Stress from the phone call alerting you to the fact that you have been chosen for an IRS audit. If you work for a local government, you’re not alone in receiving this news. These audits are the next frontier for the IRS. We are told that an audit office was opened in Las Cruses, New Mexico, specifically for federal, state, and local government (FSLG) audits.

We both got that call, but we were lucky. We were not the first local governments in our area that were “chosen” to be audited, so we were able to benchmark off of the experiences of our “sister cities” to help us prepare ahead of time. This article might help give you the same advantage.

So, What’s Coming Next?

After you get the call, a meeting is set with you, the auditor, and those officials that you specifically designate. A caution—you may want to consider whom you want to attend. The semiformality of the meeting may not lend itself to inviting certain individuals.

It may be helpful, for instance, to have a staff member attend who prepares the 941 forms. On the other hand, if a staff member is not aware of the gravity of the situation, a frivolity or relaxed demeanor may be a detriment to the efficient operation of the meeting and may give the auditor the wrong impression. The auditor also can request staff holding certain positions to attend the meeting.

Next, you will receive a letter letting you know which year is being examined and which documents you must have ready for the assigned examination date.

The examination is in your local government office. IRS usually selects a year that is two years prior to the current year.

After the single year is completed, the IRS could open another year either before or after, or both. This is at the discretion of the auditor and depends on what he or she finds in the first year of examination.

And then begins the march of the 4564 forms—the information document requests.

What Documents Do I Need to Provide?

The list of documents an auditor may request can be long and varied. Each request for information will come on Form 4564 or information document request.

We were asked to submit these initial documents:

• Accounts payable for the calendar year being audited in Excel format.
• Check registers with description and amount.
• List of employees.
• Authorization and declaration form or whom they can communicate with or who can make decisions concerning the audit.
• Payroll records (W-2s, W-3s, and W-4s for the year being audited).
• Personnel manuals, personnel handbooks, employee handbooks, and fringe benefit policies.
• Travel handbooks, manuals, or policies.
• Employee contracts (unions, managers, and attorneys).
• Work papers reconciling 941s to the general ledger.
• Vehicle policies, including names and positions of employees who drive vehicles home.
• Other policies (cellphone and uniform).
• Cafeteria plan documents.

The IRS auditor will decide what additional information is needed. 

Some Basics

The first suggestion for participating in an audit is to be prompt and timely in gathering, scanning, and sending information. It is best to provide complete information and be friendly. An adversarial attitude is not recommended in this interaction.

Another suggestion is to consider the level of attorney interaction in the process. The initial contact with the auditor should be friendly and relaxed. You may want to weigh whether it is beneficial to bring a litigious atmosphere to the meeting. Perhaps it may be best to keep the initial meeting light.

On the other hand, it may be to your benefit to have your attorney present in case you need to eventually challenge the decision.

The length of the audit may vary. Our experiences were vastly different; the time between initial meeting and settlement could take between one and five months. The meetings could take place in person or through e-mail and mail contact, and the settlement decisions may be quick or lengthy, depending on the auditor.

What Is the Auditor Looking For?

The auditor will be looking for instances of violations of IRS tax issues. It’s recommended that your organization review the "Fringe Benefit Guide for Federal, State, and Local Governments" (www.irs.gov/pub/irs-pdf/p5137.pdf). This document will outline many IRS issues that governments encounter.

Areas for Possible Review

This list of items to watch for is not—and is not intended to be—an all-inclusive list. Each organization will have items specific to their entity, region, and structure to monitor.

Use of government facilities. A discount of no more than 20 percent of the price charged to the general public for the service that a resident would normally pay is allowed to be excluded as a taxable benefit on an employee’s W-2. For example: admittance to a local government pool or recreation center not created specifically for employees, their spouses, and their dependent children’s use.

Gifts. Gifts of more than $25 and all gift cards are includable as income on the employee’s W-2.

Vehicles. Some vehicles used for employee commuting may be excluded as a nontaxable working condition fringe benefit.

To qualify, these vehicles must meet certain guidelines so that the employee is not likely to use the vehicle more than minimally for personal purposes because of the vehicle design. Some of the qualifying vehicles include clearly marked police or fire vehicle, an ambulance or hearse, a passenger bus, bucket trucks, and dump trucks.

A more complete list of qualifiable vehicles can be found in the “Fringe Benefit Guide for Federal, State and Local Governments.”

Other commuting use of vehicles may be a taxable benefit, includable on the employee’s W-4. The method of calculation of the taxable benefit will vary; again, check the guide.

W-9s. A W-9 is an information form that is generally issued to vendors or providers of services, so they can report their taxpayer identification number (TIN). We suggest that you develop a policy about the issuance and receipt of W-9s from vendors. For us, payment will not be made to a vendor without a valid W-9 on file.

Remember, if the vendor is a limited liability company (LLC), the vendor must completely fill in the line indicating the type of LLC its organization falls under: C-Corp (C), S-Corp (S), or Partnership (P).

Form 1099. Have you followed the guidelines pertaining to when, which form, and to whom 1099s should be issued? Although there is a wide range of 1099s, there are several types that will most likely be used more than others. One version, 1099-MISC, is usually used for general services more than $600 and paid in the course of business.

The 1099-MISCs are required for services performed by someone who is not your employee, for prizes and awards, for medical and health care payments, and for payments to attorneys. Any medical services vendor or attorney should receive a 1099, even if technically structured as a corporation. The IRS considers veterinary services “medical services.”

The 1099s are not required if services are provided by corporations. Corporations can include LLCs who are designated as C-Corps or S-Corps. An LLC–Partnership should be issued a 1099. Remember, medical, health care, and attorney vendors need to be given a 1099 regardless if they are a corporation or not. Further guidance can be found in the 1099-MISC instructions at www.irs.gov/pub/irs-pdf/i1099msc.pdf.

Backup withholding and payment to the IRS at the rate of 28 percent of the payment to the recipient is necessary if you do not have a TIN.

1099-S is generally for the purchase of land. In addition to regular land purchases, it’s important to remember right-of-way (ROW) purchases for street widening or other circumstances. These purchases sometimes get overlooked in the rush to timely issue 1099s.

Work clothes and uniforms. Nontaxable work clothes and uniforms must meet these two requirements:

• Employees must wear them as a condition of their employment.

• The clothes are not suitable for everyday wear.

The IRS further qualifies “work clothes” in publication 17, 2014 Tax Guide (http://www.irs.gov/pub/irs-pdf/p17.pdf). “It is not enough that you wear distinctive clothing. The clothing must be specifically required by your employer. Nor is it enough that you do not, in fact, wear your work clothes away from work. The clothing must not be suitable for taking the place of your regular clothing.”

Uniform allowances or reimbursements are includable in income if they fail to meet the accountable rules test:

• Must have a business connection. That is, you must have paid or incurred deductible expenses while performing services as an employee of your employer.

• Must adequately account for these expenses within a reasonable period of time.

• Must return any excess reimbursement or allowance within a reasonable period of time.

The IRS definition of “reasonable time” covers these situations:

• Issued an advance within 30 days of the time the expense is incurred.

• Adequately accounted for the expenses within 60 days after they were paid or incurred.

Excess reimbursement is returned 120 days after the expense was paid or incurred. A periodic statement is given (at least quarterly) that asks the individual to either return or adequately account for outstanding advances, and the individual must comply within 120 days of the statement date.

Awards or prizes. The fringe benefit guide gives instruction on what awards or prizes are taxable. As a general rule, these awards may be excluded from income:

Employee achievement awards. Prizes or awards transferred to charities.

De minimis awards and prizes. Examples of de minimis include nominal gifts for birthdays, holidays, holiday turkey, flowers, coffee mugs, and parking passes for the employee of the month.

The guide also gives examples that are always taxable as wages to the employee:

• Cash or cash equivalent awards such as gift certificates; any amount.
• Non-cash prizes won by employees from random drawings at employer-sponsored events.
• Awards for performance, such as outstanding customer service or employee of the month, years-of-service award.

Specific guidance on awards or prizes can be found at www.irs.gov/pub/irs-pdf/p5137.pdf.

Independent contractors. The IRS states: “People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors.”

Whether these people are independent contractors or employees, however, depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.

The earnings of a person who is working as an independent contractor are subject to self-employment tax (see www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Defined). Two rules-of-thumb determine whether someone should be treated as an independent contractor or as an employee: the 20-factor-test (Rev. Rule. 87-41) or the modernized method of determination called “the common law rules.”

The determination of whether an individual is an independent contractor or employee comes down to three broad-based determinants:

Behavioral control. Instructions on tools or equipment to use, required attendance at meetings, what recognition is given to workers, reprimands for poor performance, and where to purchase supplies.

Financial control. Reimbursed expenses, extent of the worker’s investment, profit or loss options for a worker, and provision of materials or equipment for the job by workers.

Types of relationship. Written contracts, employee-type benefits, permanency of the relationship.

If you’re not sure whether or not an individual qualifies as an employee or contract employee, other criteria are included on the IRS form SS-8, which helps determine the employee status (www.irs.gov/pub/irs-pdf/fss8.pdf). You can also refer to IRS publication 15-A, “Employer’s Supplemental Tax Guide” (www.irs.gov/pub/irs-pdf/p15a.pdf).

If you believe you have misclassified some employees as independent contractors, a voluntary classification settlement program (VCSP) is available. To apply for this program, you will need to use Form 8952, application for voluntary classification program (VCSP.) You will then need to file IRS Form 8919 to pay uncollected Social Security and Medicare taxes.

It is becoming more important than ever to classify employees correctly, when you consider the additional penalties that may come from not paying possible mandated health care coverage from the Affordable Care Act.

The Final Determination

The IRS auditor, depending on the findings, may ask you to file a Form 941-X, which is an adjusted employer’s quarterly federal tax return, to pay additional taxes owed, or to issue additional 1099s or additional forms.

The auditor will then issue a “summary of tax due,” which is a summary of issues, and publication 5 “appeal rights.”

Finally—the coup de grace—the customer satisfaction survey. The IRS, after all, operates in the customer service sector.

In both our situations, we found the IRS auditor to be easy to work with and pleasant. Part of this may have come from our willingness to cooperate and the timely submittal of information.

This experience, however, is not one we are anxious to repeat.