Top 10 Payroll Mistakes Companies Make

The Internal Revenue Service is focused on closing the tax gap. One way it hopes to do so is by collecting under-withheld employment taxes. As part of the Employment Tax Research Project (ETRP) launched in 2010, the IRS is reviewing the payroll practices of 6,000 employers in four main areas: worker misclassification, fringe benefits, executive compensation and payroll taxes. Once the research project is complete, the IRS will identify areas in which compliance errors routinely occur and focus audits on those issues. Companies not selected as part of the research project should look at their payroll practices and make any necessary corrections before the IRS comes knocking. We have already observed the IRS paying a lot more attention to employment tax issues and pursuing penalties with a diligence we have not previously witnessed in this area. Because we are seeing an expanded audit scope and depth of diligence by the IRS, we've put together a list of common payroll mistakes we've seen companies make. We recommend that companies, at a minimum, look at these issues:

Workers are generally classified as either employees or independent contractors. Getting this classification right is a big deal. Depending on the classification, how compensation gets reported to the IRS is different (Form W-2 vs. Form 1099). Whether the worker is entitled to benefits (like medical insurance coverage, retirement plan benefits and grants of equity compensation) can hinge on the worker's status as an employee. Whether a worker is subject to federal income tax and employment tax withholding is also contingent on status. If there has been an improper classification, the Voluntary Classification Settlement Program (VCSP) allows eligible employers to voluntarily reclassify workers as employees on a prospective basis and get into compliance by paying 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year.

If a company issues a payment to a vendor without first obtaining a Form W-9, the payment could be subject to mandatory backup withholding at a 28 percent rate. Even when it is later determined that the vendor is not subject to backup withholding (for example, the vendor is later determined to be a corporation), if the company did not obtain a Form W-9 prior to issuing payment, there may still be an issue: on audit, the IRS has pursued the collection of a failure-to-deposit penalty on the amount that should have been withheld—because at the time of payment, the company did not know that the vendor payment was exempt from backup withholding.