4 Thorny Payroll Tax Issues and How to Handle Them

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Small businesses historically have created 70% of all jobs in the United States. With such a high percentage of the workforce, employee-related tax challenges for small business owners are probably inevitable. Here are four common tax pitfalls and what you can do about them.

Personal Use of Company Cars

Many small business owners and some employees drive cars or trucks that are owned or leased by their companies. This arrangement lets the company deduct the costs of the vehicle. However, employees (including owners) are viewed by the IRS as gaining a taxable benefit for their personal driving. How is this valued?

The tax law gives companies several options about how to value the personal use, including:

* Report all of the value of vehicle usage and let the employee deduct his or her business use. While the easiest option for the company, it isn’t helpful for employees.

* Report the fair market value of the personal usage (what the employee would have to pay a third party for the same benefit).

* Figure the value of personal usage based on something called an annual lease value (ALV).

Discussion of each of these methods for valuing personal usage can be found in IRS Publication 15-B.

Worker Classification

When you need additional help, should you hire an employee or engage an independent contractor? There are both tax and practical considerations to this decision. Taxwise, it’s considerably less costly to use an independent contractor. With this in mind, the question of worker classification—as an employee or independent contractor—is high on the IRS’s audit list. And states also look closely at worker classification when workers seek unemployment benefits or workers’ compensation.

The problem is that you can’t simply attach a label to a worker and automatically make it stick. From the government’s perspective, if you have sufficient control over the worker—you have the right to say when, where, and how the work gets done—then the worker is an employee, regardless of any label. According to the IRS rules for worker classification, a determination depends on behavior and financial issues as well as the relationship of the parties.

What to do:

• Look at how other companies within your industry classify their workers. If there is a long-standing industry practice of treating certain workers as independent contractors, this can be helpful.
• Have independent contractors sign agreements acknowledging that they are responsible for their own taxes. These agreements won’t bind the IRS, but they are helpful to show that both you and your contractors view the arrangement as other than employer-employee.
• Be consistent. Treat all workers doing the same type of work in the same manner.
• Issue Form 1099-MISC to workers you are treating as independent contractors.

Recent Court Decisions Increase Uncertainty

The U.S. Tax Court and federal courts are continually deciding thorny tax questions. Do these decisions affect you? It depends.

One key issue that’s moving through the courts at the moment concerns the constitutionality of the Patient Protection and Affordable Care Act (“Obamacare”). One U.S. district court  has said that the federal government has no constitutional basis to mandate that each person buy health coverage and has concluded that the entire act, including various tax provisions (such as the small employer health care credit), is unconstitutional. No one is quite sure at this time what this means for the tax provisions within the Act.

Another case (Quality Stores, Inc.) decided last year said that severance benefits were not wages for purposes of payroll taxes. The IRS, as well as some courts, continue to disagree. Some practitioners have been advising companies with laid off workers that paid FICA and other payroll taxes on severance benefits to file refund claims even though the issue isn't settled. Why? Because generally refund claims must be filed within three years of the original return filing date. The IRS has indicated it will not give refunds at this time. Companies that paid severance benefits in the past several years should discuss this issue with their CPAs or other tax advisors.

Cash Flow Problems

Small businesses, from time to time, may experience cash flow problems. Not having sufficient cash means deciding which creditors to pay first.

It’s vital for small business owners to pay the government first when it comes to certain payroll taxes and excise taxes. The income taxes and employees’ share of FICA that you withhold from their pay is considered “trust fund” money. Excise taxes you collect in the course of your business, such as a gas station’s collection of excise taxes on gasoline sales, are also trust fund money.

You have collected the money in trust and, as a responsible person, must pay it to the government. If you fail to do so, you can be held 100% personally liable for the unpaid amount, plus penalties and interest. This is true even if your business is incorporated or is a limited liability company; your entity does not protect you from this tax obligation.

The IRS has helpful information about the trust fund recovery penalty. If you are facing a cash crunch with unpaid trust fund taxes, meet with your financial advisor to figure out the best way to handle the situation.