The IRS estimates that $54 billion of tax revenues are lost annually relating to noncompliance of employment taxes. What is being done to collect this money? The IRS has entered into agreements with 29 state agencies to share the results of employment tax examinations and has begun to randomly select employers for Form 941 audit exams.
Employers are aware that if an individual is treated as an employee, the employer is required to withhold and contribute a matching amount of FICA and Medicare taxes from the employee’s income. If the worker is classified as an independent contractor, the employer pays no payroll taxes, is only required to report payments of $600 or more on a Form 1099-MISC, and need not pay workers compensation insurance premiums or the employer share of unemployment taxes. Employers also believe it is easier to terminate a working relationship with a contractor versus firing an employee.
Some employers erroneously believe that they have the sole discretion of determining whether a person hired is an employee or an independent contractor. Unfortunately, there is not a single, definitive test for classifying workers as either employees or independent contractors. The existing worker classification rules are complex and ambiguous, creating uncertainty in their interpretation and application for many employers. Accordingly, it is beyond the scope of this blog to discuss the various tests that are used to make such a determination. Generally, if the worker makes a substantial financial investments in tools, equipment, or a place to work, or undertakes some entrepreneurial risks, they are probably independent contractors. However, when the employer controls and directs the workers who perform services as to the end result and how it will be accomplished, it is likely an employer-employee relationship.
If your independent contractors are found to be employees, failing to withhold income and employment taxes from their wages can result in severe penalties and interest, in addition to the back taxes owed. If the IRS finds that there were intentional worker misclassifications, the penalties are more severe. Worker misclassification can also adversely affect benefit and retirement plans. Since these employees have been excluded from plan participation, the employer’s retirement plan could lose its tax-favored status. The problem is compounded when excluded employees seek restitution for lost benefits not only due to their exclusion from the benefit plan, but also for health coverage and other employee benefits.
When employment tax audits are performed, the auditor will ask whether contractors are used and will immediately test to see if the worker was properly classified. The state auditor will often ask for a copy of the consulting agreement with the contractor, to review invoicing for services rendered by the contractor (to examine the contractor’s letterhead), copy of the contract to see what services were to be provided and how such services were to be provided, request a copy of the contractor’s business card, review telephone yellow pages or Internet listings to see if the contractor is advertising his services, attempt to interview the contractor (to determine if the contractor feels that he is an employee and to ascertain how much control the employer has over the worker), and ask the employer for a listing of other clients that the contractor works for (the thinking here is that if the contractor only works for one company, the likelihood is greater that the contractor is an employee).
When services are terminated or the contractor is hurt on the job, we have seen individuals who have worked as an independent contractor file for unemployment or workers compensation stating that while the employer paid them as an independent contractor, they were really an employee. The state then becomes an advocate for the person filing the claim and the employer may find themselves owing several years of back taxes, penalties and interest even though they paid the person a premium “wage” rate because they had to pay their own self-employment taxes and health benefits.
A prudent business person often finds it necessary to consult with a competent advisor to determine if the person hired is an employee or an independent contractor. If the person is hired as a contractor, it is good business practice for the employer to request the completion of Form W-9 before services are performed.
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