December 08, 2009

Nonprofits as Employers: The IRS Is Looking at You

13 min

I. Nonprofits as Employers: The IRS is Looking At You.

a. Nonprofits as Employers

i. General employment tax issues (i.e., FICA, withholding, etc…)

1. for non-501(c)(3)s, FUTA is also required

ii. Tax-Exempt specific employer issues

1. Reasonable Compensation – Section 4958 (excess benefit transactions)

b. What is the IRS doing?

i. Employment Tax National Research Project – beginning in Feb. 2010 (originally planned on starting this November)

1. Last research project was in 1984

2. Purpose is to collect data that will allow the IRS to understand the compliance characteristics of employment tax filers

a. Secure statistically valid information for computing the Employment Tax Gap

b. Determine compliance characteristics so IRS can focus on the most noncompliant employment tax areas

3. Randomly select 2,000 taxpayers each year for next 3 years

a. Comprehensive scope across all industries/filers of employment tax reports

b. According to John Tuzynski, chief of employment tax operations in Small Business/Self-employed Division

i. Agency is training fewer than 200 auditors for the program

ii. Scope will be greater in these examinations than normal

4. Results are not expected to be available until 2013

a. The results will be used by the IRS to help it target employment tax audits – so even if you’re not included in project, the information gathered could lead to an audit

b. In FY 2008, SB/SE completed fewer than 1,200 employment tax examinations

5. Employment Tax Gap –

a. According to the IRS, 70% of the amount collected by the IRS is drawn from employment taxes

i. The “tax gap” (difference between taxes owed and taxes ultimately collected) is approx. $25B annually

b. In 2000, DOL found that from 10% to 30% of firms audited in 9 selected states had misclassified workers, improperly treating employees as independent contractors

c. Study suggested that if only 1% of all employees nationally were misclassified, the loss in unemployment insurance revenue alone would be nearly $200M annually

i. Big ticket items are FICA and income tax withholding – 1984 study estimated that U.S. employers misclassified a total of 3.4M employees, resulting in an estimated revenue loss of $1.6BN (in 1984 dollars)

d. SB/SE conducts majority of misclassification-related examinations

i. It made applicable assessments (taxes and penalties) in 71% of the examinations that it closed during FY 2008, resulting in a total of almost $64M in assessments

ii. IRS doesn’t track the number of cases that are closed because the taxpayer qualified for Section 530 relief (so it is unknown what portion of the 29% of examinations that were closed without making an assessment were closed because of Section 530)

ii. Sarah Hall Ingram (Comm’r of the Tax Exempt and Gov’t Entities Division) and Joan Hirsch (Pacific coast area manager for EO examination) spoke in a panel on Nov. 19 that one focus of the division’s compliance effort in FY 2010 will be employment taxes and, therefore, will do full examinations of “some 500” organizations to gauge compliance with employment tax regulations

1. Also said that TE/GE will focus on UBIT and charitable spending, by using multiple sources of already existing information (such as closed exams and open cases) to formulate a better understanding of practices in those areas

2. The division expects “soon” to provide examination agents with a new “check sheet” they can use in gathering information on tax-exempt organizations’ governance, an area of “passionate” interest to Ingram

3. “stay tuned” for more in international area (i.e., international grant making and transfers of funds overseas)

iii. Areas of Focus for NRP

1. Worker Classification (independent contractor, common-law employee, statutory employee, statutory non-employee)

a. 3 Categories that demonstrate Control for purposes of the common law definition of employee

i. Behavioral Control – facts that show whether the business has a right to direct and control how the work does the task for which the worker is hired including the type and degree of

1. instructions that the business gives to the worker

a. when and where to do the work

b. what tools or equipment to use

c. what workers to hire or to assist with the work

d. where to purchase supplies and services

e. what work must be performed by a specified individual

f. what order or sequence to follow

2. training that the business gives to the worker

ii. Financial Control – facts that show whether the business has a right to control the business aspects of the worker’s job include

1. the extent to which the worker has unreimbursed business expenses

2. the extent of the worker’s investment

3. the extent to which the worker makes his or her services available to the relevant market

4. how the business pays the worker

5. the extent to which the worker can realize a profit or loss

iii. Type of Relationship

1. written contracts describing the relationship the parties intended to create

2. whether or not the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay

3. The permanency of the relationship (i.e., indefinite nature or set for a specific project or period)

4. the extent to which services performed by the worker are a key aspect of the regular business of the company

b. Section 530 Relief: Section 530 of the 1978 Revenue Code (as amended)

i. Provides relief from employment tax liability for employers who misclassified workers as independent contractors using the common-law facts and circumstances standards

ii. Requirements to obtain Section 530 relief:

1. The Substantive Consistency Requirement: the TP 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 TP with respect to the worker for such periods are filed on a basis consistent with the TP’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. Judicial precedent

b. IRS rulings

c. Past IRS audit

d. A long-standing practice of a significant segment of the relevant industry

iii. Section 3509

1. When an employer erroneously treats an employee as a non-employee and does not withhold federal employment taxes, the employer is liable under IRC 3102 and IRC 3403 for the employee's share of FICA tax and the employee's income tax withholding. This is true even if the employer does not withhold the tax from the worker.

2. Although relief provisions under IRC 3402(d) and IRC 6521 are available, employers sometimes find it difficult to locate and get the cooperation of former employees in order to avail themselves of the relief.

3. IRC 3509 provides a different method for the employment taxation of reclassified wages previously treated as non-wage payments to non-employees.

4. IRC 3509 applies where Section 530 relief is not available and gives reduced rates for income tax withholding and the employee's share of FICA where an employer failed to withhold employment taxes by reason of treating such employee(s) as a non-employee. A "non-employee" includes, but is not limited to, independent contractor. The procedure does not relieve the employer of the employer's share of FICA and FUTA taxes. The rate imposed depends on whether Form 1099’s were filed and whether there was an intentional disregard of the requirements or reasonable cause for the failure.

5. The failure to file and failure to deposit penalties (6651 and 6656) will still apply unless there is reasonable cause.

6. If IRC 3509 applies, the offset provisions of IRC 3402(d) and IRC 6521 do not apply. Application of IRC 3509 is mandatory if the criteria are satisfied. Neither the examiner nor the taxpayer has a choice regarding its application. See IRC 3509(c) and (d) for exclusion criteria.

2. Fringe Benefits

a. Taxable v. Tax-Free treatment of benefits

i. In past initiatives with respect to exempt organizations, IRS has found fringe benefits that were not considered and reported as compensation, such as personal free use of a car, apartment, personal components of business travel, holiday gifts, etc…

ii. Also comes up in relocation travel/expenses, education expenses

iii. Common exceptions to income inclusion are working condition fringe benefit and de minimis fringe benefit

iv. IRS is currently reviewing recordkeeping requirements regarding personal use of employer-provided cell phones

3. Officer’s compensation

a. Reasonable compensation

i. In the NRP, the IRS is looking at it, not for excess benefit transactions, but for deductibility issues, which are generally not applicable to tax-exempt organizations

ii. There may be other executive benefits that could be considered

4. Reimbursed expenses

a. In order for reimbursed expenses, even employment related expenses, to be excluded from an employee’s income, as opposed to being considered additional compensation, the reimbursements must be made in accordance with a written reimbursement plan or otherwise qualify as a tax-free fringe benefit

i. Without a written reimbursement plan, the employee could be hit for underreporting income and the employer could be hit for failing to withhold on income and FICA

b. In past initiatives, 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…

c. Past Programs Targeting Tax-Exempts and Exec. Compensation

i. IRS Interim Report on University Compliance will be issued in the “next few months”

1. data gathered from compliance questions sent in 2008 to about 500 universities

2. In current FY will initiate formal examinations of approx. 36 schools

3. Among the data being gathered is information with respect to executive compensation practices

a. Goal is to determine types and amounts of executive compensation

b. Use the information gathered to help the IRS identify issues and areas that may need more outreach and education or further scrutiny

ii. IRS Exempt Organizations Hospital Study (final report issued in Feb. 2009)

1. Focused on community benefit and compensation-setting practices

2. Concluded that nearly all hospitals in the study reported complying with the important elements of the rebuttable presumption for establishing compensation

3. IRS will continue its enforcement work in this area through examinations and other compliance initiatives. IRS will seek a better understanding of the impact of certain aspects of existing laws, including the permitted use of for profit comparables, and the rule excepting the initial contract between the organization and the executive.

iii. Exempt Organizations Executive Compensation Compliance Project (started in 2004 and final report (on Parts I & II) issued March 2007 – (Part III is not completed and stemmed from information discovered in Parts I & II)

1. Part I – compliance check letters sent to 1,023 public charities and 200 private foundations about their compensation practices and procedures

a. Sent to organizations whose 990’s and 990-PF’s were missing certain information

2. Part II – 782 examinations (most were single issue – executive compensation, some ended up being more comprehensive), 179 of which resulted from responses to the Part I compliance checks

a. Purpose was to determine whether the compensation of disqualified persons was reasonable for purposes of the Internal Revenue Code

b. Agents also considered the private foundation rules against making loans to disqualified persons, the rules prohibiting purchase of charity assets at below market prices and the rules against sales of disqualified persons’ property to charities at inflated prices

3. Part III – one of the areas that triggered a compliance check was missing or inadequate information on the Form 990 question involving receivables from officers, directors and trustees

a. Information frequently omitted included interest rates, amount of the original loan, loan repayments, and collateral

b. Some of the loans made up a very large amount of the organization’s total assets. IRS found both very substantial loans to insiders and undocumented loans.

c. As a result of the loan information that was discovered, a new phase of the initiative began in March 2006 that was dedicated solely to loans

i. Involves 200 compliance check letters and 50 examinations

4. Report on Parts I & II noted the following compensation related recommendations:

a. 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

b. 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. EO should continue to review compensation issues in more focused projects and should pursue base-lining general compliance with the compensation rules.

d. Other IRS programs addressing employment tax compliance

i. Form SS-8 (Determination of Worker Status Program)

1. Either the worker or the company can request a determination from the IRS as to worker status (approx. 90% are filed by workers)

2. GAO thinks it’s underutilized

3. In FY 2008, IRS determined that a worker was an employee in 72% of all SS-8 requests, 25% closed without any determination made and 3% resulted in independent contractor determination

a. Query: Would an SS-8 submitted by an employer with the proper documentation and professional help be more likely to result in an independent contractor classification? It’s a risk, but at least at the end of the day there’s certainty as to treatment.

ii. The Employment Tax Examination Program (ETEP)

1. Examines employers likely to have misclassified workers based on specific criteria

iii. General employment tax examinations that lead to worker classification examinations

iv. The Questionable Employment Tax Practices (QTEP) program, through which IRS and states share information on worker classification-related examinations and other questionable employment tax issues – IRS examination will follow states generally

v. Classification Settlement Program (CSP) – enables qualifying employers under examination for misclassification-related issues to lower their misclassification-related tax liabilities if they agree to properly classify their workers in the future

e. IRS isn’t the only federal agency focused on employment tax issues

i. GAO in August issued report, “Employee Misclassification: Improved Coordination, Outreach, and Targeting Could Better Ensure Detection and Prevention”

ii. Four bills were introduced in the 110th Congress regarding worker misclassification

1. H.R. 6111 and S.3648 would amend the Fair Labor Standards Act

a. Would require employers to keep full records on independent contractors, and would add misclassification penalties

2. The Independent Contractor Proper Classification Act of 2007 (S.2044) would have amended the IRC to require IRS and DOL to exchange information

3. H.R. 5804 would have also modified misclassification rules

iii. In the 111th Congress – at least one H.R. 3408

f. In addition to civil penalties, the IRS also pursues criminal penalties in cases of employment tax fraud. Over the last 3 years, the IRS has increased the number of investigators looking into employment tax fraud cases by 249%.

II. What can Nonprofits do?

a. Review existing service relationships

i. Are worker’s appropriately classified?

ii. If a worker is being treated as an independent contractor, is the documentation consistent?

iii. Look at the Section 530 requirements.

1. Would the organization qualify for relief if the IRS determines that the worker was misclassified?

2. Not sure? Consider a request pursuant to Form SS-8

a. Quantify the risk: FICA, income tax withholding, interest, penalties, state re-classification, DOL

b. Review existing benefit arrangements

i. Have all benefits/perks been accounted for correctly? If not, how can it be corrected?

ii. 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).

iii. Do you have a written reimbursement plan?

c. Are there any loans with insiders/disqualified persons?

i. Are they properly documented and consistent with the excess benefit transaction rules?

ii. Are there any loans to employees, in general? Employment related below-market loan rules.

d. Do compensation arrangements satisfy the rebuttable presumption for reasonable compensation?