Coming Soon: Stepped-Up Tax Audits of Small Firms

IRS agents are targeting, among other things, employment tax issues, retirement plans and restaurants.

By Joan Pryde, Senior Tax Editor, the Kiplinger letters

June 4, 2008

Small business owners should brace for more audits by the Internal Revenue Service on several fronts. It has been no secret that the IRS is conducting more examinations of small businesses because it thinks they are a big reason for the tax gap -- the difference between what people pay in taxes and what the government is owed. But now, the agency is sending broader signals about what its agents are going after.

Here are some of the major targets for this year and beyond:

Worker classification. Firms are headed for an employment tax audit if IRS believes they're treating workers as independent contractors when they are really employees. One big red flag: giving a worker a W-2 and a 1099 in the same year. That indicates to IRS that the company may have changed the worker's designation simply to avoid payroll taxes, not because the worker's status actually changed.

However, experts say that there are legitimate reasons for such a change in status and that companies should stand up to the IRS if they believe they're right. "Yes, it will draw an audit, but the burden of proof is no different than it is in any other question of worker classification," says Corey Lehr, director of payroll for the University of Cincinnati and a former president of the American Payroll Association.

Businesses must be prepared to document that when the worker was a contractor, the company had less control over the worker and he or she had different duties and worked fewer hours. If those criteria are met, it's entirely possible for a worker to perform services in two different capacities. For example, a company's full-time bookkeeper might be asked to design and print an advertising brochure. The company can treat her as an employee for her bookkeeping services and as a contractor when it comes to her work on the brochure.

Restaurants. The big issue here is tip reporting. The IRS is concerned that many establishments don't bother to file Form 8027, the annual tip information reporting return. The tax agency views this return as crucial to its efforts to monitor tip compliance: It studies the forms to determine whether restaurants are following tax rules that require them to allocate tips on employees' W-2s equal to 8% of sales if the actual tips that are being reported total less than that amount. So the IRS will make a point of auditing nonfilers to see whether they are following those allocation rules.

Retirement plans offered by small business owners, especially a type of IRA known as a SEP (simplified employee pension). The IRS suspects that errors are rampant among SEP IRAs. Among common mistakes that sponsors are making: Failing to contribute a uniform share of pay for all participants. Not updating plans to reflect changes made to pension law. And making excess contributions for high-paid workers.

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