When thinking about tax obligations, companies and individuals often focus their attention on federal and state income taxes. However, it is important that companies not overlook their payroll tax obligations, as these can often be a trap for the unwary.
In fact, in a recent publication, the IRS stated that payroll taxes withheld by employers account for more than 70 percent of all revenue collected. As a result, the IRS has focused much of its enforcement efforts on payroll tax compliance. Moreover, it is not uncommon for an employer to withhold insufficient amounts given the broad range of items subject to withholding tax. For instance, the IRS broadly construes wages subject to withholding tax to generally include any consideration paid to employees in exchange for services. Accordingly, tax must be withheld on amounts paid as salaries, vacation allowances, bonuses, commissions and taxable fringe benefits among other things. Federal statute provides that employers are liable for any underpayment of tax that results from insufficient amounts being withheld. Therefore, employers should be extra careful to maintain compliance in this area.
Employers that fail to either withhold sufficient amounts or pay withholding tax due may be subject to penalties at both the federal and the state level. At the federal level, employers that fail to deposit the correct amount of withholding tax are generally subject to a penalty ranging from two to ten percent of the additional tax due. Further, employers that fail to pay withholding tax are subject to a penalty in an amount equal to 0.5 percent of the tax due, increasing at this rate for each month the failure continues, not to exceed 25 percent.
Mitigating the IRS Compliance Issues
Employers report amounts withheld from employee’s paychecks to pay FICA tax and income tax withholding under section 3402 using Form 941. The IRS requires employers to correct any employment tax reporting errors contained on Form 941 by completing Form 941X. Additionally, the adjusted return must set forth the following:
- The period in which the error was ascertained;
- The period being corrected, and;
- A detailed statement identifying the grounds for the correction.
An error is considered to have been ascertained at the time the employer has enough knowledge to correct the error. Timing is critical in this analysis because generally errors ascertained within a certain time period after the return has been filed can be corrected as an interest free adjustment. Further, for a filed Form 941X to constitute an adjustment, employers must:
- File Form 941X within the applicable statute of limitations;
- File Form 941X on the due date for the corrected return for the period in which the error is ascertained, and;
- Pay to the IRS the amount of the underpayment by the date the return is filed.
Moreover, employers that meet the requirements outlined above generally obtain added relief from failure-to-pay and failure-to-deposit penalties. Employers who report an adjustment but fail to pay the underpaid tax in a timely manner forfeit the interest relief. Additionally, employers who receive a notice from the IRS in connection with the underpayment cannot avail themselves of an interest-free adjustment.
Employers who either fail to complete a Form W-2 on behalf of an employee for whom such statement is required or who fail to include complete and accurate information on a submitted Form W-2 are subject to a penalty in the amount of $260 per form. That said, employers may reduce the penalty amount by promptly correcting the error through filing a corresponding Form W-2c. Moreover, employers may avoid the imposition of penalties altogether by demonstrating that the failure was due to reasonable cause. An employer can establish reasonable cause for waiver of penalties relating to information returns by either supplying evidence of significant mitigating factors or demonstrating that the failure arose from events beyond the employer’s control.
Lastly, employers should be aware that the correct amount of employee tax must be paid through an increased payroll deduction or some other form of agreement between the employee and the employer.
Employers report the annual tax owed under the Federal Unemployment Tax Act (FUTA) using Form 940. The tax liabilities associated with the Forms 940 are only calculated on the first $7,000 that each employee makes. Amendments to Form 940 may be made to correct errors made using the same forms from the tax year in which the error was made.
Alternatively, employers may conclusively resolve federal employment tax issues that do not involve worker classification through the IRS Voluntary Closing Agreement Process (VCAP). The IRS VCAP is available to taxpayers not currently under audit for any period provided that the taxpayer can show that compliance with the other return correction procedures would not allow for swift and conclusive resolution and entering into the agreement is consistent with the IRS’s interests. A unique benefit of this program is that in some cases, the IRS may allow employers to furnish a corrected Form W-2c without increasing the amount of wages subject to income tax withholding, thereby avoiding the issue of burdening employees with an unexpected income tax liability. To request entry into the IRS VCAP, employers simply need to submit a written request containing the information set forth in IRM 22.214.171.124.
Mitigating State Level Compliance Issues
Employers may choose to resolve employment tax liability issues at the state level by submitting amended forms and completing a Voluntary Disclosure Application (VDA) through the respective state’s VDA program. Generally, to qualify for admission into the VDA program, the employer must not have received any correspondence from the state enforcement agency in connection with its withholding tax obligation. In most cases, participants in the VDA program receive waiver of penalties but are required to pay interest upon the amount due. Additionally, through the VDA program, employers may be able to pay employees’ tax liabilities on their behalf.