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Ask The EDD Attorney – Tax Return Preparer Penalties That May Result From Payroll Tax Audits

By Robert S. Schriebman
December 18, 2015

Introduction

The IRS has had a substantial reduction in manpower primarily due to Congressional budget cuts. From the look of things these budgetary cuts will continue. As a result of these cuts, the IRS has had a dramatic reduction in manpower at both the examination and collection levels. This has caused the IRS to shift its emphasis away from traditional income tax audits. IRS audit rates are the lowest in memory. Instead the IRS is shifting its manpower and emphasis to payroll tax compliance. As part of this compliance the IRS will be taking a very close look at small to medium sized businesses that have reclassified workers from employees to independent contractors. The exposure for misclassification of workers is going to be very great. Not only will there be back payroll taxes to pay but there will also be potential liabilities for state employee benefits, as well as fines and penalties for violation of the Affordable Care Act. (ACA)

Tax practitioners who sign payroll tax returns as well as corporate income tax returns are going to be facing very stiff return preparer penalties if the IRS audit turns up misclassified workers. This article will discuss potential exposure of accountants and tax return preparers when the IRS and most likely the EDD discover that W2 workers have been misclassified as independent contractors.

Tax Return Preparer Penalties

The word is out. Both the IRS and the EDD are going to be very aggressive when it comes to assessments and penalties for misclassified workers. IRS employees are being diverted from routine collection and audit cases and are being assigned payroll investigation functions. The federal government is waking up to the fact that there are billions of dollars of lost revenue because small and medium sized businesses are treating W2 wage earners as independent contractors. There is more exposure now than ever before. 2016 and beyond are going to see aggressive payroll tax audits with resulting assessments not only in payroll taxes but in ACA fines and penalties.

Accountants and tax return preparers who turn a blind eye to these violations, fail to do proper diligence, and sign quarterly and annual payroll tax returns as well as corporate income tax returns, are looking at return preparer penalties assessed pursuant to IRC § 6694. These penalties are assessed for negligence and recklessness that are found as a result of an employment tax audit of the preparer’s client.

Once these violations are discovered by the IRS, and accusations made, it is a certainty there will be finger-pointing with a client pointing the finger at you, the preparer.

IRC § 6694 states in substance that if a tax return preparer prepares any return to which any part is a substantial understatement of liability or who knew or reasonably should have known of a substantial understatement, the preparer is going to be fined the greater of $1,000 or 50% of the income derived by that preparer for his or her services, whichever is greater. More importantly, if that understatement was due to willful or reckless conduct, the preparer shall be charged a penalty of $5,000 or 50% of the income derived by the preparer for his or her services, whichever is greater.

Of equal importance is the fact that the preparer may be referred to the IRS’ Office of Professional Responsibility and runs the risk of suspension or revocation of his or her privilege of practicing before the IRS.

Internal Revenue Manual Sect. 4.23

Internal Revenue Manual Section 4.23 sets forth key questions a preparer may be asked by the IRS auditor who discovered the worker misclassification. These questions may be as follows:

  • Did the taxpayer meet with the preparer?
  • Did the taxpayer complete a questionnaire and/or have a face-to-face meeting with the preparer?
  • What documentation was provided to the preparer?
  • Did the taxpayer receive a copy of the return?
  • Was the preparer compensated?

Signing Quarterly Payroll Tax Returns vs. Signing Only The Annual Corporate Income Tax Return

Suppose you, as the preparer, sign only the annual corporate income tax return Form 1120 or 1120S, but do not sign the quarterly 941 returns or the annual 940 return. Do you still have exposure for preparer penalties? There are portions of the corporate return that call for the disclosure of information concerning outside services. If your client has misclassified W2 wage earners as independent contractors, and told you that these are outside services, you may still have exposure for preparing a false corporate return and taking a position on that return that is not substantially justified under the tax law. Time will tell how the IRS will deal with this issue.

Information Sharing Between the IRS, the EDD and the FTB

It is no secret that there are in place standing agreements going both ways between the IRS, the EDD and the FTB for the sharing of information regarding those taxpayers who have misclassified W2 wage earners as independent contractors. If the IRS conducts the audit, initially, then shares the information with the EDD, not only will the employee face an EDD audit but the FTB may also share this information and impose its own penalties on negligent or reckless tax return preparers.

Conclusion

An accountant or tax return preparer representing clients that issue 1099s must be very careful how they practice in the future. It is very important to sit down with the client, especially a new client, and discuss its history of issuing 1099s. This is especially true if the taxpayer files payroll tax returns that only treat the owners and officers of the company as W2 wage earners and treat everyone else as 1099 recipients. If the preparer prepares the quarterly payroll tax return routinely and signs those returns without thinking twice, the consequences could be not only economically devastating but your license to practice before the IRS could be at risk as well.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure”, both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure”, both published by Commerce Clearing House.

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