The IRS’ New Employment Tax Initiative: What Does It Mean for Nonprofits?
by Jessica R. Lubar, Esq., Of Counsel, Venable LLP, Baltimore, MD
IRS National Research Program
The IRS NRP begins in Feb. 2010 and will be the first employment tax project conducted by the IRS since 1984. The purpose of the project is to collect data that will allow the IRS to understand the compliance characteristics of employment tax filers. Theoretically, the IRS should be able to use the information gathered in the NRP to target non-complying taxpayers for audits in the future. However, for the NRP, employers will be chosen randomly for examinations. The NRP will include employers from all industries in order to be comprehensive. According to John Tuzynski, chief of employment tax operations in the Small Business/Self-Employed Division, the scope of review will be greater in these examinations than normal.
The Tax Exempt and Government Entities Division will participate in the NRP and expects to do full examinations of 500 organizations in 2010.
Areas of Focus
Examiners will focus primarily on three employment tax areas: (1) Worker Classification (independent contractor, common-law employee, statutory employee, statutory non-employee); (2) Fringe Benefits; and (3) Officer’s Compensation. Tax-exempt employers also have unique employment related tax issues that may arise in an examination. For tax-exempt employers – particularly those that are tax-exempt under Sections 501(c)(3) or 501(c)(4) – issues that arise in an employment tax audit could affect reasonable compensation determinations that had been made for purposes of the IRS’ “intermediate sanctions” rules (located in Code Section 4958).
The proper classification of a service provider as either an employee or an independent contractor is a frequent area of contention between the IRS and employers. A worker is considered an employee if the employer exercises the requisite amount of control over the employee under common-law principles. Over the years, the courts and the IRS have articulated certain factors that are considered in making that determination. The IRS organized the factors that are considered into three categories: (1) Behavioral Control – whether the business has a right to direct and control how the worker does the task for which the worker is hired; (2) Financial Control – whether the business has a right to control the business aspects of the worker’s job; and (3) Type of Relationship.
Due to the factual nature of any worker classification determination and the consequences of being wrong, Congress provided relief from employment tax liability for certain employers who misclassified workers as independent contractors using the common-law facts and circumstances standards. The relief was enacted as Section 530 of the 1978 Revenue Code (as amended) and is known as “Section 530 Relief.” In order to be entitled to Section 530 Relief, a taxpayer must meet three requirements:
1. The Substantive Consistency Requirement: The taxpayer has not treated the individual as an employee for any period and has not treated any other individual holding a substantially similar position as an employee (for purposes of employment tax) for any period.
2. The Reporting Consistency Requirement: All federal returns (including information returns) that are required to be filed by the taxpayer with respect to the worker for such periods are filed on a basis consistent with the taxpayer’s treatment of the individual as an independent contractor.
3. The Reasonable Basis Requirement: The taxpayer had a reasonable basis for not treating the worker as an employee. A reasonable basis only exists if it is supported by judicial precedent, IRS rulings, a past IRS audit, or a long-standing practice of a significant segment of the relevant industry.
Misclassifying a worker as an independent contractor, whether deliberate or inadvertent, has the same consequences to a tax-exempt employer as a taxable employer. Therefore, it is critical that any employer review its relationships with its service providers to determine how they should be classified. If the proper classification is not clear, an employer may ask the IRS to determine the proper classification by filing a request for a worker classification determination on Form SS-8. A Form SS-8 may be filed by either a service provider or a service recipient, however, historically service recipients have not filed many requests for a classification determination. Practitioners differ on whether employers should make such a request.
In all events, any nonprofit that is receiving services should at the very least ensure that individuals that it treats as independent contractors would satisfy the requirements for Section 530 Relief so as to avoid the consequences of misclassification.
The fringe benefit area is frequently overlooked by employers, both nonprofit and for-profit. It often comes as a surprise to employers (and employees) that certain of the “perks” they provide should be included in an employee’s income as taxable compensation, even if no cash is paid. Perks provided by employers may be either taxable or tax-free fringe benefits. If an employer incorrectly treats a fringe benefit as tax-free, it is treated as if the employer did not report the full amount of compensation paid. The result of such an error by a tax-exempt entity has potentially significant consequences in addition to the typical employment tax consequences.
If the employee’s compensation was the subject of a reasonable compensation analysis, failure to treat a fringe benefit as taxable could invalidate the reasonable compensation determination. A taxable fringe benefit increases an employee’s compensation by the value of the fringe benefit. If the fringe benefit had not be treated as taxable by the employer, it would not have been included in the amount of the employee’s compensation that was approved pursuant to the reasonable compensation determination process. Therefore, depending on what the “perk” was, the value could be significant and affect whether the compensation qualifies for the rebuttable presumption under the intermediate sanctions rules.
Further, if a 501(c)(3) or 501(c)(4) organization does not have any contemporaneous documentation showing that the fringe benefit was provided to the employee as compensation, the perk will be considered an excess benefit resulting in penalties under Code Section 4958. Under Code Section 4958, penalties could be imposed both on the recipient of the fringe benefit and any organization manager who participated in providing the fringe benefit. For the recipient, in addition to requiring the individual to repay the excessive value of the benefit, the penalty amount is automatically 25% of the excess benefit, but it could go up to 200%.
In past initiatives with respect to tax-exempt organizations, the IRS has found fringe benefits that were not considered and reported as compensation, such as the personal free use of a car or apartment, personal components of business travel, holiday gifts, etc. Fringe benefit issues also come up when employer’s pay for relocation travel and expenses or education expenses for the employee, among other instances.
Employee reimbursements are also part of the fringe benefit review. Reimbursed expenses, even employment-related expenses, must be made in accordance with a written reimbursement plan or otherwise qualify as a tax-free fringe benefit to be excluded from an employee’s income. For employment related reimbursements to be tax-free under a written reimbursement plan, the plan must require employees to adequately account for the expenses and to pay back any excess payments received (such plans are known as accountable plans). In past initiatives, the IRS has identified the following reimbursements that sometimes fall through the cracks: expense reimbursements outside corporate policies, spouse travel expenses, tax gross-ups, non-accountable expense allowances, club memberships, etc.
In contrast to most employers’ perception of fringe benefits, the value of any benefit or “perk” provided to an employee needs to be included in compensation unless an exception applies. Common exceptions to income inclusion are the working condition fringe benefit and the de minimis fringe benefit. Even if the value of the fringe benefit that is provided is relatively small on an individual basis, if the benefit is provided to many employees, interest and penalties for failing to report it as taxable could be significant. Interest and penalties on employment taxes would apply to all unreported taxable fringe benefits, not just those paid to disqualified persons under Section 4958.
The third area of focus of the NRP – officer compensation – has different significance to nonprofit employers than for-profit employers. The primary issue for nonprofits with respect to officer compensation is the applicability of the intermediate sanction rules to compensation paid to disqualified persons. The rules under Section 4958 of the Internal Revenue Code are referred to as the intermediate sanctions rules because it provides for penalties that are less severe than revoking an organization’s tax-exempt status. Section 4958 allows the IRS to impose significant excise taxes on the insiders, such as executive officers and board members, of section 501(c)(3) and (c)(4) organizations who benefit excessively in transactions with a tax-exempt organization. In the event that the IRS determines that an insider received an excessive benefit from his relationship with an exempt organization, the IRS can impose intermediate sanctions, requiring that individual to repay the excessive amount to the organization and pay an excise tax up to 200% of the excess benefit. Under Section 4958, penalties imposed on the recipient of an excess benefit may be limited to 25% of the value of the benefit if the excess benefit transaction is “corrected” before an assessment is made by the IRS.
The IRS has recently begun vigorously enforcing this section of the Code. In fact, during the last year, we have seen the IRS impose intermediate sanctions with an unprecedented frequency. It is also important to note that the IRS may impose penalties on certain organization managers as well under Section 4958.
Among other issues, examiners conducting NRP reviews also will be looking at whether an employer is not filing required tax returns and whether the employer is backup withholding on payments to independent contractors, if necessary. Backup withholding is when a taxpayer is required to withhold 30% from payments that it makes to independent contractors under certain circumstances. Backup withholding is required if the contractor does not provide its taxpayer identification number to the payor, the payor is notified by the IRS that the taxpayer identification number is not correct, or if the IRS notifies the payor that backup withholding is required. Any Form 1099 that is submitted by an employer without a taxpayer identification number should have had backup withholding done on the payment.
Additional Initiatives Affecting Tax-Exempt Organizations
The IRS’ concern regarding employment tax compliance by nonprofits is not new. Although the current NRP is not limited to tax-exempt organizations, the IRS has in the past conducted programs focusing on compensation issues of tax-exempt organizations. The Exempt Organizations Executive Compensation Compliance Project that started in 2004 looked at executive compensation issues. While final reports were issued in March 2007 with respect to two parts of the project, the third part has not been completed. One of the areas of concern that was uncovered by the IRS during the project involved substantial loans to insiders and undocumented loans. As a result, a new phase of the project began in March 2006 that was dedicated solely to loans.
In addition, the final Report on Parts I & II of the Project noted the following compensation related recommendations: (1) future initiatives should focus on the correlation between satisfaction of the rebuttable presumption by an organization and the reasonableness of compensation paid to its disqualified persons by such an organization; (2) the relatively small percentage of corrections made by disqualified persons before contact by EO illustrates the need for a continued enforcement presence in this area; and (3) EO should continue to review compensation issues in more focused projects and should pursue baselining general compliance with the compensation rules.
What Can Nonprofits do?
The existence of the NRP and the statements made regarding tax-exempt organizations demonstrate that employment tax compliance is an area that the IRS will be focusing on for some time. Even if an employer is not subject to an examination under the NRP, employment tax is an issue that is likely to arise in future examinations of the employer. Nonprofits should take this opportunity to review their current compliance status and, if necessary, address any issues that arise before a visit from the IRS.
There are certain steps that a nonprofit employer should take:
Review existing service relationships
- Are worker’s appropriately classified?
- Are any corrections necessary?
- If a worker is being treated as an independent contractor, is the documentation consistent?
- Look at the Section 530 requirements.
- Would the organization qualify for relief if the IRS determines that the worker was misclassified?
- Not sure? Consider a request pursuant to Form SS-8
- Quantify the risk: FICA, income tax withholding, interest, penalties, state reclassification, DOL
- Have all benefits/perks been accounted for correctly? If not, how can they be corrected?
- Review your benefit plans to ensure that they exclude persons that you, as the plan sponsor, classify as independent contractors (so that any retroactive reclassification of such persons as employees will not result in unintended plan coverage).
- Do you have a written reimbursement plan that qualifies as an accountable plan?
- Are they properly documented and consistent with the excess benefit transaction rules?
- Are there any loans to employees, in general? Evaluate the application of the employment-related below-market loan rules.
- Is there contemporaneous support that any taxable fringe benefits that were not included in income were provided as compensation?
- If any portion of compensation paid, including taxable fringe benefits, would be an “excess benefit,” determine what steps are necessary to correct the excess benefit.
- Determine whether any Form 1099s have been filed that do not have the payee’s taxpayer identification number and whether backup withholding was done
Jessica Lubar is Of Counsel in Venable’s Baltimore Office. She is a member of the firm’s Nonprofit Organizations and Tax practice groups, and advises clients on a broad array of tax, estate and business matters at the state, federal and international levels, For information, contact Ms. Lubar at 410-244-7736 or firstname.lastname@example.org.
This article is not intended to provide legal advice or opinion and should not be relied on as such. Legal advice can only be provided in response to specific fact situations.