After including an initiative with its priority guidance plan for fiscal year 2016, the IRS has increased its oversight of governmental entities’ tax compliance through a balanced approach of outreach, education and examination activities. During this process, the IRS has used data-driven analytics to pinpoint selections of governmental entities for employment tax examinations. The strategy behind this is to allow the IRS to invest its limited resources in areas that will provide the greatest effect for raising tax dollars in an effort to close the tax gap. The IRS projected 75 percent of its governmental entity examination activity will be performed on governmental entities with $10 million or more in gross wages, which will allow it to increase wage base coverage while also addressing material and significant compliance issues. In addition, the IRS believes there is a high risk of noncompliance and has conducted specific compliance initiative projects.
As discussed in the IRS 2017 work plan, Federal, State, Local/Employment Tax (FSL/ET) examiners will focus on compliance by federal, state and local governmental entities with their employment tax obligations. One of the IRS compliance strategies is to examine W-2s and 1099s to determine whether certain payments should’ve been subject to Federal Insurance Contributions Act (FICA) tax and income tax withholding. Likewise, it will determine whether governmental organizations complied with backup withholding requirements due to mismatched and/or missing Taxpayer Identification Numbers on Form 1099s. As part of its data-driven approach to examination selection, the IRS will use computer models to identify employment tax returns (Forms 941, W-2 and 1099) filed by governmental entities with the highest risk of employment tax noncompliance. Based on employment tax audit results for fiscal year 2016, 89 percent of the adjustments made from examination activity were directly tied to unreported compensation (37 percent), FICA-adjusted wages (36 percent) and worker reclassification (16 percent). The IRS will use and analyze this data to select future cases.
The work plan also identified specific areas at particularly high risk for noncompliance, such as early retirement incentive plans, fringe benefits and misclassified workers. These areas more commonly result in employment tax issues and improper characterization of payments, which can lead to possible backup withholding and potentially significant penalties and interest. Employers also may need to correct or amend their W-2s and 1099s, resulting in amended business or personal returns for the workers involved.
To help mitigate potential risk in these identified areas, governments are encouraged to review their payroll processes, particularly those involving higher risk areas such as deferred compensation and incentive plans. Fringe benefit plans and reimbursement policies should be examined to assess whether they’re compliant with current tax laws. Contracts or other formal arrangements with independent contractors should be reviewed annually to identify whether classification is still appropriate and the key factors remain the same. If questions remain about proper tax treatment, an outside tax professional may provide the expertise needed to avoid issues down the road.
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