Caution is the best way to avoid an IRS payroll tax audit
The good news: you’ve finally closed an acquisition after a long process, including a few bumps along the way, difficult representation and insurance negotiations, and last-minute hiccups in sales and purchase agreements. . Now the real work begins.
Among the due diligence issues identified is the nagging question of how to deal with the company’s independent contractors. The tax due diligence report indicated a risk that the IRS could reclassify them as employees for payroll tax purposes, and the representatives and warranties insurer would not cover the issue. As usual, you decided to fix this issue after the close. However, your financial model did not include variables for the potential increase in contractor payroll costs.
Unfortunately, contractors have adamantly refused to become employees but remain essential to the business. Being critical to the business is an indicative factor that workers may be classified as employees under extremely vague tax rules.
The IRS cares about worker classification to ensure proper collection of Social Security and Medicare (FICA) taxes, as well as unemployment taxes for the worker. On the other hand, entrepreneurs are responsible for their own self-employment taxes, and FICA and unemployment taxes do not apply. Proper classification becomes even more critical for the IRS, as the Social Security fund is expected to run out of excess reserves in 2034. The IRS has even included this issue in its annual “Dirty Dozen” list of tax scams.
The best way to solve the worker classification problem is to hire an employment attorney, adopt formal policies, and follow the policies with all the appropriate bells and whistles. This would include contractors signing written non-employment agreements, working for multiple companies, monitoring their own work, assuming the risk of loss, and charging the company for their work. Additionally, companies should be careful not to list contractors as employees on their websites or on LinkedIn. This includes being aware of various state rules regarding issues between employees and contractors. However, we recognize that this may not be practical in many cases.
It may be possible to find other workers who perform the same services and agree to be classified as employees, although this may disrupt the business and upset management. Anecdotally, we find that this is rarely a viable solution and may be even more difficult in this tight job market.
Another solution is to find an employment agency that hires contractors in this line of business. Keep in mind that this can be difficult in certain areas such as public procurement, where staff must have security clearances.
Entrepreneurs can also create their own legal entities and enter into contracts with the business through these entities. This doesn’t solve the problem, just masks it. Typically, the IRS does not look at 1099 forms that are issued to entities with employee identification numbers rather than the contractor’s personal social security number. However, the scrutiny of the IRS can be raised when an entity uses many contractors. We emphasize that this is not a real solution to the problem.
Of course, you can continue to treat your workers as contractors and assume the payroll tax risk. In this case, your CPA may require the company to post a reserve for payroll taxes in its audited financial statements. And on exit, the next buyer may be more stringent in addressing the issue, including requiring an escrow to cover any potential historical exposure.
Unfortunately, there is no magic pill to solve the contractor classification dilemma, and buyers are faced with tough decisions on how to resolve them post-closing, even if they are fully compensated for the periods pre-closing.
Although audit risk has been low over the past decade, the IRS has refined its payroll tax objectives and methodologies, including an intensive payroll tax audit initiative to educate its officers on how to focus their audits and cooperate with the Department of Labor to address worker issues. misclassification issues. In addition, the Inflation Reduction Act significantly increases the IRS budget, including for issues perceived as prevalent by taxpayers, such as the misclassification of workers. As such, caution may be the right way to go.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jerome M. Schwartzman is responsible for M&A tax services and Joel Wukelic is Principal of M&A Tax Services at Stout, where he provides tax due diligence and tax structuring services to clients of the firm, as well as tax advisory services to investment banking clients and valuation of society.
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