You are being audited by the IRS, what next?
It is tax time again! There is no sure way to avoid an IRS audit. The IRS uses some sort of formula to determine what returns to audit. These formulas are among our nation’s biggest state secrets. You are more likely to uncover the U.S. Nuclear codes or find out who actually killed JFK than you are to find out how the IRS selects returns to audit. With this in mind, rather than trying to avoid an audit, it may be better to understand what happens when you are actually audited by the IRS. Below is a very brief and very simplified summary of the audit process.
When an audit begins, generally the IRS will identify issues of concern and will seek to gather information relating to those issues. The IRS can acquire information from the taxpayer him/herself through the voluntary exchange of information or by force through summonses. The IRS can also summon third parties to acquire information.
If the IRS agent is satisfied that the reviewed return was filed correctly, then he will issue a “no-change” letter to the taxpayer that effectively ends the review. If the IRS agent does not feel that the issues of concern have been resolved in the information gathering stage, then he will write what is called a Revenue Agent’s Report. This Report is also known as a “Thirty-Day Letter” because the taxpayer has thirty days to ask the IRS Appeals office to review the report.
If no request is made for the IRS Appeals office to review the Revenue Agent’s Report, then the IRS issues a “statutory notice of deficiency.” The Statutory Notice of Deficiency is also known as a “Ninety-Day Letter,” because the taxpayer has 90 days to either agree with the Revenue Agent’s Report or to file a petition to the U.S. Tax Court to challenge the deficiency.
If the Appeals office accepts your case, a settlement conference will be organized. The purpose of this conference is to settle the case and everything said in the conference is confidential. It is almost like mediation with the IRS. Generally the Appeals office will expect the taxpayer to make a settlement offer. The Appeals office may then come back with a counter-offer. Since the number one goal of the Appeals office is to settle cases, taxpayers may be able to save considerable amounts of money by negotiating a settlement. If an agreement is reached with the Appeals office, then the agreement will be memorialized with the U.S. Tax Court. If no agreement is reached, then a “statutory notice of deficiency” will be issued by the IRS.
Once a “statutory notice of deficiency” is given, Taxpayers can challenge the deficiency in the U.S. Tax Court, the appropriate Federal District Court, or in the Federal Court of Claims. The U.S. Tax Court can be used before the deficiency is actually paid. The Federal District Court and the Federal Court of Claims can only be used if the tax has already been paid. Most taxpayers opt for the U.S. Tax Court because it allows them to challenge the deficiency without having to pay the tax first. If the taxpayer loses in their challenge of the deficiency, then they are allowed to appeal to the appropriate U.S. Circuit Court of Appeals.
As a general matter, the burden of proof in court on matters raised in the “statutory notice of deficiency” is on the taxpayer. In essence, anything claimed by the IRS is presumed to be correct. This is the opposite of what we expect out of the government in criminal cases. Not only is the IRS an enormous organization with endless resources and the power of the state, they also get this extra leg up in court. Obviously, the IRS is not an entity which any taxpayer should take lightly or should want to face alone.
Employee v. Independent Contractor, The Differences and Tax Consequences
Business owners commonly face the decision between hiring full-time employees or independent contractors to do the same work. The financial benefits to a business owner have clouded the distinction between an independent contractor and an employee. Furthermore, the tax consequences for an independent contractor and an employee are substantially different.
Both an employee and an independent contractor are given tax forms at the end of a tax year showing the amounts paid to them. Specifically, an employee is given a W-2 form and an independent contractor is given a 1099 form.
When classified as an employee, the employer deducts payroll taxes from the employee’s wages and also pays payroll taxes for the employee. These amounts are indicated on the W-2. Due to the taxes being paid and withheld throughout the year, employees generally receive a refund when filling their tax returns because too much in taxes was withheld from their wages. This allows the IRS to be paid directly from employers and eliminates a need to collect taxes from individual employees at the end of a tax year.
On the other hand, an independent contractor is paid their wages in full with no deductions taken, placing the burden to pay the taxes on the individual independent contractor. This allows the employer to avoid paying withholding taxes for an employee. Also, an independent contractor is supposed to make quarterly estimated tax payments throughout a tax year. However, it is common for independent contractors to fail to pay the required estimated tax payments, especially when the independent contractors are really employees simply being paid as independent contractors.
The IRS has recently been known to perform payroll audits and to investigate whether independent contractors of a company are in fact full-time employees that should be paid as such. For the IRS and federal tax purposes, the relationship between the worker and the business must be examined to determine the proper classification as an employee or an independent contractor. Typically, the IRS considers all evidence of the degree of control and independence in the relationship.
When thinking of the proper classification between an employee and independent contractor several factors should be considered. For example, an independent contractor would likely have more than one client, while an employee would typically work for one employer. Also, an independent contractor likely sets their own schedule while an employee is assigned their schedule. Additionally, an independent contractor would typically use their own tools and have their own methods for doing work, while an employee would be provided the necessary supplies and likely be trained by a company. Although, the differences between an independent contractor and an employee seem slight and there are financial benefits clouding the distinction, a proper classification is important to comply with the applicable rules of our federal tax system.
Improperly classifying an employee as an independent contractor places a burden on an employee to comply with federal tax requirements that they should not have to comply with. Though, the benefit to the employers of not being required to pay the payroll withholding tax incentivizes employers to classify employees as independent contractors. The IRS will likely continue to engage in payroll tax audits as long as employers attempt to take advantage of the tax benefits of the independent contractor classification.
Please contact us if you need assistance with Tax or Employment Law issues: