The Internal Revenue Service Needs to Be Consistent and Fair
When Assessing Interest and Penalties on Employers Who Misclassify Their
Employees
January 2003
Reference
Number: 2003-30-042
This report has cleared the Treasury
Inspector General for Tax Administration disclosure review process and
information determined to be restricted from public release has been redacted
from this document.
January
16, 2003
MEMORANDUM FOR
COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Gordon C. Milbourn III /s/ Gordon C.
Milbourn III
Acting Deputy Inspector
General for Audit
SUBJECT: Final Audit Report – The Internal Revenue
Service Needs to Be Consistent and Fair When Assessing Interest and Penalties
on Employers Who Misclassify Their Employees (Audit # 200230018)
This
report presents the results of our review of the assessment of penalties on
certain employment tax returns. The
overall objective of this review was to determine if the Internal Revenue
Service (IRS) was achieving its goal of applying penalties in a fair and
consistent manner on these returns.
Specifically,
we focused on employment tax returns where penalties were assessed but interest
was waived.
Employment
taxes, which are taxes paid by businesses on the salaries of their employees,
represent a significant portion of the revenue collected by the IRS. These taxes are assessed on amounts paid to
employees but are not assessed on amounts paid to workers who are not
employees. Laws defining who is and who
is not considered an “employee” of a business are confusing to many
taxpayers. Businesses that misclassify
their workers as non-employees, when they should have been classified as
employees, can be liable for significant amounts of back taxes. Although Internal Revenue Code (I.R.C.)
Section 6205 allows interest to be waived on these back taxes if certain
requirements are met, it is silent regarding the assessment of penalties. Generally, the Congress has given the IRS wide latitude to
waive penalties on unpaid taxes, but has strictly limited the instances when
the IRS could waive interest. Given
these facts, it seems unreasonable that the Congress, in allowing interest to
be waived on these employment tax cases, would not expect penalties to be waived
as well.
In
summary, we found the IRS assessed employers over $4.35 million (over a 3-year
period) in penalties on employment tax accounts where interest was waived due
to Section 6205 provisions. In some
cases, the IRS assessed these penalties even after indicating to taxpayers that
the penalties could be waived. In our
opinion, it is inconsistent to charge penalties on these employment tax returns
when interest is being waived. Further,
even though businesses were told that interest would not be assessed on the
employment taxes owed, the IRS nevertheless assessed over $2.54 million in
interest on the penalties themselves that were applied to those taxes. Finally, we question whether the interest
waiving provisions of the law should apply to misclassified employee
returns. Employers who misclassify
their workers may be provided with a tax break that was intended to address a
different issue. This tax break may
even increase employers’ incentives to misclassify their workers.
To
address these concerns, we recommended that the IRS reprogram its computer
system so the computers do not automatically assess penalties on late-filed
employment tax returns where Section 6205 provisions are being applied. We also recommended that the IRS issue
instructions to applicable employees telling them not to assess penalties on
employment tax return examinations where this Section applies. Finally, we recommended that the IRS
determine whether the original intentions behind the interest waiving
provisions of Section 6205 should apply to misclassified employee returns, and
work with the Department of the Treasury to recommend appropriate legislative
changes or changes to the pertinent regulations.
Management’s Response: The IRS generally
agreed with the recommendations in this report and is taking steps to implement
them. Due to a proposed regulation that
could result in even more penalties being assessed on employment tax returns,
the IRS determined that it should implement our recommendation to review the
continued applicability of Section 6205 to misclassified employees before
taking any of our other recommended actions.
Contingent on the results of its review, the IRS agreed to use specific
computer codes to stop its computers from automatically assessing penalties on
cases meeting Section 6205 criteria and update instructions to its
employees. Management’s complete
response to the draft report is included as Appendix V.
Office
of Audit Comment: As detailed in our
report, we agree with the IRS regarding the importance of reviewing the
continued applicability of Section 6205 with respect to misclassified employee
cases. We further agree that the
importance of the IRS’ review is increased because of the proposed regulation
to assess even more penalties. However,
if no other actions are taken until the IRS’ review is complete, the IRS will
knowingly continue to apply the tax code inconsistently by assessing penalties
while waiving interest on late-filed returns involving misclassified
employees. In our opinion, the IRS
should take immediate action (as described in Recommendations 1 and 2 of this
report) to waive penalties on these cases, until it determines the continued
applicability of Section 6205 and its related regulations. If the IRS finds that Section 6205 should not apply to
misclassified employee cases, it would then be appropriate to work with the
Department of the Treasury to amend regulations or seek legislation providing
for the assessment of both interest and penalties on these cases.
While
we believe that immediate action on all of our recommendations is necessary for
the IRS to consistently and fairly implement the tax code as currently written,
we do not intend to elevate this issue to the Department of the Treasury for
resolution.
Copies
of this report are also being sent to the IRS managers who are affected by the
report recommendations. Please contact
me at (202) 622-6510 if you have questions or Parker F. Pearson, Acting
Assistant Inspector General for Audit (Small Business and Corporate Programs),
at (410) 962-9637.
Penalties Should Not be Assessed on Accounts Where Interest
Is Being Waived
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Outcome Measures
Appendix V – Management’s Response to the Draft Report
Businesses with employees are generally required to withhold income, Social Security, and Medicare taxes from their employees’ wages and turn the amounts withheld over to the Federal Government. These businesses are also generally required to match the amounts they withhold from their employees for Social Security and Medicare taxes, and pay the matching amounts (called “employment taxes”) to the Internal Revenue Service (IRS) quarterly. Businesses are generally not required to withhold or pay employment taxes on amounts paid to workers who are not their employees.
Laws defining who is and who is not considered an “employee” of a business are confusing to many taxpayers. Often, businesses may, in good faith, treat workers as non-employees when they should be treated as employees. Later, if the businesses or the IRS discover the error, the businesses are responsible to pay all back employment taxes for the misclassified employees. These back taxes can be either self-assessed (i.e., businesses identify the errors and report the back taxes themselves) or assessed by the IRS as the result of an employment tax examination.
Normally, business and individual taxpayers are liable for interest and penalties on any taxes that are not paid by the due date of their tax returns. However, employment tax regulations under Section 6205 of the Internal Revenue Code (I.R.C.) allow employers to make adjustments to returns without interest “until the last day for filing the return for the quarter in which the error was ascertained.” An error is defined as “ascertained” when the employer has sufficient knowledge of the error to be able to correct it.
Although the I.R.C. allows interest to be waived on these employment tax returns, it is silent regarding the assessment of penalties. We reviewed the IRS’ administration of the employment tax laws as written for assessing interest and penalties on back taxes due as a result of the misclassification of employees. We also assessed how changes to employment tax laws over time may have created the necessity for the IRS to seek modification to Section 6205 or its applicable regulations.
We conducted our audit at the Ogden IRS Campus from December
2001 to August 2002 using tax return information filed nationwide. The audit was performed in accordance with Government Auditing Standards. Detailed information on our audit
objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed
in Appendix II.
We identified 2,766 cases over a 3-year period on which the IRS assessed back employment taxes, waived the interest associated with the assessments (due to Section 6205 provisions), but assessed penalties (failure to file, pay, and deposit) against the employers. In our opinion, it is inconsistent for the IRS to assess penalties related to errors made by employers in determining the employment status of their workers, when it is waiving interest related to the same error.
Treasury Regulations applicable to Section 6205 specifically allow employers to make adjustments to returns, without interest, if they pay any taxes related to those adjustments by the due date of the quarterly return on which the error was ascertained. This provision applies regardless of whether the employer or the IRS first ascertains the error. Basically, in these cases, the IRS waives the interest until the employer has sufficient knowledge of the error to be able to correct it. To waive interest because the employer did not have knowledge of the error, but to assess a penalty related to that error, is an inconsistent application of the tax law.
Historically, the Congress has given the IRS wide latitude to waive penalties on unpaid taxes but has strictly limited the instances when the IRS could waive interest. For example, the IRS has authority to abate penalties for “reasonable cause.” Reasonable cause relief can be granted at the IRS’ discretion when the IRS determines that taxpayers exercised ordinary business care and prudence in determining their tax obligations. However, the IRS is only allowed to abate interest through statutory provisions or because of IRS errors or delays. There is no provision for abating interest at the IRS’ discretion, not even for reasonable cause. Given these facts, it seems reasonable that the Congress, in allowing interest to be waived on these employment tax cases, would expect penalties to be waived as well.
As previously mentioned, a reason the IRS frequently uses to
waive penalties on a tax assessment is that the taxpayer had a reasonable cause
for not reporting or paying taxes. Regulations under Section 6205 waive interest
on an assessment until the employer has sufficient knowledge of the
misclassification to be able to correct it (i.e., the ascertainment date). The fact that the employer did not have
sufficient knowledge implies reasonable cause, which would therefore suggest
that the penalties should also be waived.
In addition to the problem of assessing penalties on these accounts, we identified two other problems associated with this issue. These problems are also a condition of assessing penalties on these accounts when interest is being waived.
The IRS assessed penalties even after giving businesses
indications that they would not be assessed
Of the
2,766 returns on which penalties were charged but interest was not, we
identified 401 returns that were worked under the IRS’ SS-8 Program. Employers under this program whose workers
are determined to be employees receive a letter from the IRS stating:
“By taking the initiative to correct
your account, you may be able to forego any applicable penalties in connection
with this matter. If you will file the
employment tax return and pay the taxes in full, we will attempt to provide
relief from any penalties that may be due.”
Not only did the IRS assess penalties on these cases, but we also found evidence that at least two of the businesses specifically asked the IRS to abate the penalties as it had said it would. Both these businesses had paid the additional taxes timely, but the IRS did not abate the penalties.
Although we only identified 2 businesses that specifically asked the IRS to abate their penalties, we reviewed 115 of the 401 returns to determine how many businesses paid the tax and filed the returns by the due date of the quarter in which the error was ascertained. We found 85 (74 percent) of these 115 businesses paid and filed timely. As stated previously, it is our opinion that penalties on these cases should not have been assessed at all. Stating that the IRS would attempt to provide relief from the penalties, and then not addressing the issue, would likely frustrate taxpayers and cause additional burden.
Most returns are being charged interest on the penalty
For the 2,766 returns we identified on which the IRS had assessed back employment taxes but waived the interest related to that assessment, 2,195 (79 percent) had assessments of both the failure to file penalty and interest associated with that penalty. By law, interest is charged on the failure to file penalty from the original due date of the tax return until it is fully paid. The interest waiving provisions of Section 6205 only apply to the tax, not to interest on the penalty. Although the IRS has legal authority to assess interest on the failure to file penalty, it is once again inconsistent to assess the penalty, and accordingly, interest on the penalty.
Hypothetical example
The following is a hypothetical example to help illustrate the overall Section 6205 process. Assume that a small company started a business in October 1999 and treated its workers as independent contractors (i.e., non-employees). After an examination of the company in March 2002, the IRS determined the workers were actually employees. The IRS would have then assessed Social Security and withholding taxes, along with a failure to file penalty because the business did not file an original return in January 2000, when the return was due.
Assume the business paid the tax assessment in full by the due date of the quarterly period (April 30, 2002) in which it became aware of the error (examination date, March 2002). The IRS would then have waived the interest charge that normally would have been computed on the tax from January 2000 (due date of the original return) until the tax was full paid (April 2002). However, it would still assess the failure to file penalty from the original due date of the return (January 2000). In addition, it would assess interest on that penalty until the penalty was paid.
Therefore, the employer would have had interest waived on
the employment tax assessment because, until March 2002, he or she did not have
sufficient knowledge of his or her error to file an appropriate employment tax
return. However, the employer would
have been assessed a failure to file penalty and charged interest on that penalty.
Why these conditions occurred and their impact
These
conditions occurred for two reasons:
· Section 6205 did not provide clear guidance on whether penalties should be assessed.
· The IRS has not recognized the inconsistency of assessing penalties while waiving interest.
In reviewing the IRS’ instructions and training material, we were unable to find any procedures indicating that penalties should not be assessed on these accounts when interest is being waived under Section 6205.
As a result, over a 3-year period, the IRS assessed employers over $4.35 million in penalties (failure to file, pay, and deposit) on the 2,766 employment tax assessments meeting the criteria of Section 6205. In addition, the IRS assessed over $2.54 million in interest on the failure to file penalties.
The Director, Office of Penalties and Interest, Small Business/Self-Employed (SB/SE) Division, should:
1. Request programming changes that would restrict the IRS’ computer system from automatically assessing penalties on late-filed employment tax returns for which Section 6205 applies. This programming could be similar to the M Code provisions that now restrict interest from being assessed on these types of tax returns.
Management’s Response: The IRS reviewed the available tools for addressing this recommendation and determined computer programming changes were not needed. Computer codes currently available can be used to stop the automatic assessment of penalties on employment tax returns meeting Section 6205 criteria. (See Office of Audit Comment on page 9.)
2. Issue instructions not to assess penalties on employment tax examinations or adjustments where Section 6205 applies.
Management’s Response: The IRS will prepare and issue guidance to the field, including an update to the Internal Revenue Manual. This update will include guidance concerning the assessment or non-assessment of any penalties based on the results of their efforts in Recommendation 3 (pages 8 and 9). (See Office of Audit Comment on page 9.)
The interest-free provisions of Section 6205 can be traced back to the Social Security Act of 1935. This Act contained the following statement:
“If more or less than the correct amount of tax imposed by Section 804 is paid with respect to any wage payment, then, under regulations made under this title, proper adjustments with respect to the tax shall be made, without interest, in connection with subsequent wage payments to the same individual by the same employer.”
The Committee Hearings on this Act contained the following statement by Mr. Beaman:
“In other words, the theory of this Section is that if, as
will undoubtedly happen, particularly at the start, there comes the pay day and
the employer deducts the wrong amount through a mistake or misinterpretation of
the law, or what not, deducts too much or too little, the theory of this
paragraph is that the adjustment will be made at the next payday. We want to insert after the word ‘made’ the
words ‘without interest.’ In other
words, the idea is that, as to these small amounts, you do not have to bother
about interest.”
The intent of Section 6205 may no longer be valid for the following reasons:
· The most common errors made now relate to worker status rather than mathematical computations. All of the 2,766 returns we identified involved a worker status dispute rather than a withholding error being made on the tax return. Two IRS tax employment examination specialists verified that our cases were typical of most employment tax examinations. Given this fact, the original concept that interest would not be charged because the errors would be small and made up on future returns is no longer valid.
· Employers’ financial motives to misclassify workers as non-employees have increased since Section 6205 was originally enacted. Social Security rates have increased and additional employment taxes have been added, such as the Federal Unemployment Tax and Medicare. In addition, employers were not originally required to withhold federal income taxes from their employees’ wages, but must do so now, creating a bookkeeping and accounting burden. Also, employees are entitled to many benefits such as health insurance, paid vacation, retirement, etc., to which non-employees are not entitled.
Because of these facts, employers who misclassify their workers may be provided with a tax break that was intended to address a different issue. This tax break may even increase employers’ incentives to misclassify their workers.
3.
The Director, Office of
Penalties and Interest, SB/SE Division, should solicit input from the Office of
Chief Counsel and the Director, Compliance, SB/SE Division, regarding the
continued applicability of Section 6205 and its related regulations as it
currently pertains to misclassified employees, and work with the Department of
the Treasury to recommend appropriate legislative changes or changes to the
pertinent regulations.
Management’s Response: The IRS agreed to appoint a
group to study the continued applicability of Section 6205 to misclassified
employees along with a new proposed regulation. This group will include representatives from the SB/SE Division’s
Compliance Policy and Compliance functions, the SB/SE Division’s Chief Counsel,
and the Large and Mid-Size Business and Tax Exempt/Government Entities
Divisions. They will discuss their
findings with the Department of the Treasury’s Office of Tax Policy. Because of the proposed regulation, which
could result in even more penalties being assessed on businesses that
misclassify employees, the IRS has made this recommendation its first priority,
and plans to wait until this group has made its determination before
implementing Recommendations 1 and 2.
Office of Audit Comment: We agree with the
IRS regarding the importance of reviewing the continued applicability of
Section 6205 with respect to misclassified employee cases. We further agree that the importance of the
IRS’ review is increased because of the proposed regulation to assess even more
penalties. However, if no other actions
are taken until the IRS’ review is complete, the IRS will knowingly continue to
apply the tax code inconsistently by assessing penalties while waiving interest
on late-filed returns involving misclassified employees. In our opinion, the IRS should take
immediate action (as described in Recommendations 1 and 2 of this report) to
waive penalties on these cases until the appointed group determines the
continued applicability of Section 6205 and its related regulations.
If the IRS finds that Section 6205
should not apply to misclassified employee cases, it would then be appropriate
to work with the Department of the Treasury to amend regulations or seek
legislation providing for the assessment of both interest and penalties on
these cases.
Appendix I
Detailed Objective, Scope, and Methodology
Our overall objective was to determine if the Internal Revenue Service (IRS) was achieving its goal of applying penalties in a fair and consistent manner on certain employment tax returns. To accomplish our objective, we:
I.
Determined the number of
possible employment tax returns on which penalties (failure to file, failure to
pay, or failure to deposit) were assessed on the tax increase, but interest was
not.
A.
Obtained a computer extract
from the IRS’ Master File of 401 employment tax returns containing an M Code
(misclassified employee). Returns were
taken over a 3-year period (Calendar Years 1998-2000).
1.
Selected a statistical sample
of 162 M Coded returns (universe – 401, confidence level – 90 percent, expected
error rate – 50 percent, desired precision – 5 percent).
2.
Reviewed 143 of the 162
sampled returns to verify that all returns contained penalties and that
interest was waived under Section 6205.
3.
Reviewed 115 of the 143
returns where an ascertainment date was available to determine if the taxpayers
filed the returns and paid the additional taxes timely.
B.
Obtained a computer extract
from the IRS’ Master File of 2,365 employment tax returns containing a
Transaction Code 308 (examination assessment with an interest start date). Returns were taken over a 3-year period
(Calendar Years 1998-2000).
1.
Selected a statistical sample of 243 Transaction Code 308
returns (universe – 2,365, confidence level – 90 percent, expected error rate –
50 percent, desired precision – 5 percent).
2.
Reviewed 226 of the 243 sampled returns to verify that all
returns contained penalties and that interest was waived under Section 6205.
C.
From the computer extracts,
identified the number of accounts for which penalties were assessed, the
average dollar amount of the penalties, the total dollar amount of the
penalties, and the total dollar amount of interest assessed on the penalties. Also estimated the total dollar amount of
penalties and interest assessed on those penalties over a 5-year period.
II.
Determined if instructions
and procedures were adequate for assessing penalties on employment tax returns.
A.
Interviewed various IRS
employees concerning procedures used in working and processing employment tax
returns.
B.
Reviewed IRS instructions,
procedures, and training materials dealing with the assessment of penalties on
employment tax returns.
Appendix II
Major Contributors to This Report
Parker F. Pearson, Acting Assistant Inspector
General for Audit (Small Business and Corporate Programs)
Richard J. Dagliolo, Director
Larry Madsen, Audit Manager
Kyle Bambrough, Senior Auditor
Annette Bates, Senior Auditor
Bill Russell, Senior Auditor
Robert Carpenter, Computer Specialist
Appendix III
Acting Commissioner N:C
Deputy Commissioner, Small Business/Self-Employed Division S
Director, Office of Penalties and Interest, Small Business/Self-Employed Division S:C:CP:RC:P
Director, Reporting Compliance, Small Business/Self-Employed Division S:C:CP:RC
Director, Taxpayer Burden Reduction, Small Business/Self-Employed Division S:T:OTBR
Chief Counsel CC
National Taxpayer Advocate TA
Director,
Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O
Office of Management Controls N:CFO:F:M
Audit Liaison:
Commissioner, Small Business/Self-Employed Division S
Appendix IV
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. These benefits will be incorporated into our Semiannual Report to the Congress.
Type and Value of Outcome Measure:
· Taxpayer Rights and Entitlements – Potential; $11,477,047 in unwarranted penalties and interest on 4,610 taxpayer returns (see page 2).
Methodology Used to Measure the Reported Benefit:
The Information Technology staff of the Treasury Inspector General for Tax Administration provided a database containing 2,766 Employer’s Quarterly Federal Tax Returns (Form 941) on which interest was waived, but penalties were assessed. These returns were identified through the use of a Master File Transaction Code 308 (examination assessment with an interest start date) input to the account or through the use of a Condition Code M (interest free adjustment for Forms 941 labeled as “misclassified” employees on the returns) input to the return. The 2,766 figure was taken over a 3-year period (Calendar Years 1998-2000). The database also included the types of penalties assessed, the amount of the penalties, and the interest assessed on the penalties. The total amount of penalties, and interest on the penalties, for the 2,766 returns was $6,886,228. This averages out to 922 (2,766/3) returns and $2,295,409.33 ($6,886,228/3) in assessed penalties and interest per year. Projecting this amount over a 5-year period yields 4,610 returns and $11,477,047 in over-assessed penalties and interest.
Appendix V
The response was removed due to its size. To see the complete response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.