In today's dynamic business environment, organizations are increasingly leveraging HR-led solutions and third-party vendors to streamline benefits, payroll, and compensation management. While these solutions promise efficiency gains, they often mask hidden tax liabilities that can’t be outsourced. These liabilities can trigger costly audits, penalties, and remediation expenses. See our Full Guide for more insights on managing financial compliance.

This article sheds light on the common pressure points where HR solutions can inadvertently create tax problems and offers practical strategies for mitigating risk through improved cross-functional coordination.

The Complex Intersection of HR and Tax Compliance

The legal framework governing employee benefits and payroll sits at the nexus of tax law, employee benefits regulations, executive compensation rules, and corporate governance principles. Plan sponsors must continually assess:

  • Legal Requirements: What does the law mandate?
  • Legal Permissibility: What actions are legally permissible?
  • Plan Requirements: What stipulations are outlined in the plan documents?
  • Plan Allowances: What actions are permitted under the plan's provisions?

As benefit administration becomes more complex and companies outsource core HR functions, gaps in processes, plan compliance, and interdepartmental communication frequently emerge. These gaps are often exposed through IRS or state audits, attest findings, penalty notices, internal self-audits, or during mergers and acquisitions (M&A) due diligence. Early, structured collaboration between HR and tax departments is becoming essential to avoid costly errors.

Common Pitfalls and Tax Traps in Employee Benefits

Several specific areas within employee benefits administration are particularly prone to generating tax liabilities:

  1. Affordable Care Act (ACA) Information Reporting: ACA information reporting remains a high-penalty exposure area. Failure to file IRS Form 1095-B with the IRS or furnish IRS Form 1095-C to employees can generate penalties under Code §6721 and §6722. Penalties for late or missed filings escalate quickly.

  2. Cafeteria Plan Administration Errors: Operational errors in cafeteria plan administration can have a significant impact. Allowing mid-year election changes that do not qualify as legitimate life events, are inconsistent with plan terms, or violate consistency rules can jeopardize the plan’s qualified status. Separately, failure to perform required non-discrimination testing for key cafeteria plan benefits—such as group-term life insurance, self-insured medical reimbursement plans, dependent care assistance programs, and adoption assistance—can result in taxable benefits to highly compensated employees.

  3. Unreported Non-Cash Fringe Benefits: Unreported non-cash fringe benefits, including unrestricted company car usage for top executives and certain wellness benefits provided only to some employees, often necessitate Form W-2 corrections and penalties for employers, as well as amended income tax returns for employees.

  4. Payroll Tax Deposit Failures: Payroll tax deposit failures under Code §6656 remain a pervasive risk. Penalties range from 2% to 15% based on the degree of lateness. A common pitfall arises when employees exercise nonqualified stock options without the company's payroll provider receiving timely notice, causing late or insufficient deposits.

  5. Employee Retention Tax Credit (ERTC) Claims: The Employee Retention Tax Credit (ERTC) positions remain under intense scrutiny. The credit amounts drove a wave of aggressive filings, prompting the IRS to include ERTC on its “Dirty Dozen” list. Legislative activity would disallow late-filed claims after Jan. 31, 2024, and extend the IRS assessment period. The One Big, Beautiful Bill Act (OBBBA) introduced new enforcement provisions affecting the ERTC, which could impact the timing and validity of claims.

  6. Professional Employer Organizations (PEOs): Outsourcing payroll and benefits to Professional Employer Organizations introduces distinct risk profiles. A non-certified PEO remains the employer of record for certain administrative purposes, but the client company typically retains ultimate liability for employment tax deposits if the PEO fails to remit. By contrast, certified PEOs are IRS-certified.

Strategies for Effortless Compliance

To proactively manage these risks and ensure effortless compliance, consider the following strategies:

  • Foster Cross-Functional Collaboration: Break down silos between HR, payroll, tax, and legal departments. Establish regular communication channels and joint planning sessions to identify potential tax implications early in the decision-making process.

  • Conduct Regular Internal Audits: Implement a robust internal audit program to identify and correct errors proactively. Focus on high-risk areas such as ACA reporting, cafeteria plan administration, and fringe benefit reporting.

  • Standardize Processes and Documentation: Develop clear, documented procedures for all aspects of benefits administration, including eligibility determination, enrollment, election changes, and reporting. Ensure all employees involved in benefits administration are properly trained on these procedures.

  • Leverage Technology and Automation: Implement technology solutions that automate benefits administration processes, improve data accuracy, and provide real-time visibility into potential compliance issues. Consider AI-powered solutions that can identify anomalies and flag potential errors.

  • Seek Expert Advice: Engage with qualified tax professionals and benefits consultants to review your benefits programs and identify potential compliance gaps. Stay informed about changes in tax laws and regulations that could impact your benefits programs.

  • Due Diligence in Vendor Selection: When outsourcing HR functions, perform thorough due diligence on potential vendors. Assess their compliance expertise, security protocols, and track record for accuracy and timeliness.

The Future of Taxable Employee Benefits Compliance

The landscape of employee benefits is continuously evolving, driven by changes in regulations, technology, and workforce demographics. To stay ahead of the curve, organizations must embrace a proactive approach to compliance. By fostering cross-functional collaboration, implementing robust internal controls, and leveraging technology, companies can minimize their risk of tax liabilities and ensure effortless compliance with all applicable laws and regulations. This, in turn, will free up resources to focus on strategic initiatives that drive business growth and employee engagement.