Chapter 9 - Employment Taxes
Employees in General
All Federal contracts contain a section that discusses the Contract
Service Act and its requirements. Information about the Contract Service
Act is normally found in Section J of the solicitation package. Within
this section, there will be a Wage Determination Letter issued by the U.S.
Department of Labor, Wage and Hour Division. The Wage Determination Letter
lists the class of service employees, minimum hourly wage rates, and
fringe benefit payments required to be paid to each employee. A copy of a
Wage Determination Letter can be found in Exhibit 2-2.
Under the Contract Service Act, employers are required to treat each
individual working in the industry as an employee. The only exception is
payments made to valid subcontractors. If the prime contractor pays a
subcontractor to complete the job, the subcontractor becomes responsible
for paying wages and employment taxes. The payments made to the
subcontractors should be large since the subcontractor must pay employee
wages, worker's compensation, and the related employment taxes etc.
Subcontractors must follow the same State and Federal law as the prime contractors. To be a valid subcontractor, they must provide the following:
1. A valid Farm/Labor Contractor's License (applies in Oregon; check to see if there are similar requirements in your state).
2. Verification of Worker's Compensation coverage.
3. Proof that they work for more than one prime contractor.
As previously stated, the Contract Official (COR) will discuss the Contract Service Act with the contractor during the pre-work conference. They will discuss the contract requirements for the size of crew to be provided by the contractor; the crew size may be only three people, but a normal crew size ranges from 5 to 12 employees. It is not uncommon for a contractor to have more than one crew working at a time. Keep this in mind if a contractor tells you that it is industry practice for contractors to employ only subcontractors.
Issues Generally Encountered
An examination of a reforestation contractor can result in large employment tax adjustments. It is common to find wages being paid without consideration of employment or income tax withholding. To stay competitive in this industry, the contractors are looking for ways to pay less in wages, employment taxes and worker's compensation premiums. The contractors are keeping gross wages as small as possible which reduces both their employment tax liabilities and their worker's compensation premiums. Remember that both employment taxes and worker's compensation premiums are determined based on total wages paid.
The reforestation industry is labor intensive which means that labor costs and the related employment taxes represent the bulk of the contractor's expenses. Adjustments made in this area can generate substantial tax liabilities. The most common adjustments are reclassification of subcontractors to employees and setting up additional compensation payments to already existing employees. Substantial taxes will be generated since the wages paid to individuals seldom exceed FICA and even FUTA maximums due to the mobility of the work force. The group has found that it is not uncommon to have employment tax liabilities exceed 40 percent of additional gross wages before the application of failure to deposit, negligence, or fraud penalties.
During our examinations of reforestation contractors the group has identified the following as possible issue areas:
1. The contractors report all payments to individuals as non- employee compensation payments (subcontractor payments).
2. The contractors pay their workers in cash and deduct the payments as ordinary and necessary business expenses, not wages.
3. The contractors deduct the payment of personal expenses for the employees as other business expenses, not as wages.
4. The contractors do not file Forms W-2 or 1099 with the Internal Revenue Service.
Subcontractor Payments
We are finding that the majority of the prime contractors are reporting only subcontractor payments. If the contractor has only subcontractors then they would not be liable for either FICA or FUTA taxes. However, this is usually not the case. We have found that the prime contractors normally have some employees and some subcontractors.
When auditing the employee versus subcontractor issue, you need to secure certain information from the contractors. First, secure a listing of the individuals who received non-employee compensation payments during the examination year. The group found it was easier to create a data base from the contractor's cancelled checks rather then trying to get this information from the contractor. The data base gave us the ability to accumulate payments by payee and determine when the payments were received and how much was received by each individual.
Next, question the contractor on the work performed by each individual. Start with the suggested questions outlined in Chapter 3, of this Guide and addother questions that are relevant. You can use the "20 Common law factors" found in Exhibit 9-1, to develop other questions that pertain to your case.
Exhibit 9-1 will give you a definition of each factor, along with references to Revenue Rulings or Court Cases.
Our revenue officer examiner was successful in reclassifying subcontractor payments to employee wages. The revenue officer examiner relied heavily on whether or not the subcontractor held a valid Farm/Labor Contractor's License (for additional information on the Farm Labor License, refer to Chapter 2). Since Oregon may be the only state that requires a license, you may wish to contact the Forest Service or Bureau of Land Management to obtain additional information on whether or not the individuals receiving subcontractor payments are valid subcontractors.
If you determine that a reclassification issue exists, you will want to first determine if the taxpayer has an IRC section 530 safe haven. If the taxpayer does not have a IRC section 530 safe haven, then you will need to consider whether or not the taxpayer is allowed the relief provisions of IRC section 3509. The discussion of IRC sections 530 and 3509 appears later in this section, under Application of the Law. If the taxpayer has not filed returns, you will need to give proper consideration to the use of either Delinquent Return or Substitute for Return procedures which are discussed below.
Delinquent or Substitute for Return: If the contractor has not filed employment tax returns and you make the determination that a portion of the subcontractor payments are, in fact, employee wages, you will need to follow either the Delinquent or Substitute for Return procedures outlined in Exhibit
9-2. Exhibit 9-2 contains the Delinquent and Substitute for Returns procedures used in the Portland District.
When it has been determined that the contractors are required to file employment tax returns but do not have an EIN, you will need to secure a EIN before you can close the case. An EIN can be quickly obtained from the Service Center by using the following procedure.
Securing an Employer's Identification Number (EIN):
If the employer does not have an EIN, the examiner should assist in securing one. The following procedure will allow the examiner to secure a number quickly:
1. Form SS-4 should be prepared for the employer.
2. Call the Service Center servicing your District.
a. The Service Center will ask for information directly off the prepared Form SS-4.
b. In the upper-left corner of the completed Form SS-4, type the newly assigned EIN number and an ID number that will be given to you by the Service Center.
c. Mail the completed Form SS-4 to the Service Center servicing your district within 5 days from the time the new EIN number has been issued.
Cash Wages Deducted on the Return
Deductions for cash wages may be identified on the return as labor
under cost of goods sold, as contract labor, or commissions. If wage
expense has been increased by cash wages paid, the issue will become
apparent when you reconcile payroll. Requesting employment tax return
transcripts, prior to beginning the examination will help you determine if
employment taxes are being filed and will show FICA wages reported by the
contractor.
Deductions for cash wages may be combined with other business expenses. It
may not be easy to identify whether or not the contractors are deducting
wages paid in cash since the contractors do not maintain adequate books
and records. Therefore, if you do not identify this issue during the
pre-audit of the return, be sure to include questions about cash payments
in the initial interview. Ask the contractors if they ever use cash to pay
business expenses, find out what types of expenses are paid by cash, and
ask the contractors if they pay employees in cash. This information will
be useful as the audit progresses.
Unsubstantiated Cash Expenses
The group has found that, within this industry, dealing in cash is common while retaining receipts seems to be uncommon. Since it is very difficult to disallow all unsubstantiated expenses you need to determine if the contractor's testimony (from the initial interview or later interviews) is corroborated by the documents you have been given. The contractor's receipts should support the contractor's need to deal in cash. For example, the contractors report that cash is needed by their foremen to purchase gas and food for the employees when they are in remote forest areas. The receipts should be for gas and food that has been purchased outside of the contractor's home town. The group found contractors giving the following explanations to substantiate the use of cash:
1. Checks Issued to the Foreman or to Cash
As previously mentioned, contractors may be deducting checks issued to
their foremen or to cash as other business expenses, (that is, auto
expenses etc.). The contractor's defense is that the reforestation
industry is cash intensive. They report that their foremen need cash to
manage the workers while in remote forest areas. According to the
contractors, the foremen are unable to cash personal checks and they do
not have credit cards to purchase food or gas or to pay lodging for the
workers. To determine if the contractor's testimony is consistent with the
records, you will want to ask to see the employee reimbursement vouchers.
The contractor must pay such benefits pursuant to an "accountable
plan" as defined in the regulations issued under IRC section 62(C);
otherwise the advances/reimbursements must be included on the employee's
Form W-2. Note that substantiation is required by IRC section
274(d).
If you suspect that the contractor is paying wages in cash, be sure to ask
the contractor for copies of his or her job bids. You will be able to use
the job bids to develop a percentage (wages as a percentage of gross
income) to compare to the return. If the percentage of wages per the
return is less than the amounts reported on the job bids then the
contractor most likely is paying wages in cash. You will also want to
request the payroll records and compare
the hourly rate per the payroll to the hourly rate per the job bids,
looking for differences.
If the contractor does not provide adequate substantiation for either
employee reimbursements or cash expenditures and if receipts do not agree
with oral testimony, the unsubstantiated expense may be disallowed under
IRC section 162. However, if you have sufficient facts to indicate that
wages were paid in cash, an alternative position is to allow the payments
as wage expense under IRC section 162 and set up the related employment
tax liabilities.
2. Payment of Expenses for Employees
Sometimes the contractors may be including items paid on behalf of their employees as ordinary and necessary business expenses. For example, the contractor may be paying employees' apartment rent or buying their gas, clothing, or groceries. The contractor's defense is that he or she must provide for his or her employees since the workers are nonresident aliens or that it is a requirement of their job.
These employer-provided items are "fringe benefits." A fringe benefit is any property or service (or cash under certain circumstances) that an employee receives from his or her employer in lieu of or in addition to regular taxable wages. If a benefit is not specifically excluded from gross income by the Code (for example, IRC sections 105, 106, 107, 117(d), 119, 120, 125, 127, 129, and 132), its value must be treated as compensation and reported as wages on the employee's Form W-2.
Under IRC section 119, an employee may exclude from gross income the
value of any meals or lodging furnished in kind to the employee by or on
behalf of the employer for the convenience of the employer, provided that
certain requirements are met. Meals must be furnished on the business
premises of the employer, and, in the case of lodging, the employee must
accept lodging on the business premises of the employer as a condition of
employment. IRC section 119 does not permit an employee to exclude from
gross income cash the employer gives the employee to purchase meals or
lodging.
Amounts paid for an employee's meals, lodging, or gasoline may be excluded
from the employee's income to the extent the amounts are reimbursements or
allowances for travel expenses incurred by the employee while "away
from home" and are paid under an accountable plan as described in the
regulations under IRC section 62(c). In general, a reimbursement or other
expense allowance arrangement is an accountable plan if the requirements
of business connection, timely substantiation, and timely return of
amounts in excess of expenses are satisfied.
In general, an arrangement that provides advances, allowance, or reimbursements for business expenses paid or incurred by the employee in connection with performing services as an employee of the employer and that are deductible under IRC section 162 1 will satisfy the business connection requirement. If amounts are provided for expenses that are not deductible under IRC section 162, the business connection requirement is not satisfied. For example, travel expenses are deductible only if the employee is "away from home." Accordingly, it is important to establish whether the employees are, in fact, away from home for tax purposes. Copies of the contract award letters will probably give you the job locations. You should be able to match the cash receipts by date and location to the contract award letters.
If an arrangement is not an accountable plan, all amounts paid thereunder are treated as paid under a nonaccountable plan, are required to be reported on the employee's Form W-2, and are wages for purposes of withholding and payment of employment taxes.
Employer-provided clothing may be excluded from the employee's gross income as a working condition fringe benefit under IRC section 132(d) provided the clothing is a special item required in the employee's work that does not replace items of ordinary clothing. Examples of such items include work shoes or special gloves, and a "uniform" that is required as a condition of employment and that is not adaptable to general wear. An employer may provide a working condition fringe benefit in cash, provided that the employee verifies that the payment was actually used for the intended expense and any excess cash is returned to the employer.
Any of an employee's personal, living, or family expenses, such as travel that is not away from home, that are paid for or provided in kind by the employer must be included in the employee's income and reported on Form W-2. See IRC section 262.
To determine whether a fringe benefit furnished to an employee is wages for employment tax purposes, look at the definitions of wages and the exclusions therefrom which are found in IRC section 3121(a) for FICA purposes, IRC section 3306(b) for FUTA purposes, and IRC section 3401(a) for income tax withholding.
3. Payments to Nonresident Aliens
In general, if you pay wages to nonresident aliens, you must withhold income tax (unless excepted by regulations) and Social Security taxes as you would for a U.S. citizen. The wages are subject to FICA and FUTA taxes. Nonresident aliens can be exempted from "wages" under a U.S. treaty provision, if the alien is lawfully admitted into the United States to do agricultural labor. Tree planters and tree thinners are not considered to be agriculture workers and, therefore, are not exempted from FICA or FUTA. A detailed discussion of "Agriculture Labor" has been included under Application of the Law, since employers may consider tree planters or tree thinners to be agriculture workers.
Contractors may report that they are paying the expenses of the nonresident aliens brought to the United States to plant trees. Again these payments are considered to be additional compensation to an already existing employee unless IRC section 119 applies.
Employees temporarily admitted into the United States to do agricultural work are exempt from FICA and FUTA provided they are admitted to the United States under the H-2 Visa program. Under the H-2 Visa program, the employer is responsible to secure a visa, provide transportation for the workers both to and from Mexico, as well as house the nonresident aliens while they are working in the United States. Immigration (INS) should be contacted to determine if, to whom, and how many H-2 Visas have been given out in your State. A detailed discussion of "temporary workers" has been included under Application of the Law, since it is possible that you may find contractors who consider their employees to fall under the exemption for "temporary worker admitted to the United States."
Application of the Law
Wages Subject to Employment Taxes - IRC Section 3401
Federal employment taxes consist of three components: FICA and FUTA taxes and income tax withholding. In general, wages subject to Federal employment taxes include all pay you give an employee for services performed. The pay may be in cash or in other forms. It includes salaries, vacation allowances, bonuses, fringe benefits, and commissions. It does not matter how you measure or pay the payments.
Any employee Social Security tax and employee state unemployment compensation tax you pay for your employees (rather than deducting it) is includible in Social Security and FUTA wages.
Measure pay that is not in money (such as goods, lodging, and meals) by its fair market value. This kind of pay may be subject to tax and withholding.
Employee Reimbursements - IRC Sections 62(c) and 274(d)
Payments to employees for travel and other necessary expenses of your business generally are taxable if: (1) the employee is not required to or does not substantiate those expenses to you with receipts or other documentation, or (2) you advance an amount to the employee for business expenses and he or she is not required to or does not return any amount he or she does not use for business expenses. "The foregoing requirements, which are defined as business connection, timely substantiation, and timely return of excess by the Regulations issued under IRC section 62(c), must be satisfied or the plan will not be an accountable plan, as defined in the regulations under IRC section 62(c).
If the employer indicates that employees are reimbursed, a certain amount for travel expenses incurred, whether or not away from home, the business connection requirement generally will not be satisfied. However, the business connection requirement will be satisfied if, on December 12, 1989, the allowance was identified by the payor either by making a separate payment or by specifically identifying the amount of the per diem allowance, or a per diem allowance computed on the basis commonly used in the reforestation industry. See Treas. Reg. section 1.62-2(d)(3)(ii).
What must be included in the Form W-2 -- Reimbursements for employee business expenses as follows:
-- Show as wages the total reimbursements if:
a. The employee does not account to you (that is, does not furnish receipts or other evidence) for those expenses; or
b. You advance amounts to your employee for business expenses and do not require the employee to return amounts that he or she does not use for business expenses. The same is true if the employee does not return the amount even if you require it.
Section 530 of the Revenue Act of 1978
Even though a worker is deemed an employee, Section 530 of the Revenue Act of 1978 provides that if, for purposes of employment taxes, a taxpayer did not treat an individual as a common-law employee for any period, then the individual will be deemed not to be a common-law employee for that period, unless the taxpayer had no reasonable basis for not treating the individual as an employee.
The relief applies only if (1) all Federal tax returns (including
information returns) required to be filed by the taxpayers with respect to
the individual for that period are timely filed (Rev. Rul. 81-224) on a
consistent basis with the taxpayer's treatment of the individual as not
being an employee, and (2) the taxpayer must not have treated any worker
holding a substantially similar position as an employee for employment tax
purposes after December 31, 1978.
There are several alternate standards in determining whether a taxpayer
has a reasonable basis for not treating an individual as an employee.
Reasonable reliance on any of the following standards is sufficient:
1. Judicial precedent or published rulings (whether or not relating to the particular industry or business in which the taxpayer is engaged) or by relying on technical advice, a letter ruling, or a determination letter pertaining to the taxpayer; or
2. A past Internal Revenue Service audit of the taxpayer, if the audit entailed no assessments attributable to the taxpayer's employment tax treatment of individuals holding positions substantially similar to the position held by the individual whose status is at issue; or
3. Long-standing recognized practice of a significant segment of the industry in which the individual was engaged.
A taxpayer who fails to meet any of the above standards is nevertheless entitled to relief if the taxpayer can demonstrate in some other manner a reasonable basis for not treating the individual as an employee. In general, for FUTA purposes, IRC section 3306(k) provides that agricultural labor has the same meaning as assigned to it by IRC section 3121(g).
Form 1099 Search: As previously stated, to qualify for the relief under IRC section 530, the taxpayer must show that all the required Federal returns have been timely filed. It has been the group's experience that the reforestation contractors would provide copies of completed Form 1099 upon request; however, these forms were never filed with the Service Center. To be sure any contractor is allowed the relief provisions of IRC section 530, we suggest that you request a Payor Master File On-Line (PMFOL). The PMFOL is a research tool that will access the Payor Master File (PMF) either by Social Security Number or Employer Identification Number. You will find instructions on how to read a PMFOL in Exhibit 9-3. Below is a list of the information that can be obtained from the PMFOL and may be helpful in determining if IRC section 530 applies:
1. The PMFOL will identify the tax year on the PMF for which the taxpayer has filed;
2. The PMFOL will identify the tax years for which the late filing penalties have been proposed and the tax years for which the taxpayer was warned of a violation;
3. The PMFOL will identify the number of Forms 1099 issued by the taxpayer; and
4. The PMFOL will identify the total payments of all payees that received this Form 1099.
IRC Section 3509 - Relief
Employment status controversies that arise when a worker who has been treated as an independent contractor is reclassified as an employee have been further aggravated by the sometimes enormous tax burdens that result. Although relief provisions under IRC sections 3402(d) and 6521 are available, employers sometimes find it difficult to locate and get the cooperation of former employees to avail themselves of this relief. A difficult burden is placed on the taxpayer's business when the provisions of the law cited above are enforced. Some businesses have even been forced into bankruptcy.
Public Law 97-248, dated September 3, 1982, and made effective for assessments made after December 31, 1982, provides a "statutory offset mechanism that will apply in reclassification cases." The mechanism in IRC section 3509 is mandatory. IRC section 3509 provides different rates for determining an employer's employment tax liability when the employer fails to withhold income taxes on the employee's share of the FICA tax from wages paid to an employee. This procedure does not relieve the employer of the employer's share of FICA and FUTA. However, this relief is not available to any employer who has intentionally disregarded the requirement to deduct and withhold income or the employee's Social Security taxes.
IRC section 3509 affects only the employee FICA tax and the income tax required to be withheld from the employee's wages under IRC sections 3102 and 3402. The employer's FICA tax is not affected. A small percentage of the tax required to be withheld from the employee's wages is assessed against the employer, but the full amount may also be collected from the employee. The employer may not recover from the employee any of the tax determined under IRC section 3509; neither may the provisions of IRC sections 3402(d) and 6521 be applied. The FICA tax and the income tax withholding in the sample report below are computed under IRC section 3509.
1987 1988 1989 1990
IRC section 3509(a)
Income Tax Withholding 1.5% 1.5% 1.5% 1.5%
==== ==== ==== ====
Employee Social Security Tax 1.43% 1.52% 1.52% 1.53%
Employer Social Security Tax 7.15% 7.51% 7.51% 7.65%
----- ----- ----- -----
Total 8.58% 9.03% 9.03% 10.68%
===== ===== ===== ======
IRC Section 3509(b) -- Employers Disregard Reporting Requirements
1987 1988 1989 1990
Income Tax Withholding 3.0% 3.0% 3.0% 3.0%
==== ==== ==== ====
Employee Social Security Tax 2.86% 3.04% 3.04% 3.06%
Employer Social Security Tax 7.15% 7.51% 7.51% 7.65%
------ ------ ------ -----
Total 10.01% 10.55% 10.55% 13.71%
====== ====== ====== ======
Agricultural Labor - IRC Section 3212
IRC section 3111 imposes upon every employer FICA tax on the "wages" paid to individuals in his or her "employment." IRC section 3101 imposes a similar tax upon the employee on "wages" received by him or her with respect to "employment." IRC section 3402 provides that every employer making a payment of wages shall deduct and withhold income tax upon such wages. For FICA tax purposes, "wages" are defined by IRC section 3121(a) and "employment" is defined by IRC section 3121(b). For income tax withholding purposes, wages are defined by IRC section 3401(a). There are exceptions to the definitions of wages and employment, and in the reforestation industry contractors may maintain that the agricultural labor exception applies. 2 IRC section 3121(a) provides that wages for FICA tax purposes means all remuneration for employment paid in any medium other than cash for agricultural labor is excluded from the definition of wages. Cash remuneration paid in a calendar year for agricultural labor is not wages, unless (1) the cash paid to the employee by the employer for such labor is $150 or more or (2) subject to certain limited exceptions, the employer's expenditures for agricultural labor in such year exceeds $2,500.
IRC section 3121(b)(2) excludes from the definition of employment, services performed by foreign agricultural workers lawfully admitted to the United States from the Bahamas, Jamaica, and the other British West Indies, or from any other foreign country or possession thereof, on a temporary basis to perform "agricultural labor." IRC section 3121(b)(2) is specifically discussed in the next section.
IRC section 3401(a)(2) provides that remuneration paid for agricultural labor, as defined in IRC section 3121(g), is not wages unless such remuneration is considered wages under IRC section 3121(b).
Agricultural labor is specifically defined by IRC section 3121(g) to include certain services performed (1) raising or harvesting agricultural or horticultural products on a farm; (2) in the employ of the owner or tenant or other operator of a farm in connection with the care of the farm and its equipment, provided the major part of the services are performed on a farm; (3) in connection with the handling, processing, or packaging of an agricultural or horticultural commodity; or (4) doing house work in a private home if it is on a farm that is operated for profit.
Section 31.3121(g)-1(a)(1) of the Employment Tax Regulations provides that in general, the term does not include services performed in connection with forestry, lumbering, or landscaping. Thus, the services employees perform in the reforestation industry are not agricultural labor and are not exempt from the definition of employment under IRC section 3121(b)(1). Thus, all remuneration the employees receive is wages, unless specifically excluded by another Code section.
Temporary Workers Admitted to United States - IRC Section 3121
Under the general rules, if a nonresident alien performs services in the United States for a U.S. employer, wages earned for such service will be subject to the FICA tax. See Treas. Reg. section 31.3121(b)-3(b).
Rev. Rul. 77-140, 1977-1 C.B. 301, holds that services performed for farmers in the United States by alien workers who illegally entered the country are not excepted from employment for purpose of FICA.
In Moorhead v. United States, 774 F.2d 936 (9th Cir, 1985), the Court of Appeals held that an alien holder of a "green card" who commutes daily to the United States to perform agricultural services, but who has the right to reside permanently in the United States, is not within the FICA exemption under IRC section 3121(b)(1). Moorhead analyzed the alien's immigration status in light of the plain language of IRC section 3121(b)(1) to determine whether the requirements of that section were met.
Moorhead held that the exemption under IRC section 3121(b)(1) applies only to workers admitted to the United States under 8 U.S.C. Section 1101(a)(15)(ii) of the Immigration and Nationality Act (the "INA"), commonly called "H-2 workers."
Exhibit 9-1 - Twenty Common Law Factors [Exhibit omitted]
Exhibit 9-2 - Delinquent/Substitute Return Procedures [Exhibit
omitted]
Exhibit 9-3 - PMFOL [Exhibit omitted]