There are many reasons employers don’t withhold or pay employment taxes.  For some, it may be an attempt to use the government as a bank to “borrow" the money for a short while with good intentions to pay it back later.  For others, it may be a situation where an employer collects the taxes and elects to keep the money during a period of financial difficulty rather than pay it to the IRS.  For a small number, it involves philosophical differences with the tax law of the United States that courts consistently reject. Regardless of the reason, federal law requires employment tax withholding and payment by employers.

Employment taxes consist of federal income tax withholding along with Social Security and Medicare taxes and unemployment taxes.  Also, many states have withholding for various employment-related taxes, such as contributions to a worker’s compensation fund.  Improper reporting or payment of employment taxes affects the ease with which employees can claim future benefits from these programs.

The IRS takes a variety of steps to combat employment tax non-compliance.  The agency has a number of civil actions it can take like audits and filing liens against property the taxpayer owns.  In addition to civil actions, IRS Criminal Investigation investigates and refers for prosecution individuals and businesses that have willfully attempted to avoid filing and paying employment taxes. These efforts have led to significant criminal convictions resulting in incarceration and fines.

The IRS urges all businesses to resist the temptation to become involved in or victimized by unlawful activities.  The eight most common types of employment tax noncompliance include:

1. Pyramiding.  “Pyramiding” of employment taxes is a fraudulent practice where a business withholds taxes from its employees but intentionally fails to remit them to the IRS. Often, the cause is a lack of profit or capital for operating costs, so the business owner uses the trust funds to pay other liabilities. The quarterly employment tax liabilities accumulate until the employer has little hope of catching up. A business involved in pyramiding either shuts down or files bankruptcy and then starts a new business under different name, starting the cycle all over again.

2. Unreliable Third Party Payers. There are two primary categories of third party payers: Payroll Service Providers and Professional Employer Organizations. Payroll Service Providers typically perform services for employers such as filing employment tax returns and making employment tax payments. Professional Employer Organizations offer employee leasing.  That is, they handle administrative, personnel, and payroll accounting functions for employees who have been leased to other companies that use their services. Many of these companies provide outstanding services to employers. Unfortunately, in some instances, companies of both types of services have failed to pay the collected employment taxes to the IRS. When these employment services companies dissolve, millions in employment taxes can be left unpaid. Employers are urged to exercise due diligence in selecting and monitoring a third party payer. For example, when choosing a third party payer, employers should look for one that is reputable and uses the Electronic Federal Tax Payment System. This allows the business owners to verify payments made on their behalf. Also, an employer should never allow their address of record with the IRS to be changed to that of the third party payer.

3. Frivolous Arguments. Unscrupulous individuals and promoters have used a variety of false or misleading arguments for not paying employment taxes. These schemes are based on an incorrect interpretation of the tax law. One variation of this scheme involves the improper use of Form 941c, "Supporting Statement to Correct Information on Form 941," to attempt to get a refund of previously paid employment taxes.

4. Offshore Employee Leasing. This scheme, which was designated as a “Listed Transaction” by the Service misuses the otherwise legal business practices of employee leasing. Under the typical promotion, an individual taxpayer supposedly resigns from his or her current employer or Professional Corporation and signs an employment contract with an offshore employee leasing company. The offshore company indirectly leases the individual’s services back to the original employer using a domestic leasing company as an intermediary. After entering into the leasing arrangement, the individual performs the same services as previously. While the total amount paid for the individuals’ services stays the same or increases, most of the funds are sent offshore as “deferred” compensation. The “deferred” compensation is then paid to the individual as a loan or ends up in an account under the individual’s control.

5. Misclassifying Worker Status: Sometimes employers incorrectly treat employees as independent contractors to avoid paying employment taxes. Generally if the payer has the right to control what work will be done and how it will be done, the worker is an employee.  Employers who misclassify employees as independent contractors will be liable for the employment taxes on wages paid to the misclassified worker and subject to penalties.

6. Paying Employees in Cash: Paying employees in whole or partially in cash is a common method of evading income and employment taxes. There is nothing wrong with compensating an employee in cash, but employment taxes are owed regardless of how employees are paid. And the IRS will build its case using all available information even if there are no payroll records or checks.

7. Filing False Payroll Tax Returns or Failing to File Payroll Tax Returns: Preparing false payroll tax returns, intentionally understating the amount of wages on which taxes are owed or failing to file employment tax returns are methods commonly used to evade employment taxes.

8. S Corporation Officers Compensation Treated as Corporate Distributions: In an effort to avoid employment taxes, some S Corporations are improperly treating officers’ compensation as a corporate distribution instead of wages or salary. By law, officers are employees of the corporation for employment tax purposes and compensation they receive for their services is subject to employment taxes.

The IRS encourages employees to report any concerns that an employer is failing to properly withhold any pay federal income and employment taxes.