What Business and Nonprofit Leaders Should Know about Payroll Tax Audits

payroll expenditure or revenue account, profit or loss

What comes to mind when you hear you’re about to be audited? If you’re like most people, it’s an unpleasant idea focused solely on proving the accuracy of recent income tax returns. That’s not the only type of audit though; the IRS conducts a number of less familiar audits that often take business and nonprofit leaders by surprise. Payroll and employment tax audits are a prime example. (While nonprofits aren’t always subject to the same employee taxes as businesses, they must still comply with laws regarding federal withholding, Social Security, Medicare and other applicable payroll taxes.)

In a payroll audit, the first thing to be aware of is that these audits can be even more complex and problematic than those dedicated to income tax. That’s due in part to the sheer volume of details involved: multiple employees with differing tax rates and numerous pay periods are covered by a single audit year. In addition, there’s significant potential for ripple effects that can complicate the resolution process. If the IRS uncovers an issue related to the year under audit, fixing it could impact other tax years as well.  

During your audit, the IRS will examine records that document employee hours worked versus hours paid, withholding taxes allotted for FICA, Medicare and income, and the timeliness and accuracy of associated deposits into appropriate designated accounts. Other key evaluation points include whether or not the organization’s use of contract labor is defensible (should these workers have been categorized as employees rather than independent contractors?) and whether the organization fulfilled its obligations to issue required tax documents to workers and submit them to the IRS.

Scrupulous attention to payroll processes, tax obligations and record-keeping will pay off handsomely if your organization undergoes a payroll tax audit. Being able to easily access clear records that support your position can save countless hours of headache and anxiety when the IRS comes calling. If you don’t have these or worse yet, the IRS does identify a problem area, the situation becomes infinitely more complicated.

As mentioned previously, changes to the audit year’s payroll taxes often affect multiple tax years. Since audits occur one or more years after the initial incident, uncovering a mistake in that earlier return can throw into question the accuracy of subsequent tax reporting and payments. If the mistake is trivial and the IRS perceives it to be an honest one, agents typically decline to open an examination of other recent returns. Instead, they’ll simply expect you to comply with regulations on future returns, but if they think the organization knowingly tried to evade its full tax obligations in some manner, you should expect investigation of later returns.

Determining how much the organization owes in additional taxes, penalties and fees is another challenge. A relatively straightforward miscalculation of withholdings isn’t too difficult, but what happens if the IRS rules that workers were incorrectly classified as contractors? In that case, you might need to make restitution to staff who have previously paid the employer portion of Social Security and Medicare taxes that were actually your responsibility. And that’s on top of any IRS-imposed penalties and interest.

There is a safe harbor provision that can help some organizations in contractor versus employee corrections. Section 530 allows some taxpayers who prove their mistake was reasonable, consistent and supported by consistent tax reporting to qualify for relief from past taxes, penalties and interest.

It’s not guaranteed, however, and for nonprofits there is a risk even greater than the financial costs of “failing” a payroll tax audit. These entities can lose their exempt status if the IRS finds substantial noncompliance with tax and reporting rules. That could threaten the very existence of most such organizations!

Few filers treat taxes casually, but this cursory look at payroll tax audits and their potential consequences should further establish the tax code as something that should never be ignored or given only partial compliance. When it comes to taxes, there’s only one safe strategy: calculate them, file them and pay them – on time and accurately, every time. If that seems like a tall order, remember that the tax experts at HBP are always here to help you.