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:: Reforesting Industry - Chapter 7 - Employment Taxes   Table of Contents 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. 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:   A valid Farm/Labor Contractor's License (applies in Oregon; check to see if there are similar requirements in your state).   Verification of Worker's Compensation coverage.   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:   The contractors report all payments to individuals as non-employee compensation payments (subcontractor payments).   The contractors pay their workers in cash and deduct the payments as ordinary and necessary business expenses, not wages.   The contractors deduct the payment of personal expenses for the employees as other business expenses, not as wages.   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 canceled 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 add other questions that are relevant. Refer to the training materials "Independent Contractor or Employee?" Training 3320-102 (Rev 10-96) TPDS 84238I. 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 an 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. 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. 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:   Form SS-4 should be prepared for the employer.   Call the Service Center servicing your District.   The Service Center will ask for information directly off the prepared Form SS-4.   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.   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 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:   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.   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 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.   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. 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.

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