As part of a national research project that began in 2010, the IRS is now in the process of examining various organizations to find out whether they are complying with the laws governing employment tax reporting and withholding. Both for-profit and tax-exempt entities are being looked at by the IRS as part of this project. The IRS’ decision to include tax-exempt nonprofits in the pool of entities that may be examined could result in these nonprofits having to face challenging issues, and possible significant tax liabilities.
The IRS has randomly selected several thousand entities for this audit. The examinations will cover specific areas of the tax law where the IRS perceives abuses have taken place. These areas include worker classification, fringe benefits, officer compensation, and reimbursement of employee expenses.
This means, for example, that a nonprofit that may have improperly classified workers as independent contractors (instead of as employees) could face a significant tax bill if it is audited and these errors are discovered.
For federal tax purposes, to determine whether a worker is an employee or an independent contractor, the general rule is that the right to direct and control the individual who performs the services, not only as to the result to be accomplished but also as to the details and means by which that result is accomplished, is indicative of an employer-employee relationship. In other words, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. It isn’t necessary for the putative employer to actually direct or control the manner in which the services are performed; it is sufficient if it has the right to do so. An independent contractor, on the other hand, is generally not subject to the control of the business that is receiving the services as to how the services are to be provided. The independent contractor generally makes these types of decisions.
In determining how a worker should be classified, i.e. as an employee of independent contractor, there are numerous factors that an entity (both nonprofit and for-profit) should examine. Although a complete discussion of all of the factors is beyond the scope of this article, a sample of some of the factors are listed below. These factors help determine whether the requisite degree of control is present such that the worker should be classified as an employee.
Some of the factors that are examined include the type and degree of instructions that are given to a worker by the entity that is receiving the services, where the work is done, the training provided to the worker, whether the worker is reimbursed for out of pocket expenses, how the worker is paid (by the job or by the hour), and how the parties perceive their relationship (i.e. whether the parties have entered into an agreement that designates the worker as an employee or independent contractor). Generally speaking, the greater the volume and detail of the instructions and training provided by the entity to a worker, the more likely it is that the worker will be classified as an employee. If the work is performed at a location that belongs to the entity (as opposed to the worker’s place of business), the more likely it is that the worker will be deemed to be an employee. Reimbursing a worker for out of pocket expenses and paying the worker by the hour (or in a manner other than by the job) also tend to show that the worker is an employee.
Tax-exempt entities that have classified one or more workers as independent contractors should conduct a thorough review of their records, policies, and procedures concerning worker classification (as well as the other areas that will be focused on by the IRS) to ensure that, if questioned, they can support their decisions. Having complete and accurate records, as well as sound policies and procedures, should help make any examination less stressful and time-consuming and reduce the potential tax exposure.
Compensation and fringe benefits
In addition to the worker classification issue, examinations will focus on compensation and fringe benefits that are provided by nonprofits to their employees, especially officers. The IRS will determine if entities are properly valuing the fringe benefits provided and whether they are including (and properly accounting for) these benefits when reporting the compensation being paid to their employees. If a fringe benefit is taxable, it is normally treated as additional salary or wages. This means that income taxes and employment taxes (such as Social Security (FICA)) must be withheld and remitted to the government based on the value of the fringe benefit. Failure to do so could subject the employer to liability for the amount that it should have withheld, plus penalties and interest.
An additional complication for nonprofits that fail to properly include fringe benefits in compensation, or that incorrectly value these benefits, is possible exposure to the intermediate sanction rules in Internal Revenue Code Section 4958. These rules, which generally apply to entities classified as public charities, prohibit excessive compensation and other benefits from being paid by a public charity to certain “disqualified persons.” If these rules are violated, significant penalties may be assessed on both the disqualified person who received the excessive benefits and on the charity’s managers who participated in awarding the excessive benefits.
Although there are many types of fringe benefits that the IRS is examining, one example is the car allowance. The Internal Revenue Code contains very specific rules on how to value, and account for, the benefit of an employer-provided car. As a result, it is important for employees who use an employer-provided vehicle to maintain logs that track personal and business use. If an employee fails to maintain accurate records that show the personal and business use of the vehicle, the IRS may seek to include the full value of the vehicle’s use in the employee’s income. This will have employment tax consequences to the nonprofit (because the employee may be viewed as having received additional salary/wages for which no withholding was taken) and may also result in a violation of the intermediate sanction rules if the employee’s compensation (including fringe benefits) exceeds what is reasonable under the circumstances. This same analysis (and potential consequences) will apply to other fringe benefits, such as reimbursement for educational expenses, childcare assistance payments, cafeteria plans, and employee discounts. Maintaining complete and accurate records will greatly assist the entity and the worker if an examination is undertaken.
What to do if audited
If a nonprofit is selected for examination by the IRS, the IRS may seek to scrutinize a substantial number of records. It is essential to ensure that privileged records, such as records that are cloaked with the attorney-client privilege, are protected from disclosure to the IRS. For example, letters sent by the nonprofit’s attorneys to the nonprofit are generally not subject to disclosure. As a result, these documents should be withheld from disclosure to the IRS.
Additionally, the entity should designate one person who will interact with the IRS examiner. This person can be someone “in-house” who is experienced with IRS examinations or outside counsel or a certified public accountant. Having a well-defined “chain of command” will help reduce the chances of any misunderstandings with the IRS and also reduce the chances of inconsistent information and statements being provided to the IRS. The person who is designated to communicate with the IRS examiner should ask that all requests for information from the IRS be in writing. In addition to leaving no question as to what is needed, this will prevent multiple requests by the IRS for the same information.
If you have any questions, please contact Jeffrey D. Davine at (310) 312-3178 or at [email protected]. Jeffrey D. Davine is a partner in the Tax Department of the law firm of Mitchell Silberberg & Knupp LLP in Los Angeles. His practice is focused on assisting individuals and entities having disputes with the Internal Revenue Service and State taxing authorities, representing nonprofit entities, and charitable gift planning. Mr. Davine was formerly an Attorney with the IRS.