Federal and state governments have developed the Unemployment Insurance Program, which provides unemployment benefits to certain workers who are not working through no fault of their own and meet certain eligibility requirements as established by state laws. Unemployment insurance benefits provide temporary financial relief to employees who are no longer working but are actively searching for employment. Each state is given the right to administer an unemployment insurance program within the guidelines established by the federal government; the programs are funded by the unemployment insurance tax that is generally imposed on employers.
In New York State, the Unemployment Insurance Program is administered by the Department of Labor (DOL), and the unemployment insurance tax (UIT) is paid by all employers, including government entities, partnerships, corporations, sole proprietors, and household employers. The UIT due for each employee is computed by multiplying the lesser of total wages or remuneration paid to the employee or the 2017 maximum taxable threshold of $10,900 by the unemployment insurance contribution rate, which ranges from 1.3% to 9.1% based on the employer’s individual experience in the unemployment insurance system. The maximum taxable threshold increases from year to year. The UIT is paid to the DOL, which invests the taxes it receives in the unemployment insurance fund. This fund is used to pay all valid unemployment claims that are made to the DOL by eligible individuals.
In addition to collecting, investing, and paying unemployment insurance, the DOL is also responsible for UIT audits to validate that each employer or taxpayer is properly reporting and paying the UIT. UIT audits generally begin in the same manner as all other tax audits: a notice is mailed to the employer indicating that it has been selected for an examination of its books and records and includes the date, time, and place the auditor has selected to review the records at the taxpayer’s premises. The notice also contains a list of information to be provided for the selected audit period. The taxpayer is also provided with a power of attorney form, which can be used to authorize a third party to represent it in the examination.
The DOL often chooses employers to audit randomly, including selection by zip code. Some of the more specific reasons include—
- prior audit history that results in changes;
- an individual classified as an independent contractor filing an unemployment claim;
- unfiled unemployment insurance tax returns; or
- a person notifying the DOL anonymously of a taxpayer’s potentially inappropriate activity.
Prior to the appointment date, an auditor will often conduct an unexpected field visit to the taxpayer’s location to obtain a better understanding of the business and to speak with individuals at the premises.
Generally, UIT audits cover a three-year period, and a standard list of documents, books, and records is requested by the auditor for review. Depending on the industry and each taxpayer’s particular activities, not all documents may be necessary, available, or required. The auditor’s focus is generally on three main categories: 1) wages paid to employees, 2) payments made to individuals recorded in the general ledger that are not reported on a Form W-2 or Form 1099-MISC, and 3) payments to individuals claimed to be independent contractors.
Wages paid to employees are reviewed to ensure that all payroll reports, income tax returns, and payroll tax returns materially reconcile. In many cases, the auditor will also select a period and an individual to trace remuneration to payments made per the disbursement journal, bank statements, or other payment logs. Other times, the auditor will review the taxpayer’s industry and, based on industry standards, determine whether a discretionary remuneration has been added to each employee’s total wages, which can affect the amount subject to UIT. Certain industries in which discretionary remuneration can be added to the employee’s base salary include barber-shops, beauty parlors, and restaurants. A discretionary amount that is added to the salary reflected on the Forms W-2 of employees in these industries can be computed with a tip percentage or an employee meal percentage.
Many times, taxpayers hire individuals for short-term, infrequent services and do not include these individuals as employees (W-2) or independent contractors (1099-MISC). In these situations, the auditor will request more information on the services these individuals provide and, based on the description, determine whether the individual should or should not be treated as an employee subject to UIT.
Last, and probably most important, the auditor reviews payments made to independent contractors per Forms 1096-MISC and 1099-MISC. Forms 1099-MISC are reviewed to ensure that they reconcile to Form 1096-MISC, the income tax return, and the general ledger. The auditor will also review the independent contractor agreements with, invoices from, and liability insurance certificates provided by these individuals, as well as descriptions of the services they provide and whether such services are on an exclusive basis. Furthermore, the auditor will select an individual for one of the periods and conduct a trace of the reported amount paid to the payments made per the disbursement journal, bank statements, or other payment logs. Based on the review of these documents and the taxpayer’s relationship with the individual, the auditor will determine if any of the independent contractors should be reclassified as employees and therefore subject to the payment of UIT on their behalf.
It has been the authors’ experience that the main focus during UIT audits is on the classification of independent contractors. The level of supervision, direction, and control the employer retains will dictate whether an individual the employer claims is an independent contractor must be classified as an employee. Some of the factors that are used to determine whether an individual is an employee in this context include, but are not limited to—
- employer chooses when, where and how services are performed;
- employer provides the tools, equipment, supplies, and work space to perform the services;
- employer directly supervises the services;
- employer sets the hours of work;
- employer requires the individual to work exclusively for the company;
- employer pays a set rate of pay; and
- employer evaluates the job performance and has the right to hire and fire the individual.
Many times, the DOL will schedule an informal conference to try to resolve the matter.
Independent contractors must generally be free of supervision, direction, and control of the taxpayer. Many of the factors that substantiate independence from the taxpayer include offering services to the general public without restrictions by the taxpayer; having an established business; advertising services via the Internet or print; having business cards and company letterheads; maintaining one’s own insurance; utilizing one’s own facilities, equipment, and supplies; paying one’s own expenses; setting one’s own schedule; having the freedom to refuse work; and hiring other individuals to perform services in one’s absence or to assist.
After the Audit
Once the UIT audit is complete, the auditor will provide the results to the taxpayer. If there are no changes, the audit case will be automatically closed. If there is a tax due as reflected in an assessment and the taxpayer is in agreement, the assessed amount must be paid. If there is a tax due and the taxpayer is not in agreement, the taxpayer has the option of requesting a hearing before an administrative law judge within 30 days of receiving the assessment from the DOL. The request should clearly provide the relevant facts and other supporting information and the reasons why the taxpayer does not agree with the determination. Many times, depending on the reason for the hearing request, the DOL will schedule an informal conference to try to resolve the matter. If the matter cannot be resolved during the informal conference, a formal hearing is conducted before an administrative law judge.
It is important for CPAs to understand the full UIT audit process when assisting clients (or undergoing one themselves). UIT auditors are reviewed based on how many cases they review and close. The result is a quick turnover of UIT audit cases, unless a complicated matter arises during the examination that requires additional time to gather or provide documentation. Therefore, like all other types of audits, the key to a successful process is quickly providing all the requested information in a timely manner, working with the auditor in responding to questions, and, where possible, maintaining open, amicable communications with the auditor.