest version of the publication, at least one labor and employment attorney thinks it’s a good time to take a fresh look. “This is an area where we’ve seen an uptick in audit and examination activity at the IRS,” said Nancy Hilu, senior counsel with Hanson Bridgett in San Francisco.

Employment tax audits typically occur thanks to the IRS’s computer selection programs, which pick out employers based on criteria that are seen by the agency as risk areas or red flags, or because of employers’ previous results on IRS compliance programs.

“A lot of times when the IRS starts to initiate an examination, one of the first things they look at is an employer’s internal controls,” said Hilu. “If they feel they’re sufficient, they’re more likely to shorten their examination and be satisfied with what they’ve seen and feel that the likelihood of finding errors is minimal. In areas where they see there are not sufficient controls, they tend to expand examinations.”

The publication also describes several relief provisions, along with appeals procedures and judicial review, if an employer believes it is not liable. Among the problem areas spotlighted by IRS examiners are fringe benefits such as employee meals, along with misclassification of employees as independent contractors.

“Some of the areas where we’ve seen issues have been surrounding fringe benefits and their tax treatment, not properly coding fringe benefits as taxable when the IRS would require that they be taxed,” said Hilu. “Meals are usually a big area where we see issues, and other types of fringe benefits. The other area where we see a major issue is not properly categorizing someone as an employee, and treating them as an independent contractor, so that the proper taxes aren’t being withheld on wages paid by the employer. Those seem to be the two largest areas where we’ve seen issues.”

Hilu has seen an uptick in taxpayers being selected for examination after negative articles appeared about them in media outlets such as newspapers, perhaps highlighting a financial scandal in a local government agency. “I think this is particularly true when it comes to a governmental employer like a county or a city or a state,” said Hilu. “They may be in the news and the IRS pays attention to those types of stories. If they seem credible, they may select an employer for examination based on what they’ve seen in the news and the media. We’ve seen that increasingly, and I think that’s just the way a lot of things are right now, where the media is more at the forefront of a lot of processes.”

Mismatches of data with other information returns received by the IRS can also trigger an audit.

“That is a traditional source of being selected for examination,” said Hilu. “The IRS still does that too. We’ve seen that a lot with retirement plans, for example, where what was reported on a Form 5500 doesn’t match something else that the IRS has seen and so the IRS will issue an initial examination notice and request documents to be reviewed. If they’re satisfied with what they see in the documentation, that reconciles what they thought was a discrepancy, and the examination is closed. But if the data shows that additional examination may be warranted, they’ll expand what they’re requesting to look at, maybe schedule a meeting to talk to the plan administrator. It goes back to documentation and internal controls being strong. Being able to provide the IRS with the information they’re requesting in a very clear and complete manner oftentimes will cause an examination to get closed instead of expanded, in a satisfactory manner.”

Hilu recommends employers ensure they have the proper controls in place. “We wanted to highlight vigilance on the part of employers,” she said. “Make sure they’re reviewing their processes and ensuring they comply with what the IRS requirements are for reporting and withholding.”

IRS building entrance

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Michael Cohn

Michael Cohn

Michael Cohn, editor-in-chief of AccountingToday.com, has been covering business and technology for a variety of publications since 1985.