What to expect during an executive compensation audit
Withholding income tax is crucial to our federal government’s general revenues, but it turns out that employers are struggling to comply with the rules, according to two payroll tax consultants speaking at the 2021 virtual convention of the American Payroll Association on July 15.
More than 70% of all revenue collected by the federal government comes from income tax withholding, said Ken Fitzgerald, tax director at Deloitte Tax LLP.
About 20 years ago, the Internal Revenue Service discovered that employment tax audits were more lucrative than corporate tax audits in closing the tax gap, said Jason Russell, director of Deloitte Tax LLP. To enforce withholding rules, the IRS focuses on three main areas in an employment tax audit: worker classification, capital deposit funding, and employee benefits, Russell said.
Classification of workers
“It’s strange to see the classification of workers apply to executives, but we see it,” Russell said, noting that this might be more common among companies considering going public. These companies may have high performing employees who refuse to come on board as employees, he said. To secure their services, the company may agree to hire them as entrepreneurs. “It has always mystified me as a practitioner,” said Russell, “because the business should be in charge.”
Other companies hire contractors for budgetary reasons. They may not have the budget to hire employees, but they do have the budget to hire contractors. This is especially problematic when contractors and employees perform the same tasks side-by-side, Russell said. The IRS doesn’t care about the budget that funds their wages, he said.
The IRS will, however, care about how their salary is reported, Fitzgerald said. Real entrepreneurs usually have an employer identification number. By reviewing accounts payable records, the IRS will look for all Social Security numbers, which is often a red flag that the worker is a paid employee as a contractor, he said.
Executives leaving the company to return as a consultant are another common problem, Russell said. Usually, they are paid to answer questions during the transition to new leadership. Their salary is extended severance pay and must be reported on a W-2 form, he said.
Stock compensation is non-cash compensation offered to employees, such as stocks, that can be used to raise an otherwise below market salary. Compliance issues are all related to delays in reporting payments and filing withheld taxes, and penalties can run into the tens of millions of dollars, Russell said.
Often, companies don’t realize that an equity transaction is a separate payroll event, Russell said. Most businesses file their taxes on a bi-weekly schedule. However, when the liability reaches $ 100,000, the company becomes a depositor the next day. “You have to run a same day payroll,” he said. “If you go by your regular filing schedule, it will be late. “
The IRS can be hit and miss about benefits, Russell said, but payroll needs to be aware simply because of the potential magnitude of the penalties. “We had surprises where the IRS imposed several hundred thousand dollars in fines and even several million dollars. So it goes beyond the gift card program, ”he said.
“Most of the things you give to your employees tend to be taxable,” Russell said. During the pandemic, employer reimbursement for Internet access in an employee’s home became a tax-free benefit. The IRS may revisit this when the pandemic is over, he said.
Free lunches are also coming under scrutiny. “The IRS doesn’t get free lunches,” Russell said, “and they don’t think you should either.”
Among executives, personal security is increasingly prevalent and may or may not be taxable depending on who is in charge. If the CEO can decide to have security and an armored car to get to and from work, but not evenings and weekends, that’s taxable, Russell said. If a third party determines the threat risk and provides security accordingly, it would not be taxable.
The IRS has various settlement programs that can help employers significantly reduce their exposure to penalties, Russell said. For the maximum benefit, it is best if the employer goes to the IRS before the IRS has the employer in its sights.