The IRS’s first attempts to rein in abuse by “ghost employers” — those who pay their workers but do not pay employment tax and federal payroll income tax withholding — had some success, and the Service should ramp up its pursuit, the Treasury Inspector General for Tax Administration (TIGTA) said in a recent report. TIGTA says the IRS has difficulty spotting ghost employers because it will have no record of them if they never file returns.

“Ghost Employers present a significant vulnerability to tax administration, as their scheme cannot be detected by existing IRS enforcement streams,” TIGTA said in its report, Criminal Investigation Had Success With Ghost Employers, While Civil Enforcement Efforts Can Be Improved (TIGTA Rep’t No. 2024-300-019 (April 12, 2024)). “Accordingly, it is important for the IRS to assess the risk that Ghost Employers pose to tax administration.”

While employment tax fraud takes several forms, including paying workers in cash to avoid a paper trail of payments, the most egregious ghost employers withhold taxes from employees but do not file employment tax returns and do not make federal tax deposits, the report said.

These unpaid taxes potentially have a big impact on the tax gap, the difference between taxes owed and taxes paid. Taxes paid by employers accounted for about 65% of total tax receipts in 2022, so when they “ghost” employees and Treasury, their actions can have a big impact on the federal government’s bottom line, the report said. Of the total 2022 tax receipts of $4.9 trillion, employment taxes and federal payroll income tax withholding were $3.18 trillion, the report said.

The IRS’s first coordinated and systemic approach to tracking down ghost employers started in November 2017 when the IRS Criminal Investigation (CI) unit began trying to match Forms W-2, Wage and Tax Statement, attached to Forms 1040, U.S. Individual Income Tax Return, with the IRS’s payroll tax Forms 941 database to verify whether the corresponding payroll taxes had been filed and paid.

The outcome: 33 people were prosecuted for employment tax fraud, resulting in about $43.6 million in total restitution. Another 136 cases remained active as of May 2023, the report said, pointing out that “the workload and labor time needed to develop these cases are significant.”

The IRS’s civil enforcement effort, which it calls the Ghost Employer Project, was less successful, TIGTA said. As part of its audit, TIGTA requested a status update on 280 cases that had been selected randomly to be reviewed by the Small Business/Self-Employed Division field collection and examination functions.

TIGTA received a spreadsheet that had limited information pertaining to only 178 cases and confirmed that this was the only supporting documentation available.

“Based on our review of the project, we found only seven cases involving potential ghost employers,” the report said. “While several cases are still being worked, including eight by CI, we believe that the Ghost Employer Project resulted in limited success in identifying significant noncompliance activity by ghost employers.”

The Ghost Employer Project faced problems caused by the COVID-19 pandemic and ended in May 2022, even though many cases were still being worked, TIGTA said. It urged the IRS to continue to pursue civil penalties against ghost employers.

“One of the key indicators of fraud that the courts focus on is the failure to file returns,” TIGTA wrote. “For ghost employer cases, the consistent development and proper application of civil fraud penalties will help reduce this activity by imposing tangible economic consequences on taxpayers that engage in those transactions.”

TIGTA made four recommendations: refinements to filters to improve the identification of ghost employers; improved tracking of enforcement actions; addressing recommendations from the Ghost Employer Project team; and reminding collection employees to refer ghost employer cases to examination for potential assessment of civil fraud penalties.

The IRS agreed with all four recommendations.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.