Payroll tax audits occur when the IRS looks at a business’s payroll taxes to determine whether they have underpaid. Some business owners might hire independent contractors, which means they don’t have a tax obligation. If the IRS disagrees that these workers are independent contractors, the business will be subject to payroll taxes. There are additional potential consequences to having independent contractors labeled as employees as well.
The majority of payroll tax audits take place over three years. However, if you have never filed a Form 941 or other employment tax paperwork, the IRS can audit decades of financial information. There isn’t a statute of limitations.
You are more likely to face a payroll audit if you only hire independent contractors than if you have a mix of employees and independent contractors.
If you are determined to owe payroll taxes, the financial impact can be catastrophic. Every case is different, so it will depend on the level of financial liability you have. But regardless, you’ll likely need to pay the back taxes, interest, and any penalties imposed by the IRS.
Some potential penalties include:
In some cases, you might be subject to several of these penalties at once. That means you might have to pay the back taxes plus more than 50 percent of the original total, along with interest. Most businesses don’t have enough capital to be able to avoid this.
After finishing an audit of a tax payroll, the IRS can be expected to share their results with your state tax agency. In California, this will typically trigger a state payroll tax audit. If you’re found guilty there, you will owe back payroll taxes to the state as well.
Payroll tax audits might be the result of computer software flagging potential issues. They might also be the result of human interference. It’s common for unhappy contractors to file complaints with the IRS when they’re unable to pay a self-employment tax. They might file official paperwork asking the IRS to begin an investigation into whether they qualify as a contractor or an employee.
When this form is filed, the IRS tends to follow up fairly promptly. It can be filed by both workers and businesses, but usually is filed by the worker. If the IRS gets a request to investigate, usually their first step is to ask the business about their contractors and employees. At this point, the situation is not yet an audit. But it is serious.
If the IRS reaches out to you about your payroll taxes or your employee contracts, it’s a good idea to get in contact with an experienced tax attorney. Depending on the situation, a skilled tax attorney might be able to avoid having an audit opened at all. They will fill out an official Form SS-8, which allows you to answer questions about your contractors and employees.
There are some key differences between contractors and employees that not every business owner understands. It’s not enough to simply state in the contract that they are a contractor rather than an employee.
When the IRS decides whether to classify someone as an employee or contractor, they use a “common law” test that examines 20 different factors. Common law means that it comes from English law rather than a specific part of US federal legislation.
Some of the factors in this test have to do with how much control an employer has over their workers. Most recently, the IRS has started using a test with three categories. These are the relationship of the worker to the business, the level of financial control exerted, and the level of behavioral control exerted.
Both the three-category and 20-part test are complex. There isn’t a single algorithm that can decide whether a business will be subject to a payroll tax audit or not. Every cases is judged on an individual basis by looking at the results of the test, the existing circumstances, and any other red flags.
If you’re the subject of a payroll tax audit, it’s important to prove that you employ contractors rather than employees. Tax attorneys understand the differences between these groups and can compile evidence to prove your case. If you have found yourself convicted of payroll tax avoidance after an audit, an attorney can help you appeal. They will either represent you in court or appeal the ruling to the Appeals Division of the IRS.
When you can’t prove definitively that you employ contractors, you still have some legal options. There was legislation passed several decades ago to make it easier for business owners to hire contractors that didn’t pass the 20-part test. This legislation provided relief to business owners, but it isn’t part of official IRS codes. A lot of tax attorneys don’t know about it because they haven’t studied it. But it can help you appeal an IRS judgment.
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