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In a recent audit, Maryland found itself owing the IRS a hefty $5.4 million, a significant sum resulting from complex payroll and withholding issues that the state had previously overlooked. The audit, which reviewed the 2020 tax year, flagged discrepancies in withholding practices, over-contributions to deferred compensation plans, and backup withholding for vendors. Though Maryland worked to reduce the initial liability from over $16 million, the experience highlights key compliance concerns that business owners—big or small—should understand to avoid similar pitfalls.
Why Maryland Owed Millions: Key Issues Identified in the Audit
The IRS audit of Maryland identified three major compliance issues:
- Failure to Properly Withhold Employment Taxes
Nine Maryland state agencies fell short in withholding the appropriate employment taxes for certain employees. This kind of oversight can quickly add up, as failing to withhold the correct amount exposes organizations to significant liability, including back taxes and potential penalties. - Excess Contributions to Deferred Compensation Plans
Some employees contributed more than the legal limits to their deferred compensation plans, such as 401(k)s. For the 2020 tax year, employees could contribute a maximum of $19,500, and any excess was subject to additional taxes. Businesses, too, need to monitor employee contributions closely to avoid these overages, as they can have serious tax implications for both employers and employees. - Backup Withholding Issues
Maryland struggled to prove that backup withholding had been properly applied to certain vendors. Backup withholding requires that businesses withhold a percentage (typically 24%) from payments to contractors who fail to provide accurate tax identification numbers or correct mismatches. While the process might seem cumbersome, failing to adhere to it places the burden of unpaid taxes on the payer—underscoring why due diligence in record-keeping is vital.
Lessons for Business Owners: Payroll and Withholding Compliance Essentials
For businesses, the Maryland audit serves as a reminder of the complexities involved in payroll and withholding tax compliance. Here are some takeaways and best practices that every business owner should keep in mind:
- Stay Vigilant with Payroll Tax Compliance
Properly withholding employment taxes for employees is essential. The IRS has strict requirements for Social Security, Medicare, and federal income tax withholding, and inaccuracies can result in unexpected liabilities. Regular audits, periodic reviews, and leveraging payroll software can help minimize errors. - Keep an Eye on Deferred Compensation Limits
Businesses offering deferred compensation plans, such as 401(k)s, should ensure employees do not exceed annual contribution limits. Over-contributions lead to tax complications for both the employer and the employee. Setting up automated checks within payroll systems can alert businesses when employees approach their limits. - Understand Backup Withholding Requirements
Backup withholding applies when a contractor fails to provide a correct taxpayer identification number. To comply, businesses must verify contractor information, resolve mismatches quickly, and initiate withholding if issues aren’t corrected. This process helps avoid IRS penalties and protects businesses from assuming tax liability for their contractors. - Establish Strong Internal Controls and Regular Training
Maryland’s experience underlines the importance of internal controls and training for personnel involved in payroll and tax administration. Business owners should consider providing regular training on tax withholding requirements and compliance best practices. This could include updates on new tax laws, system changes, and employee responsibilities related to payroll management. - Consider Outsourcing or Consulting with Tax Professionals
Given the complexity of tax compliance, many businesses can benefit from professional payroll or tax services. While it may seem like an added expense, partnering with experts can help ensure accurate filings, correct withholding, and up-to-date practices—sparing businesses from costly errors and audits down the line.
Final Thoughts: A Proactive Approach to Tax Compliance
Maryland’s audit experience serves as a cautionary tale for business owners across the country. Compliance with payroll and withholding rules is not just a formality—it’s a critical aspect of financial stewardship. As regulations evolve, businesses must remain proactive by implementing robust systems, ensuring thorough training, and seeking guidance when needed. Taking these steps can help companies avoid the costly consequences Maryland faced and maintain a clean slate with the IRS.
For any business, large or small, a solid commitment to compliance is key to sustainable growth. A proactive approach to tax management not only minimizes risk but also builds trust with employees, vendors, and the IRS—a win-win for any organization aiming to succeed.
