Employee payroll and benefits are a central function of the HR department. Part of these activities involves reporting to the IRS, which pays close attention to this information. Even small mistakes can trigger notices and penalties, with serious cases progressing into full examinations from the agency.
Companies should be careful to avoid these 13 mistakes, as they’re likely to draw IRS attention.
1. Form 941 to W-3 mismatches
Every quarter, employers file Form 941, which reports wages paid and the taxes withheld from those wages. At the end of the year, they’ll also submit a W – 3 form which covers the whole year.
If the paperwork doesn’t add up, the IRS will start asking questions. Avoid this by checking the numbers add up before submitting. Frequent mismatches will require a professional IRS audit defense.
2. Late Federal Tax Deposits
The IRS expects companies to provide payroll tax deposits at the correct time. Missing the window by just a day starts a financial penalty that begins at 2% but quickly grows to 15%.
A pattern of late deposits also suggests the company is having cash flow problems, which could make the IRS take a closer look at the payroll process.
3. Worker Misclassification
The IRS may take an interest in how contractors you hire operate. If you employ contractors with the following attributes, it could draw IRS attention:
- They work for set hours
- They use company equipment
- They report to an internal manager
Such work circumstances could mean that the IRS considers the worker an employee rather than an independent contractor. For the IRS, this is an important distinction because the tax implications are different.
4. Fringe benefit imputation gaps
Some perks count as taxable income even when no cash changes hands. For example, things like the following are taxable and need a dollar value added to the worker’s W-2. :
- A company car used for personal trips
- Life insurance coverage over $50,000
- Employer-paid housing
When the IRS cross-checks benefit records against wage reports and finds the value missing, the gap is easy to spot.
5. Accountable plan errors
Reimbursements are only tax-free under an accountable plan. This means that when employees submit receipts as evidence, the expense needs to have a clear link to the business.
Without clear documentation, these expenses can turn into taxable income as far as the IRS is concerned.
6. Incorrect Taxpayer Identification Numbers
When an employer files a 1099 for a contractor, the IRS matches the name and Taxpayer Identification Number against its own records. When they don’t line up, the IRS will generate a CP-2100 notice.
If the same vendor fails to provide accurate information twice in the same 3-year window, the employer has to start withholding 24% on future payments. Avoid the inconvenience by running the match first.
7. ACA 1095-C Inconsistencies
Employers with 50 or more full-time staff have to file Form 1095-C. The form reports what health coverage they offer each month. The codes on the form need to match what was actually offered.
Mismatches trigger Letter 226-J, which proposes penalties two to three years after the filing.
8. Third-party Sick Pay Reporting Lapses
When a disability insurer pays sick benefits to a worker, both the insurer and the employer have a responsibility to report it.
What often happens is that each side assumes the other is dealing with it, and the W-2 ends up wrong. A written agreement spelling out who reports what, plus a quarterly check-in with the insurer, prevents this oversight.
9. Tip Reporting Issues
Workers receiving tips have a financial obligation to report what they receive. Employers may also have to file Form 8027 every year, providing a summary of tip activity.
One of the fastest ways to trigger IRS interest is when tips received via credit card are much higher than the reported cash tips. This suggests cash tips are being pocketed off the books.
10. Equity Compensation Mistakes
Equity compensation adds real complexity to payroll. It’s important to report them correctly and at the right time. Miss the timing or skip the tax event entirely, and the employee gets a wrong W-2 that shows up as an error on their personal return.
11. Backup Withholding Failures
If your company receives a B-notice, it means the IRS is informing you that a contractor’s taxpayer ID doesn’t match its records. After two B notices in three years from the same vendor, the employer needs to start withholding 24% from that vendor’s payments.
Companies that don’t withhold this percentage could be held responsible for paying the taxes that should have been collected themselves.
12. ERC Documentation Gaps
During the COVID-19 pandemic, measures like the Employee Retention Credit were introduced to relieve the financial burden on struggling companies.
Companies that made questionable claims back then are discovering years later that the IRS is still working its way through their COVID-era audit lists.
13. Unusually high 1099 ratios
If most companies in your industry pay people through W-2 wages and your company runs mostly on 1099 contractors, it might trigger IRS attention. A sudden switch from W-2 to 1099 reporting without an obvious business reason draws even more attention.
Next steps
Providing you’re not deliberately trying to defraud them, your company will only draw the IRS’s attention if you make mistakes with reporting or filing. It’s important for HR departments to have robust accounting measures and systems to check and validate financial reporting.
That way, any mismatches will come to light before any information is passed on to the IRS. If a notice does arrive in the mail, it helps to enlist accounting professionals to clear up the matter and to avoid further escalation.
If you’re interested in learning more about accounting and finances, see our further blog posts.
Guest writer
