Unfortunately, there are a lot of abusive promoters pushing noncompliant Section 125 plans. Sometimes, businesses spot red flags before signing up for a plan. In other cases, employers learn of the issues themselves and are able to voluntarily fix their Section 125 plan.
But a lot of businesses aren’t that lucky – instead, they discover the issues during an IRS audit of their payroll returns and/or benefit plans. If you’re facing an audit, you need to know what to expect.
The following blog post offers an overview of payroll and benefit tax audits. While not required, it’s strongly recommended that you consult with a tax professional during the audit process. To learn more about how an experienced tax attorney can help, contact Wiggam Law to set up a consultation.
Key Takeaways
- Payroll audit selection – The IRS can select businesses for payroll audits based on worker complaints, inconsistent information on returns, late or missing federal tax deposits, and unusual payroll activity.
- Type of audit – A payroll tax audit can occur by mail, at an IRS field office, or at the taxpayer’s place of business.
- How the payroll audit process begins – The IRS notifies the taxpayer of the audit by letter, which outlines the scope of the audit and the information the IRS wants the taxpayer to provide.
- What the IRS looks for during an audit – The IRS is looking for information that confirms the Section 125 plan complies with IRS rules and statutes, both in its creation and administration.
- Payroll audit mistakes – Common mistakes taxpayers make during a Section 125 plan audit include not promptly responding to the IRS, not taking the audit seriously, and not consulting with a tax professional for help.
Why the IRS Picked You for an Audit
There are multiple potential reasons why the IRS picked your organization for a payroll tax audit. Some of the most common include:
- Current or former worker who believes they are incorrectly classified as an independent contractor instead of an employee, so they file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
- Current or former employee reaches out to the IRS or the Department of Labor about issues related to a Section 125 plan, in particular.
- Discrepancies between IRS Form 941, Employer’s Quarterly Federal Tax Return, and IRS Form W-2, Wage and Tax Statement filings.
- Late or missing federal payroll tax deposits.
- Unusual changes in payroll reporting and federal tax deposits.
- More-than-normal amended tax returns.
- Examinations of related tax returns, such as those of a current or former employee or another organization that’s somehow connected to the taxpayer.
The IRS also selects businesses randomly for audits, but this is probably the least common reason, given how time and labor-intensive payroll tax audits can be and the limited resources of the IRS.
The Employment Tax Audit Process
The IRS conducts audits either by mail or through in-person interviews. Correspondence (mail) audits involve the taxpayer sending information to the IRS to support the information on their tax returns. In-person interviews are more involved and usually apply to more complicated tax issues. These interviews can take place either at the taxpayer’s place of business (field audit) or in an IRS office (office audit).
The exact procedure for a payroll audit can vary depending on the type of audit, but most follow the same general process.
First Contact from the IRS
Initial contact about the audit will always occur when the IRS sends a letter to your business. This letter will explain what type of audit you’re facing, the tax periods under review, and what you need to do to comply with the IRS during the audit. Depending on what triggered this first contact, it’s sometimes possible to avoid a full-blown payroll audit.
For instance, if the IRS received Form SS-8 from a former or current worker, the IRS may not start with an actual audit. Instead, the IRS may ask for additional information to confirm the worker’s status. How you respond will determine if an official payroll tax audit is needed. For best results, seek guidance from a tax attorney with experience in payroll audits and worker classification issues.
In addition to notifying you about the audit, the audit notice will also identify the scope of the audit. Specifically, what tax years it applies to, as well as the returns being audited and the issues or concerns the IRS has.
Understand that most IRS audits, including those involving employment taxes, usually only go back three years. That said, the IRS may go back as far as six years in some cases. There’s also no limit to how far back the IRS can conduct an audit if it relates to a tax year with unfiled returns or fraudulent information.
Audit Preparation: Gathering Necessary Documentation
The following is a list of documents you should make sure you have and be ready to present to the IRS during the audit.
- Section 125 plan documents and any underlying benefit plan documents, such as FSAs.
- Form W-2 and IRS Form W-3, Transmittal of Wage and Tax Statements records.
- Non-discrimination test procedures and results.
- Yearly claim denial reports.
- Bank payroll statements.
- Copies of relevant tax filings, such as IRS Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, Form 941, and IRS Form 5500, Annual Return/Report of Employee Benefit Plan.
- Benefit plan amendment histories, if applicable.
- Payroll registers for each employee.
- Benefit election forms, including signed salary reduction agreements or enrollment forms.
- Proof of federal tax deposits (EFTPS receipts).
- Copies of insurance policies, if applicable.
- Copies of IRS Form W-4, Employee’s Withholding Certificate, for each employee.
- Contracts with independent contractors, if applicable.
- Wage reconciliation documents, if applicable.
- Any supporting documentation for benefits, bonuses, reimbursements, or claimed tax credits.
- Proof of employer contributions to the benefit plan.
- Benefit plan vendor contracts, if applicable.
- Correspondence with employees concerning plan changes or disputes concerning benefits.
The above is a lengthy list, and the IRS may not ask for everything listed. But it’s recommended that you make sure you have them just in case.
If you don’t have a document requested by the IRS, you’ll need to figure out how to find an alternative way to produce the information, such as various other documents that, when taken together, offer the information contained in the documents you don’t have. If that’s not possible, you can then talk to your tax professional about how to handle this situation and what it means for your audit.
If you have the documents, you should review them to see that they show your Section 125 plan is above board and the creation and administration of the cafeteria plan is compliant with IRS rules and statutes. If you find a problem, it’s better than you find out now so you can prepare a response or explanation for the IRS as opposed to the IRS informing you of the issue.
The Audit
If you’re subject to a correspondence audit, you’ll mail the documents requested (copies, not originals) to the appropriate IRS field office and revenue agent handling your case. If the amount of documents that need to be sent is unreasonably large, you have the option to request a field or office audit to present the requested documents or provide them in an alternative format, such as on a USB drive.
Besides providing the documents, you may also need to fill out a questionnaire during a correspondence audit. It’s highly advisable to answer the questions with the help of a qualified tax professional.
If you’re dealing with a field or office audit, then, in addition to the production of documents, you and others at your organization may need to sit for an audit interview. This is where an IRS representative asks questions about the Section 125 plan and how it’s been administered.
During a payroll or Section 125 plan audit, the IRS will focus on facts and issues such as whether the employer properly set up and administered the cafeteria plan without abusing IRS rules. This may include an examination of:
- How the plan issued benefits.
- How verification procedures worked.
- How pre-tax deductions worked.
- Whether certain benefits were paid before employees provided the required verification.
- Whether non-discrimination tests were properly carried out.
- The existence of necessary plan documents and a record of employee elections for plan participation.
The main point to remember is that the IRS will focus on how the plan worked in practice, not what labels were used to reference the plan or what a plan promoter claims.
Most audits last a few months, but some could last longer depending on the complexity of the tax issues and the level of taxpayer cooperation.
Audit Resolution
At the end of the audit, the auditor will release their results, and if you disagree, you have a chance to dispute. A no-change audit means the auditor accepts your plan and your returns as filed. However, if you “fail” the audit, the auditor will propose tax and penalties, and they may disqualify your Section 125 plan.
Mistakes Employers Sometimes Make During Payroll Audits
Surviving an audit is no easy task, but things can get more difficult and/or take much longer if you or someone from your organization commits one or more of the following mistakes right before or during the audit:
- Not providing the requested information (or if the information can’t be provided, not providing a sufficient explanation).
- Relying on explanations or information from the benefit plan vendor.
- Making changes to documentation without proper explanation.
- Responding to the IRS in a way that expands the scope of the audit and brings unnecessary suspicion to the Section 125 plan.
- Assuming that what gets sent to the IRS doesn’t really matter, and not understanding how a taxpayer responds to an IRS request during an audit can dramatically change the scope of the audit.
- Trying to handle the audit process alone.
At best, these mistakes lead to a more annoying and disruptive audit. At worst, the mistakes could result in:
- Disqualification of the Section 125 plan;
- A retroactive reclassification of pre-tax deductions and taxable wages;
- Back payroll taxes owed by the employer and employee;
- Back income taxes owed by the employee;
- Tax penalties and interest added to the unpaid payroll taxes; and/or
- Civil liability and fines as a result of Section 125 plan noncompliance that also violates other federal laws, like ERISA (Employee Retirement Income Security Act).
This could result in you and your employees incurring unexpected tax bills reflecting large tax debts, which could lead to IRS collection actions if appropriate tax settlement options aren’t negotiated with the IRS.
FAQs About Payroll and Benefit Audits
What is a Section 125 plan audit?
This is when the IRS audits a business’s Section 125 or cafeteria plan to ensure it meets legal requirements. The audit may look at Premium Only Plans (POP), Flexible Spending Accounts (FSA), and Dependent Care Assistance plans.
Do I need to do an internal audit of my employee benefit plans?
It depends on the number of plan participants. Typically, if you have more than 100 participants, you’ll need to select an independent, qualified public accounting firm to conduct an internal audit for you. The Department of Labor has more guidance on the requirements.
Should I give the auditor all the requested documents?
Yes, but consider consulting with a tax professional first. Taxpayers are generally required to comply with IRS information requests, though a tax attorney can help ensure the request is appropriate and that your rights are protected.
Don’t Handle an IRS Payroll Audit Without Professional Tax Help
Payroll audits with the IRS are challenging, but not impossible to get through. However, if the IRS contacts you about an employment tax audit due to concerns over questionable Section 125 plan practices, you’re facing a more complicated and potentially serious tax matter. Not only is your organization at risk, but your employees, as well.
Wiggam Law has extensive experience helping taxpayers get through payroll and Section 125 plan audits, especially when there might have been one or more mistakes or errors in the plan’s implementation or operation. If you have an upcoming audit of your cafeteria plan or payroll tax filings, we can help. Schedule a consultation by contacting us online or calling (404) 609-1300.
Sources
https://www.irs.gov/businesses/small-businesses-self-employed/irs-audits https://www.irs.gov/government-entities/federal-state-local-governments/faqs-for-government-entities-regarding-cafeteria-plans
https://www.irs.gov/businesses/small-businesses-self-employed/audits-records-request
